Alternative Asset Opportunities, asset allocation, catalyst, correlation, dividend tax treatment, Event Driven, Expected Value, fighting the Fed, Investegate, IRR, Liquidations, Margin of Safety, offer premium, portfolio allocation, QE, Recommended Cash Offer, Risk Arbitrage, risk-on risk-off, takeover offers, Takeover Panel, VIX, volatility, wind-down
My 10-part series on catalysts last year (stretching from Jan to Dec!) was well received, judging by the readership & links. I vaguely promised a summary to wrap up the series – as we’re well into the new year (already?!), it now seems appropriate to deliver that post (& hopefully it proves useful).
By the end of last summer, I concluded there’s little point fighting the Fed… A fortunate decision, as the market’s been decidedly risk-on since then! Though I must say, the power of central bank liquidity still surprises me. If you recall, last summer, we appeared to face a pretty bleak outlook both sides of the Atlantic: The fiscal cliff in the US & the sovereign debt crisis in Europe. [Hmmph, different stories...same destination!] Personally, I considered the cliff to be just like those periodic kerfuffles over the US debt ceiling – no genuine threat, but divisive political rhetoric could certainly roil the markets (& perhaps prompt a rating-agency response). On the other hand, the European crisis…er, what happened, where the hell did that go..?!
This risk-on attitude’s left my portfolio light on investments with shorter-term/lower-risk catalysts (i.e. event-driven investments). However, I still strive to pick new investments which (ideally) possess at least one longer-term/higher-risk catalyst. That type of catalyst doesn’t necessarily mean you avoid downside risk, but hopefully it stacks the deck in your favour vs. what the average value investment (complete with margin of safety) might offer. It may also accelerate the time-line for a stock’s realization of its intrinsic value/upside potential. Anyway, much of my event-driven exposure was ultimately re-invested in Alternative Asset Opportunities (TLI:LN) – so I simply exchanged a low return/relatively uncorrelated risk for a cheap/high return/totally uncorrelated risk! Go on, you might want to give it a try..!
But we all know where this easy-money complacency & confidence can lead, in the end… But how do you protect yourself against potential market volatility & losses? I’m not a big fan of surplus cash in my portfolio, but there’s an obvious alternative – lower-risk event-driven/catalyst investments are an immensely useful allocation within your portfolio. [Investments which benefit from volatility are useful too, an area I'm beginning to explore in much greater depth. Please email me at email@example.com if you have any interesting volatility ideas/thoughts you'd like to share & discuss. But note, in my opinion, 100% of VIX ETPs are probably worthless as longer term investments (due to the usual VIX futures curve), so viable alternatives are required].
We may not be there yet (yes, we all want to ride the wave..!), but the time is coming when an array of catalyst investments will offer better protection for your portfolio (and allow you to sleep at night). [Lord knows if any of us will get that timing right, though!?] However, this year may prove crucial... The market tends to look ahead about 18 mths, so 2015 is going to be right on the horizon later this year. And that’s when the Fed’s promised to end this bloody quantitative easing experiment, all with zero negative economic impact and (still) no sign of higher inflation…
Yeah, the probable absurdity of that statement should serve as ample warning for a possibly fearful lurch lower in the market, at some point. The VIX is also worth watching – it almost hit 12 the other day! Now, that isn’t cause for immediate concern – if you look at the longer-term chart, on occasion the VIX has bottom bumped for a year or more at a time – but it does inevitably lead to vicious market volatility…
So, let’s revisit catalysts:
A catalyst is any kind of transaction/fact/event/etc., actual or potential, that offers the opportunity for a full/partial realization of value in a stock, within a (reasonably) accelerated timescale.
Think in terms of Internal Rate of Return (IRR). Say you find a great value investment, which you think has a nice margin of safety & perhaps an upside of 75%. But how long will it take to realize - 3 yrs, 5 yrs, 7 yrs?! That equates to an IRR of 20.5%, 11.8% & 8.3% pa, respectively. Now assume a catalyst exists that helps to realize the full upside potential within a year – that’s a bloody 75% IRR instead! Wow! Or let’s picture you’ve 20 stocks to choose from: A catalyst may simply be the deciding factor in making a stock choice, or (if you want to be more precise) it can be a marvelous stock selector in terms of respective (potential) IRRS. It may even enhance your margin of safety.
To complicate things, you can combine this with an Expected Value (EV) approach. A catalyst might persuade you to attach higher probabilities to certain scenario(s), thereby increasing the EV of your investment return. For example, I was invested in a particular Risk Arbitrage investment – a Recommended Cash Offer. In this instance, rather bizarrely, the share price vs. the offer price still offered a Gross Return of 16.3%. Considering all aspects of the deal, I attached probabilities of 96% to the Offer going through & 4% to a deal failure. I estimated failure would lead to a 30% loss, so the EV of the Gross Return was actually 14.5%.
