The great investment strategies: special situations

Few strategies cause as much controversy as special situations investing. What does it mean and how can ordinary investors use it to their advantage?

Special situations investing is one of those market strategies that causes huge amounts of controversy, precisely because its definition is very hard to pin down.

A special situation isn’t necessarily about value fundamentals (except when it is) or momentum (unless this forms part of the situation) and applies not only to shares – bonds, property, commodities, all have the potential for a special situation play.

The simplest definition is that special situations are when an investor has identified the potential for a huge change in valuation and is prepared, based on their research, to overload their position to take maximum advantage.  

The catalyst for a special situation may often involve events that cause change or dislocation within the administrative, rather than the business level of a company. For example, litigation costs, a merger situation, spin-offs, shareholder activism, acquisitions, bankruptcy, changes in the capital structure or the effect of share buybacks. The defining feature of all these situations is that the window for investors to act is relatively short before the opportunity to profit disappears.

The father of special situations

The origins of special situations investing lie with the theories first proposed by Maurece Schiller in his 1955 book: Special Situations in Stocks and Bonds. Schiller, not to be confused with the similarly named Robert Shiller, was a near contemporary of Benjamin Graham and, like Graham, experienced the disastrous market conditions of the 1930s in the wake of the Wall Street Crash and subsequent global trade slump.

Unlike Graham, and arguably John Maynard Keynes, Schiller’s reaction to the bear market took a very different turn. Whereas as these other great investors defined and applied a pure value approach to find undeniable bargains, Schiller looked at how investors could profit from the inevitable fallout caused by the economic slump – how the waves of mergers, bankruptcies, share issues, takeovers and recapitalisations could create unique opportunities for price arbitrage.

Schiller’s contribution was to collect all these examples together and create a system for analysis and understanding that ordinary investors could use. He wasn’t shy about saying so either. In his book he writes special situations were “in a sense created by myself.” Who is to say that he is wrong, but arguably his greatest contribution was to label what investors had already done instinctively?

Schiller’s system

Schiller argues that unlike say, value investing, a special situation investor takes a position with a clear idea of how much profit they will make when the position is liquidated. There is no buy and hold and wait for the future in Schiller’s view. This is because investors are focusing on one aspect - a merger arbitrage for example - and look for the profit arising only from that part of the situation.

The rules of fundamental value don’t really apply in the short space of time that usually characterise most administrative corporate actions. In other words, these are often one-time events. Timeliness and a focus on expected profits were Schiller’s main preoccupations.  

Schiller came up with a useful checklist to identify how to manage your expected profits.

1. Is the situation limited to the calculated profit?
2. Does the situation have more than one corporate action which may benefit it?
3. Will the profit be a fixed amount established only at end of the corporate action?
4. Will the profit accumulate progressively as the situation develops?
5. Can you take profits before the end of the situation?
6. Could protracted duration consume the profit, or could this work to your advantage?

If you had to critique Schiller’s approach, you could say it relies heavily on price information being 100% efficient, which would be stretching it a bit given what we now understand about behavioural economics.

Arguably, Schiller also underplays the extent to which special situations need a combination of privileged market access and plentiful capital to work efficiently. It also goes without saying that it is very risky. For instance, it is hard to imagine that many private investors will buy up distressed debt and then using the courts to try and seize assets, as Elliot Management Corporation did with Argentine debt in the 2010s.  

Therefore, it is highly likely that most private investors will attempt to access special situations via a large network of dedicated funds, but even these can come with their own risks.

What to look for in a special situations fund

The enthusiasm for special situations has ebbed and flowed over the past couple of decades. The astonishing success of Fidelity Special Situations under Anthony Bolton spurred many investment funds over past few years to simply rebrand themselves as “special situation”, mainly as a marketing exercise without any qualitative change in their investment approach. The broad nature of what constitutes a “special situation” makes it easier to camouflage what might otherwise be a standard stock-picking or value approach.

Artemis UK Special Situations is another long-established fund. Merely as an example, both funds seem to favour the same set of basic stock-picking principles – out-of-favour companies, or those with large “moats” around their businesses. For example, big outsourcers, sin stocks such as tobacco, or unloved oil and gas shares. These fund examples are illustrative only, and not a recommendation or endorsement. 

When trying to make an informed assessment of a fund like these, an investor needs to ask the following questions:

1. Does the strategy mean concentration of assets?

Pursuing special situations based on value principles will naturally lead to a narrow number of assets being chosen. The potential returns will be higher, but the possibility for long periods of under-performance while the rest of market moves ahead is a significant risk.

2. Are the holdings subject to market rotation?

Special situations funds are as sensitive to overall market trends as anything else. A rotation from growth into value stocks, for instance, will naturally benefit those funds that are heavily invested in low price/earnings (PE), high dividend yield companies.

3. Are holdings acquired in the expectation of future corporate action?

Schiller’s argument that corporate actions are the main drivers of special situations is useful for investors trying to make sense of what a specific fund is trying to achieve. A company that could be paying out special dividends, needs a spin-out, or has a debt restructuring on the cards are all drivers of profit.