I meant to write this post when beginning the blog to assist in describing my investment style but it slipped my mind. It resurfaced in my thinking when I recently read a book Margin of Safety, by Seth Klarman. Some areas he cites in the book that are useful to look for opportunities are very similar to what I look for.
The title of this blog post sums up why certain situations in the market can often lead to better than average risk/return characteristics. There is a huge amount of dollars spent by major fund managers and brokers in analysing the bigger companies which can make that area arguably more efficiently priced. There are still opportunities I believe though because although the research can be quite in depth, the major players are often pressured by short term performance which can lead to misjudgements. Generally speaking, the more researched this space is results in fewer opportunities from mispricing. So areas where major institutions are not as prevalent should be where we should examine.
Some situations I find retail investors do not place enough value on investments that may be limited in terms of huge upside, yet have a high probability of very limited downside. They find it boring. I believe this partially stems from a lot of Australians viewing property as the way to slow and steady wealth building where you invest the vast majority of your assets, and the stock market as a place where you have far less invested and try and make a fast fortune. That helps explain the vast amount that is poured into speculative mining, biotech and technology plays over long time periods that don’t on average produce good returns. An investment opportunity that shows a high probability of earning returns well greater than inflation (yet perhaps does not have the potential to quickly double in price) are often shunned by retail investors. For example, a company announces a wind up of a LIC and if the market stays flat perhaps there is a return of 7% awaiting in 6 months’ time. Suddenly with the prospect of making large returns finished, many retail investors want to exit immediately and look for a new investment that offers greater upside potential.
I will try and briefly describe situations that meet the 2 criteria discussed above. i.e. where there is not as much institutional presence and where retail investors may sacrifice safer high yielding returns in favour of faster ways of growing their wealth.
Wind ups – discussed briefly above. I will add that a slow wind up can also help shareholder’s tax position. For example, investors can receive a large portion of the market cap back in their pockets at a profit without paying CGT. Let’s say you purchase a stock for $1, and management then plan to slowly wind up the company assets of $1.50 a share over a couple of years. Perhaps most of the assets are easy to liquidate meaning 90 cents is paid back to you in the first year. This just reduces your cost base to 10 cents rather than being a taxable event in the first year. I would also argue your typical equities manager doesn’t spend so much time on these opportunities, they would prefer their quarterly market commentaries talk about strong growing and exciting companies instead.
LICs trading less than NTA – You will not see that many institutions will invest in another LIC. I don’t think they enjoy the thinking that they are relying on another fund manager to do the job for them. Retail investors have a tendency to fall for the slick marketing and get involved often at peaks in the market and subscribe into floats of new LICs. They will pay $1 and sometimes the new LIC has costs of listing such that on day one they already only have 97 or 98 cents in the dollar to invest. “Free” options may also partially limit the upside. In nearly all cases they then begin to trade at discounts to NTA, in some cases in the order of 20 to 30%. Strangely retail investors then decide they are angry with the manager about the discount and it is time to sell, precisely when they should often consider buying!
REITS trading less than NTA – Similar comments to above. I would add the desire for most retail investors to have property exposure via their own physical residential real estate holdings also arguably can assist in pricing REITS more attractively.
Hybrids – These often don’t fit cleanly into institutional mandates so it can result in less institutional presence. I find the retail investors these are marketed to are not very sophisticated. Also the securities often contain a wide variety of features that they do not understand. This can make this area worthwhile to look for opportunities. In recent times hybrids from Crown Ltd and Elders in the secondary market have provided good opportunities for those that did the research. Unfortunately not me 😦
Hybrids part 2 – In terms of not fitting cleanly into institutional mandates, it is even more apparent when we are dealing with credit rating downgrades. It is common for some mandates to be forced into selling a security because it is downgraded below a minimum rating criteria. The Multiplex security was a good example of this where some astute buyers took advantage of after the GFC. This area may make interesting hunting ground when Australia suffers its next recession.
Takeovers – Once a takeover is announced the share price will generally gain significantly on the day. Investors both institutional and retail are often overjoyed and want to quickly take profits and move onto another opportunity. They may have just made 30 or 40% on the day and now that stock is very unlikely to have another 30-40% upside left. This especially leads to retail investors moving on. They forget that perhaps in a friendly takeover there may only be another 5% upside but what if the funds can be received within 4 months and because it is friendly there are very little risks involved? Annually that may be a very attractive return. In a hostile situation perhaps another bidder may come along and some bidding tension result in the final bid another 20% higher? One must be wary of binary situations where one bidder may walk away and the share price could fall substantially. Institutions are often overly scared of reporting such a situation to clients so they will tend to sell too conservatively to completely eliminate such risk. If you are prepared to take on this risk, there may be the odd bad result but if you play this game long enough over time the average risk/return profile tends to stand up extremely well.
