Ben Graham: Classes of Special Situations (3 of 3)

This is the last post on the three-part series on timeless writings of Benjamin Graham, the father of value inveting.  On this last part, Ben Graham discusses the various categories of Special Situations  which investors can engage on.

Let us turn now to a condensed description and discussion of the various types of special situations. These could be divided into two main categories: (I) Security exchanges or distributions, (II) Cash pay-outs. Only in a rare case does a special situation, as we use the term, work itself out in a higher market without a cash or security distribution occurring somewhere in the picture. However, a more conventional classification may better serve our present purpose.

Class A. Standard Arbitrages, Based on a Reorganization, Recapitalization, or Merger Plan

In bankruptcy reorganizations, particularly those of railroads, the operation consists of buying old and selling “when-issued” securities. Railroad arbitrage has had a curious history in the past five years. In more than half of the cases the plans have been consummated and the expected profit realized – although almost always after a longer time lag than was originally anticipated. In the remainder the plans have been changed or dropped and the when-issued trades cancelled; or else such cancellation is now expected, chiefly as a result of the Wheeler Bill. Nevertheless, large profits were made by many arbitragers, even in the unsuccessful plans, because the old securities advanced greatly above the price they paid, in spite of the plan’s failure. Thus, what was intended to be an old-fashioned arbitrage turned into a successful bond speculation.

This experience illustrates one pleasing aspect of the special situation operation, which is that if your deal works out pleasing aspect of the special situation operation, which is that if your deal works out you are sure to make a profit, but if it doesn’t, you may still make a profit. The hazards of arbitraging increase as the general market level rises, because your chances of loss in the event of the plan’s failure become correspondingly greater. To this important extent many types of special situation are tied with general market conditions; but it is still true in the average or representative case the result depends upon corporate and not on market price developments.

Arbitrages in industrials generally grow out of mergers or recapitalizations and involve the sale of existing rather than when-issued securities. In the recent Raytheon-Submarine Signal merger, one could buy Submarine Signal and sell Raytheon on announcement at an indicated spread of about 18%. That arbitrage was successfully consummated within sixty days. Similarly¸ when the General Cable Recapitalization Plan announced, one could buy a share of A stock at 52 and sell four shares of common for 5 – a spread of about 13% – with consummation in 45 days. However, such operations have as a pre-requisite the ability to borrow the stock for the duration of the arbitrage. Under present conditions of no margin trading, such borrowing is so difficult as to prevent many (though not all) of these deals.

In the utility field, somewhat similar arbitrages have been available as a result of exchange offers made by holding companies for their preferred stocks. Recent examples are United Corporation and American Superpower.

There are, of course, various hazards involved in all these arbitrages. They include possible rejection by stockholders; possible legal action by minority holders; possible disapproval by the SEC, etc. The experienced operator does not ignore these hazards, but attempts to measure them carefully in the particular circumstances of each case.

It will be noted that the industrial, utility and rail arbitrages fall respectively into three distinct classes with regard to the time element. One might almost say that the first is usually a matter of weeks, the second of months, and the third of years.

An exception to this rule was the United Light & Power arbitrage. Here one bought a share of old preferred and sold five shares of new common “when issued” against it, at an initial spread of about 10% net. Because of litigation that reached the Supreme Court, this utility recapitalization too fully two years between proposal and consummation. Though it yielded the expected profit in dollars, the time element made the outcome far from brilliant.

Class B. Cash Payouts in Recapitalizations or Mergers

A recent example of this type is Central and Southwestern Utilities 2nd preferred. Under a recapitalization and merger plan, presented to the SEC on Feb 5, 1946, the holders were given the option of taking the full redemption value in cash or the equivalent in new common stock at the syndicate offering price. The current redemption value was $220 per share, against the market price of 185. Thus the expected profit would be 19%, plus interest at about 3% per annum for the duration of the operation. The hurdles to be surmounted here include (a) SEC approval; (b) court approval; (c) ability to secure an underwriting of new common stock at a specified minimum price; (d) miscellaneous delays, most frequently caused by litigation. If the plan should fail, the buyer risks a fall in the price of his shares; but contrariwise in the typical preferred stock or bond pay-out, there is virtually no chance of getting more than the redemption value accorded under the plan. We must recognize here an inherent weakness in this type of operation. [Sequel: The plan was carried out, and the preferred holders who asked for cash received $223 in February 1947.]

The experienced analyst knows that the chance of ultimate loss diminishes to the extent that the preferred stock is cushioned by the presence of proportionally large common stock equity. Thus he should feel differently as regards Cities Service 1st Preferred selling at 132, with total claim of 181 (or 193 call price), as compared with American Power and Light $6 Preferred selling at 117 with a total claim of 145 (or 160 at call price). The maximum indicated gain for Cities Service Preferred is backed by $1.20 in market value of common stock; while each dollar paid American P. & L. plan, the purchaser of Cities Service Preferred will undoubtedly of common stock; while each dollar paid American P. & L. plan, the purchaser of Cities Service Preferred will undoubtedly fare the better of the two. [Sequel: The pending plan for paying off the American Power & Light Preferred was withdrawn, and the $6 issue sold at 91 at the end of 1947. Conversely, a plan was proposed and carried out for paying off the Cities Service Preferred issues. As a consequence the First preferred was exchanged for bonds, making it worth $157 per share at the end of 1947.]

