Mike Price sends: This is part two of the series on special situation investing. View part one here. The special situations written about here will be:

Closed-End Fund Arbitrage
Closed-end funds are mutual funds that have a limited amount of shares and trade on a public exchange (NYSE, NASDAQ) like stocks. Because of the nature of the funds trading on an open exchange they frequently trade above, at a premium, or below, at a discount, to their NAV - Net Asset Value or the value of the mutual fund at the time. Thus a smart arbitrager can find a closed-end fund trading at a discount and buy it until the gap closes, or do vice versa and short a closed-end fund trading at a premium.

However it is not that simple - if it was these situations would not exist. Some closed-end funds trade at a steep discount to their NAV, but the discount is probably deserved, as closed-end funds that underperform or have always traded for a discount should not be bought without a foreseeable catalyst - like activists - that will propel the fund back to it’s NAV.

Currently my favorite in this category is the Gabelli Dividend & Income Trust (GDV). The fund “invests at least 80% of its assets in dividend paying or other income producing securities. In addition, under normal market conditions, at least 50% of the Fund’s assets will consist of dividend paying equity securities.” according to its website. Currently it trades for about a 15.5% discount to its NAV. Returns have been satisfactory and the dividend yield is 6.6%, so while you wait for reversion to mean, which is about 18%, you own a fund with satisfactory performance and a good yield.

Activism
A method rising in popularity among hedge fund managers is activism. In this method the manager buys >5% of a company he believes is not returning value to shareholders and becomes active in the business until value is returned to shareholders. When selecting companies to buy the manager usually looks for undervalued companies based low cash flow multiples, or companies with a lot of FCF and cash, he then buys 5 or more percent of the company which requires him to file with the SEC, when he files he not only discloses his holdings in the company but he also writes a letter to the board of directors about why he has bought the shares, what he thinks is wrong with the company and how he believes value can be released. This filing is available for everyone to see on the SEC website. Sometimes the company will immediately comply with the manager, but other times the fight can get pretty scary between a manager and a company.

Obviously regular investors cannot become activists, but ‘piggybacking’ activists is easily possible. When trying to find good activist investments one can use the sec website to follow each filing daily from activists, follow all 13Ds filed, when one is found it must be scrutinized to be reassured that the company will comply with the activist and value will be returned to shareholders, but when an opportunity is found great returns will most likely follow.

Deep, Deep Value
Deep value has been discussed on this site before, I interviewed deep value focused investor Henry Lu and I purchased Lazare Kaplan (LKI) which is trading below its Net Net Current Assets. Deep value is basically buying companies trading deeply below assets, at a very low price to earnings multiple or a very high cash flow yield. Companies trading at a fraction of their book or for 1x earnings is what Benjamin Graham originally championed buying.

This type of investing is usually called “cigar-butt” investing, you buy the stock, or pick up the cigar butt, for one last puff then quickly sell it. When investing in deep value the quality of the company is ignored and the investor is focused just on finding companiess so ignored by Wall Street they can be bought for as low as $.25 on the dollar. Because business quality is ignored value traps may be purchased, value traps are companies which appeared to be undervalued but are discounted for a reason, and they will stay discounted, or fall and become more discounted.

To avoid value traps one must look for companies not only deeply undervalued but also with quality, or at least profitable and have an expectation of earnings which will not fall. Also you must make sure management wants to return value to shareholders, if a company is trading below its cash, you must determine how management is going to use the cash, if they will just let it sit then a discount must be applied to cash to adjust for ignorant management.

LEAPS
I won’t go over the basics of options here, go here for that. LEAPS are options with a longer period of time attached to them, usually about two years.

As an example lets say I have resarched DirecTV (DTV) and have decided they are a good business which is discounted when compared to its peers, has good financials and good management, but the only thing holding them back is the fact that GM holds a large portion of the common stock and investors fear this. I also believe in the near future GM will sell all of these shares, whether it be because they are forced into bankruptcy or if DTV buys back these shares, as they have already started doing.

Because I believe in the company, and think investors will realize this once GM sells the shares and DirecTV is no longer connected to them, I can buy LEAPS for JAN 08 with a strike price of $17, the current price is $17.50 and the options are priced at $2.75. If I buy one contract my investment is $275 (one contract is 100 shares), as opposed to $1,750 if I had bought 100 shares of the common stock.

Lets say in the next year and a half the stock appreciates to $26 per share because GM sells their shares and investors realize it’s a good company, my investment in the LEAPS has appreciated about 330% (I bought them for $2.75 the price of the options is now $9, $26-$17) and my investment in the common stock is up only 49%.

Also if DirecTV were to fall because GM refused to sell it shares or something else happened to force DTV’s shares down you would only lose you initial investment of $275 with the LEAPS, but you could possibly lose a much higher amount.

Conclusion
I believe that even great investors can only find 6-8 really good investment per year, to insure good investment returns when markets are volatile and good investments are hard to find special situations are needed to propel returns to an exceptional level. Afterall special situations are just ‘value with a catalyst’.

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