In investing, a Special Situation is a specific structural, non-operational event that affects the value of a specific corporation or its securities. The term is used as an umbrella for numerous corporate restructuring, transactional or financial engineering efforts.
From Ben Graham to Joel Greenblatt
The term Special Situations in investing was popularized by Joel Greenblatt in his book You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits (the book’s content by far outperforms its cheesy title). As the plurality of the term indicates, it is an aggregative term for different types of situations. What they all have in common are that they are arbitrage opportunities with a clearly defined timeline and limited risk.
In fact, the origin of the term Special Situation traces back to Ben Graham, as a subsection in chapter 15 of the Intelligent Investor is called Special Situations or “Workouts”. As the book is intended for laymen investors, Graham spends little time discussing these situations.
Workouts – The Buffett Partnership
In 1959 Warren Buffett started an investment partnership. The Buffett Partnership Ltd had an immensely successful existence until Buffett chose to wind it down in 1969 and concentrate his wealth in the funds biggest investment, Berkshire Hathaway.
In the early years of the partnership, Buffett would break the Buffett Partnership portfolio into two separate categories, Generals and Workouts. In the Generals category were stocks that traded at a deep discount to what Buffett estimated to be their Intrinsic Value.
Workouts, on the other hand, were stocks whose financial results depend on corporate
action rather than supply and demand factors created by buyers and sellers of those securities. In a letter to his partners from 1957, Buffett writes:
Perhaps an explanation of the term “work-out” is in order. A work-out is an investment which is dependent on a specific corporate action for its profit rather than a general advance in the price of the stock as in the case of undervalued situations. Work-outs come about through: sales, mergers, liquidations, tenders, etc. In each case, the risk is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline generally.
For the Buffett Partnership, Workouts was also a way of being concentrated and diversified at the same time. As the return of the workouts was not dependent on the gyrations of the stock market, the risk profile of each category differed. If the stock market were to fall drastically, resources dedicated to workouts would be ploughed into Generals. Conversely, if there was a lack of opportunities in the general market due to high valuations, resources could be deployed to Workouts.
Types of Special Situations
There are various kinds of special situations. The most common include the following:
- Rights Offerings
- Risk Arbitrage
- Merger Securities
- Stub Stocks
- Tender Offers
- Distressed Debt
Top Special Situations Funds
Many hedge funds specialize in Special Situations. There are also a number of mutual funds, ETFs and wealth managers that deploy special situations in the investment strategies and products.
- Horizon Kinetics is an asset management company that operates both mutual funds as well as separately managed accounts. Their research and investment philosophy focuses on what they call Predictive Attributes of Outperformance. Those attributed include Spin-offs, Liquidations and Dormant Assets.
- Oaktree Capital, an asset management company co-founded by Howard Marks, specialized in Distressed Debt Investing. The company has a long-term track record of generating double-digit returns in high-yield bonds, distressed debt and liquidation situations.
Workouts are Arbitrage Opportunities
In its essence, what special situations often present to an investor is an opportunity to arbitrate on mispricing between assets and markets within a set time horizon.