Class C. Cash Payments on Sale or Liquidation

In most cases where a company sells out its business to another or merely liquidates its assets piecemeal, the ultimate amount received by the security holder exceeds the market price at the time the sale or liquidation is proposed. (This condition grows out of the nature of the price making factors in the security market). In the case of a sale for cash on a going concern basis, the large profits are most often to be made by those who buy before the negotiations are begun or completed. But even after the terms are announced, there is often an interesting spread to be realized if the sale is consummated.

Quite a number of such sales have recently taken place in the textile-mill field. At this time the most recent example is a bid of $365 per share for stock of the Luther Mfg. Co., contingent on acceptance by not less than 95% of the stock. A week before the purchase offer was made public the stock was quoted at $150 bid. [Sequel: The purchase at $365 was consummated.] Most of these purchase offers, even though contingent on acceptance by a large majority, have become effective; and those which failed generally did so because a still higher bid was forthcoming from other quarters.

A vote to liquidate assets by piecemeal sale is rather infrequent, except that we have had a number of such liquidations of public utility holding companies under statutory pressure.

In such cases the amount of cash to be realized for the assets, less the corporate liabilities and expenses, is subject to estimation and consequent error. Where estimates are made by the management, they are customarily on the conservative side. In most instances, the market price at the time of the vote to liquidate proves to be appreciably less than the amount recovered. A protracted liquidation of this kind has been under way in Ogden Corp., showing a very good percentage profit for those who bought at an early stage. Brewster Corp. is an example in the industrial field. At this writing the tax liabilities of Brewster have not been determined. As against a stated book value of 5 and a market price of about 4.25, the current “expert” estimate of ultimate realization ranges between 5.5 and 6. [Sequel: The stockholders have since received $5.75 per share in cash, and are expected to realize something additional.]

Class D. Litigated Matters

These are fairly numerous cases in which the value of a security depends largely on the put come of litigation. This may involve a damage or subordination suit, disputed income tax liability, and an appeal from reorganization plan wiping out stock issues. In general, the market undervalues a litigated claim as an asset and overvalues it as a liability. Hence the students of these situations often have an opportunity to buy into them at less than their true value, and to realize attractive profits – on the average – when the litigation is disposed of.

Class E. Public Utility Breakups

These have been a very important group of special situations in recent years. They are an essentially temporary phenomenon in that they will pass out of the picture when compliance with Section 11 of the Public Utility Holding Company Act has been completed for the industry.

Their unique feature is that the profit in them depends upon the principle that a holding company is worth more dead than alive – i.e., that its separate assets, net, will sell for more than the parent company securities. This has brought about the paradoxical situation that the stocks of holding companies bitterly fighting dissolution – presumably for the sake of their owners, the shareholders – have been depressed in price by this valiant battle and have advanced when they lost their fight.

The technical quality which sets these situations apart from others is the fact that they usually depend upon an estimate or forecast of the market value of securities which are to be distributed and are not now traded in. In some cases there is a marrow market for existing minority shares, but it may not be too informing in relation to conditions after the majority shares come on the market. (An example of this is Philadelphia Co., which is the central factor in the valuation of Standard Gas and Electric Preferred issues. The curb-market price for the 3.2% minority interest may or may not be representative of the value of the entire issue.)

Improvement in the art of utility analysis, favored by the relative infrequency of unlooked for developments in the field, makes it possible to calculate fairly dependably what any operating company stock is likely to sell at under current market conditions. Thus the hazard in exploiting these breakup situations grows largely out of the uncertain time element, with the attendant possibility of an unfavorable change in market conditions before the distributions are received.

Class F. Miscellaneous Special Situations

This catch-all category includes everything we have not already classified. There is no point in trying to make our descriptions comprehensive since a good deal depends on one’s personal definition of “special situation.” We may suggest two additional varieties by way of example only. A peculiar one would be the rather major field of hedging operations – most characteristically the sale of a common stock against ownership of a convertible bond or preferred stock. (Here the security-exchange feature operates to protect against loss rather than to create the profit.) Another, more limited, would be the purchase of a guaranteed security on the expectation that it will later be made exchangeable into a bond on attractive terms, in order to save heavy corporate income tax. (This occurred in the case of Delaware Hudson and D.L. & W. leased-line stocks.)

Conclusion

At the outset of this section, we grouped special situations and undervalued securities together. The reader will have noticed that we do not consider these terms as synonymous – although it may be held that special situations constitute a major sub-division of undervalued securities. The essence of a special situation is an expected corporate (not market) development, within a time period estimable in the light of past experience. Thus here, as almost everywhere else in finance, wide experience is a major factor in lasting success; it must be supplemented by careful study of each situation and the possession of sound though somewhat specialized judgment.

Special situations, as we define them, appeal mightily to one class of temperament for the very reason that they leave other people cold. They lack industrial glamour, speculative dynamite, or more sober growth prospects. But they do afford the analyst an opportunity to deal with security values very much as the merchant deals with his inventory, calculating in advance his average profits and his average holding period. In this sense they occupy an interesting middle ground between security purchases for ordinary speculation or investment and security purchases for resale in syndicate or dealership operations.

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