Rights Issues (part 1) – Retail investors may often be strapped for cash to take up renounceable rights issues. Or they just do not want to increase their exposure too much in a company so they have a tendency to sell on market where they can the renounceable rights. If one likes the underlying investment this may provide an attractive way of entry. Institutions may pass up on the seemingly attractive arbitrage as they are probably focused on bigger decisions and getting involved would mean work for the corporate actions department.
Rights Issues (part2) – I am referring here to when a company makes a rights issue for good reasons. Perhaps for example an acquisition that is viewed by all as making sense then it may lead to a little short term indigestion of surplus stock. Investors both institutional and retail within a day find themselves having increased exposure to the company. Institutions may have tight sector or company restrictions and may need to sell back to keep the weight the same. Retail investors often do not manage their cash well or to begin with run far too high stock concentrations meaning they also don’t want to increase their exposure. This can perhaps be an opportunity in the underlying stock.
Scrip mergers – Similar to the rights issues retail investors don’t like complicated administrative things to deal with and tax issues to consider, even institutions are in the same boat. This can mean complicated scrip takeovers and mergers can provide attractive entries into certain stocks.
Delistings – A retail investor may fear the process with a delisting, and an institutional investor may not have the mandate to hold. For example, quite a few years ago I bought the stock AYT for about 3 cents. It provided loans for investors to buy into the eventual failed plantation schemes and was in wind up mode. MVT were trying to take it over at 3.5 cents and as a tactic their bid expired quickly and the company would delist. Many sold at around 3.5 cents because of fear of the process. I hung on and received payments over 13 cents the next 3 or 4 years from the share registry even though it was never listed. The loans were enforceable (after a high profile, complicated and drawn-out court case) and largely paid back to the company.
Legal action pending – I could use the example just given above in this category, where the market almost forgets or at least misprices the probability of an outstanding legal case. APW was another example a few years back. I still hold and have written plenty about but the way I came into this a few years ago which is interesting. It was already well under NTA but the icing on the cake was a legal case that they were probably unlikely to win. If they did win however it would add about 25% to the NTA, over time it appeared the market had just given up on this because it was rarely discussed and considered on balance unlikely. So it was like effectively paying nothing for maybe a 40% chance they could add 25% to the NTA. The share price eventually climbed about 25% not too long after the case when in fact they did win.
Spinoffs – Both retail and institutional investors may receive shares in a spinoff company that is suddenly very small for their portfolios. They have a tendency to not want to have to think about these new shares and to make things easier just sell them. They are less price conscious as sometimes the holdings are small for them, this may create opportunities. Statistically the evidence shows this is certainly the case both in Australia and the U.S. Quite often the company being subject to the spinoff was not given much focus to from the parent, and once these shackles are broken can then outperform.
Potential demergers – Rather than waiting for a spinoff opportunity it may be attractive to speculate beforehand. Recently we saw Crown Ltd rise substantially with plans to demerge. A couple of months ago I mentioned how Sandon Capital had some research about the increased value in TTS if they were to demerge. If you had of invested in Fosters before they demerged TWH that may have been attractive. Often pre demerger the companies have been underperformers and shunned by retail and institutional investors.
Taxation (part 1 franking availability) – Some companies have large capacity to pay franked dividends where they are currently not utilizing appropriately. Many institutional fund managers are set up such that these are not as valuable in a managed fund compared to say an individual receiving them in their directly managed SMSF. Retail investors probably may not even be aware the company has this capacity on their balance sheet. Therefore, they may represent undervalued situations in the market.
Taxation (part 2 large losses to carry forward) – Some often poorly performed companies historically may have done so poorly much of the business has ceased. They could represent a small shell company with is little as under $10 mill in cash waiting for a new future direction. Sometimes they may well trade significantly less than the cash they have in the bank. If an acquirer can buy the company out and keep the direction of the company for the same purposes, there could be significant hidden value in the tax losses. For example, and oil and gas explorer/producer buying out another oil and gas explorer/producer. The same company purpose is needed to offset the losses against future gains to reduce tax. Also when companies are very small they can be attractive for “backdoor listings”. If another company needs to raise funds then acquiring a listed shell company may be far easier and cheaper than doing your own ASX listing, so there may be hidden value in this also. It is not inconceivable a company with a market cap of $5 mill, trades at a market price of $3 mill whilst having prior tax losses on the balance sheet in the order of tens of millions. This may very much suit an acquirer! One needs to however treat these with caution. The risks are that the current management suck cash out of the company quickly and just want to keep their jobs with little concern for shareholders. You want to see an activist shareholder already present to extract the values, management to have some skin in the game or become the activist yourself.