Let’s work our way through the different catalysts:
i) Liquidations are top of the heap! They’re usually announced only after a company’s sold most/all of its assets/business. They offer a highly certain final asset value/return, and are usually concluded within 6 months to 2 years. (Prudent) management will be as conservative as possible, at this point, so any surprises will hopefully be positive. In aggregate, this means liquidations have v attractive IRRs & EVs! However, their gross return will be low, they can be difficult to buy, and they often delist – so you need to be aggressive & committed with your position.
I usually see news of liquidations during my daily market review. Plug in ‘liquidate’, ‘liquidation’ & related phrases as a keyword/free text search on Investegate or the RNS section of the LSE website – it should generate a list of relevant announcements & an occasional gem. A couple of the liquidations I highlighted here are still ongoing.
ii) Wind-downs are an extended form of liquidation, usually where the company still has most/all of its assets/business to sell – sometimes they precede a liquidation. They can take 1 to 3 years, there’s usually no clear distribution time-line, and asset values may change significantly in the interim (almost inevitably lower, not higher!?). Management can still be over optimistic when a wind-down’s announced, so you may need/want to factor in an appropriate haircut to asset values. The presence of debt will, of course, exacerbate the impact of any significant change in asset values.
One issue that may arise with wind-downs (not liquidations): Be v clear on the exact characterization of distributions. Don’t be fooled by the words dividend, distribution, or even special dividend – what you want to see is ‘capital return’ or ‘return of capital’. The former may be subject to Income Tax, while the latter are more probably liable to Capital Gains Tax. The last you want is to invest your capital in a wind-down & then see it returned as taxable income!
Here’s almost a dozen wind-downs to consider – be sure to diversify!
iii) Takeover Offers are a catalyst with a much shorter duration, usually 2 to 8 months. In terms of risk, they probably fall somewhere between liquidations & wind-downs: Your Gross Return is reasonably well-defined, but price volatility & the chances of failure are higher.
Obviously, rumours of a takeover are not a catalyst! Bid rumours are dime a dozen, but there are always fresh mugs who fall for them. The bump in the share price, vs. the odds of a bid materializing (say, at a 35% premium), means chasing these stocks is a losing proposition on an EV basis. Viable Risk Arb usually first presents itself when a company announces (perhaps in response to ‘media speculation’ or a ‘share price movement’) it’s received a preliminary approach. Let’s rank takeover situations in terms of decreasing risk:
- Board’s in discussion with an undisclosed third party
- Board’s in discussion regarding a possible management buyout
- Board’s in discussion with a number of undisclosed third parties
- The potential acquirer(s) identity is announced by the board, or acquirer(s)
- A potential offer price is announced, by the board or acquirer. Confirmation it’s a share offer, or even better a cash offer, helps
- A potential offer/price is announced by another acquirer
- A recommended share offer’s announced by the board
- A recommended cash offer’s announced by the board
- A recommended offer is declared unconditional
Gross return will generally decrease as deal risk declines (but your EV & IRR will likely improve). Offer premiums usually average between 25-45%, and much of the premium can be eliminated even if only potential discussions are announced, so take care. Patience helps – people get bored with slow deal progress, and many stocks subsequently fall back within 10-15% of their pre-announcement price! Of course, risk/reward is v personal – one investor may be happy to clip a 3-5% return from a recommended offer. To another, this is madness – they’d prefer to bet on a preliminary approach announcement, which is riskier but might still offer (say) 15-20% upside.
Share offers can be a tough proposition. Sure, just hedge yourself by shorting the acquirer’s shares – but that isn’t so easy for many private investors, or (smaller) situations. I prefer cash offers anyway, I believe they present lower deal risk. But share offers are occasionally intriguing – if the acquirer looks cheap & interesting (their shares may have dropped on the deal), the takeover might offer an attractive entry point.
Don’t simply focus on the offer price/value either, value investing’s the best way to evaluate takeovers. Do focus on sales (growth), gross/operating margins, debt & cashflows – not earnings ratios – as any corporate acquirer would. Determining your own fair value targets may protect you from investing in over-valued deals (which are more likely to collapse), or alert you to the possibility of higher offer(s).
So, where do you find these situations? Well, if you’re an avid daily reader of finance/investing websites & blogs, you’ll come across them nearly every day. A systematic tracking approach is invaluable both for individual situations, and for developing your Risk Arb experience. Reuters has a good site here (check/change your region), and they/Bloomberg regularly publish arbitrage spread tables.
However, the media & hedge funds will invariably focus on the larger/global deals, so smaller/local situations can offer an investing edge for regular investors. And if you prefer UK/Irish situations, just input ‘Takeover Panel’ as a keyword on Investegate. This will generate daily/weekly UK & Irish Takeover Panel Disclosure Tables – which are a great summary of all current potential & actual offers.
To be continued…