A Primer on Special Situations Investing

Summary: At Anchor, we believe the careful selection of special situations can be an effective method of differentiation, diversification, and generating high active share in an equity portfolio. Special Situations include spinoffs, recapitalizations, turnarounds, and restructurings. They might also include companies with a controversy and/or ownership overhang, or stocks with unconventional value metrics. Moreover, we believe special situation investing exploits the skills and value-added capabilities of value-oriented fundamental research analysts.

Because many special situation equities are underfollowed and under owned by institutional and mainstream investors, they present unique opportunities for the enterprising security analyst. At Anchor, we conduct our own research, and strive to maintain the skill sets, talent, and experience to conduct thorough research on companies which are ignored by both active and passive investors. Sourcing and researching these ideas requires a creative and contrarian mindset, a niche network of boutique and referral sources, and, perhaps most importantly, patience (a multi-year holding period).

Because of their vintage as public companies or limited public float, special situations are often excluded from major market and sector indices. They are stocks that ETFs cannot or will not own until a considerable time has passed, making them ripe candidates for inclusion in actively managed portfolios.

One index which tracks a segment of Special Situations, the Bloomberg Spinoff Index, has produced a cumulative return of 191% over the last ten years through December 31, 2014, handily outperforming the 70% return of the S&P 500. (source: Bloomberg)

Recent Anchor Focused Value Special Situations include:

Large Cap: General Motors; a bankruptcy turnaround and recapitalization from the 2008 financial crisis.

Mid Cap: Veritiv Corporation; a newly formed company via merger and spinoff from International Paper.

Small Cap: Marcus and Millichap; a recent vintage IPO with ownership overhang from its founder.

The growing presence of shareholder activists has also catalyzed the public markets and pressured many companies to separate certain segments of their businesses, adding to the investable universe of spinoffs and recapitalizations.

Special Situation investing entails many risks, including permanent loss or impairment of capital. Risk factors typically include higher volatility, higher leverage on the balance sheet, and non-systematic (company-specific) risks that require skillful execution by company management, in a turnaround for example. Access to capital markets is also critical, especially for companies that have ongoing recapitalization efforts and needs.

As compensation for these risks, investors should require a high (if not extraordinarily high) rate of return. Such outsized returns can be a major contributor to index-beating results, especially within a more concentrated portfolio.