Tax loss selling – I wrote about this here…
Companies with large single holdings – Sometimes a company, often an LIC may run a concentrated position in another company and the market is slow to react if that holding surges in price. Some examples in recent years that spring to mind are HHV had 20% of funds in Sirtex, MVT had 40% funds in INA, HHY had 30% funds in CSE, CSE have nearly all their funds in SYR etc. As discussed above institutions are usually not present in LICs, and often the retail investors trading them do not watch the underlying investments of the LIC very closely. This year on the blog I have timed entries into HHV, GVF, HHY, TOP, SNC and particularly NCC recently quite well I believe due to other investors not paying close enough attention to the underlying holdings of the LIC.
Director or “insider” buying – I feel you have to be very selective here. The amounts should be significant for the director involved in terms of personal wealth, and ideally they have a decent track record investing themselves. Have seen plenty of examples of some director buying at peaks in the market so it is just a tool to use with discretion.
Company buybacks – Like director buying just mentioned you need to be selective here also as there are plenty of examples on average that companies buy back their shares at precisely the wrong time. I think it is more of a signal to watch when used in LICs or REITS trading at a discount to NTA. If you can sense the balance sheet allows and the company has hinted a buyback may be imminent then a purchase in anticipation of the buyback may prove a solid entry point.
Company inclusions / exclusions in major stock indices benchmarks – In recent years’ active managers around the world are having on average a terrible time with performance, so I expect the growth in ETFs and index investing to continue to be strong. This is likely to present more opportunities in taking positions that can capitalize on index funds being forced buyers or sellers in certain companies being included or excluded from benchmarks.
Small companies in general – The smaller the company is obviously the larger institutional fund managers cannot invest in it to obtain a stake that is meaningful in terms of their own portfolio. The smaller the company it is the more likely you are placing your investment skills against participants in the market that are less sophisticated.
Illiquid small caps – this can be an area suitable for me given my modest funds to manage. Convention would say this is a major negative. This view, and the fact that many fund managers can not get set in a position, can see some good investments get bypassed by many knowledgeable investors. Ideally they are situations where I am not reliant on selling on market any time soon. That could mean the business is sound enough to hold for many years. Maybe it pays the return via regular dividends, or regularly can buy back shares, or perhaps it involves a slow wind up of assets. An impatient investor who needs out may provide a bargain due to selling at very cheap prices because of the illiquidity.
Lost mandates and forced selling – This can impact smaller companies more severely. Shareholders owning greater than 5% in a company will have to disclose when they are reducing this my more than 1%. Occasionally there may be situations where you discover this selling matches the news about the manager having lost an investment mandate. The client behind the mandate may not give the manager much discretion and this could be an opportunity, the selling may be done with little regard to the valuation at the time.
LIC options – I added this recently because over the last few years there has been a surge in new LICs come to the market with “free” options. I haven’t found many buying opportunities yet but suspect it may be a good hunting ground. In the example of spinoffs, the average punter often sees the spinoff company as a tiny new share holding of nuisance value and can end up selling without any thoughts about the underlying value of the security. I can see in the future many participants in LIC floats in recent years will firstly quit in frustration at a discount to NTA. They then also may sell the options into thin markets with no research at all about their value. Another scenario is they simply are short of cash to exercise the options in the future anyway. Here they also may sell the options on market, and because the value of the trade is likely to be small they may not bother with much research as to their underlying value.
LIC catalysts options expiry and dividends – The share price of LICs with large overhang of options can often find it difficult to perform. I notice as this overhang is dealt with it can lead to quite a positive re-rating of the LIC. Another factor that can kickstart a LIC share price that is suffering is the announcement of an inaugural dividend or a big increase in dividend. The good thing about this is it is often telegraphed to investors if you bother to read the annual and half yearly reports (which many LIC investors don’t). If you follow the profit reserves, franking, and how the portfolio is going including sales they have made in the period, you can get a good insight. I was buying SNC in the second half of 2016 partially on this basis. It appeared the announcement of a large franked dividend in early 2017 was the turning point and for awhile led to them trading at a premium of nearly 10% to NTA. Quite dramatic when there was a discount of about 15% at times in the previous year, and this large dividend was always quite predictable if you listened to what management were saying.
For an investor like me who seeks to limit drawdowns on the portfolio, yet still achieve returns greater than inflation to make a living, these areas can be rewarding to examine. These are areas I have written down in the past for myself to look for. They are also very similar to one of the chapters I read in Seth Klarman’s book. Though here I have just written as briefly as I can and more directly linked to my own experiences on the ASX. If you think of similar “special situations” I have not mentioned I would be interested to know.