Lesson 1 of 7
Why special situations exist
A special situation is priced by an event and a forced seller, not by an ordinary judgment about value.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- In a special situation an event, not an ordinary view on value, decides who sells: a spin-off, a merger, a tender offer, a rights issue or a reorganization.
- Many of the sellers in that event are forced: a rule, a mandate or a size limit decides for them, not a judgment about value.
- Most carry a stated catalyst, a date the gap is tested against. A holding company's discount is the exception, which is why it can last.
A special situation is a company whose price is set by an event rather than by the ordinary weighing of value. Some of the shares change hands because a rule or a mandate requires it, not because anyone has judged them worth less. The situation resolves on a stated date, which is the part an ordinary holding does not have.
What forces the sale
- 1An eventA spin-off, merger, rights issue or reorganisation
- 2A forced sellerA rule or a mandate, not a view on value
- 3A price below the estimate
- 4A stated catalystA date, not a hope
- 5The gap closes
Who is forced to sell
An index fund holds a company because a rule says to, not because a committee likes the price. When a spin-off is too small or in the wrong sector for that rule, the fund must sell the new shares soon after they arrive, at whatever price is on offer. A bond fund whose mandate reads investment grade only is often required to sell a bond soon after it is downgraded below investment grade, even in the middle of a panic. Holders paid in new bonds or preferred shares they never chose, in place of the cash or stock they expected from a merger, often sell them at once. None of this is a judgment that the shares are worth less. It is a rule doing exactly what it was written to do.
What sets it apart from an ordinary idea
An ordinary idea trading below your estimate of its value can stay there for years, for no reason it has to change. A special situation carries a mechanism instead: a distribution date, a closing date, a tender deadline, a plan of reorganisation. That date is what the forced seller is selling into, and what a holder on the other side is waiting for.
An ordinary idea
- Priced below an estimate of value, for reasons that can persist.
- No date decides when the gap closes.
- The seller on the other side may be acting on a view.
A special situation
- Priced by a mandate or a rule, not a view on value.
- Usually carries a stated event that sets the date the gap is tested against.
- The seller may be required to sell at any price offered.
A special situation usually carries a date. An ordinary idea does not.
What the event does not remove
A forced sale explains why a price gap exists. It does not remove the ordinary risk of being wrong about what is on the other side of it. A merger can still break before it closes. A reorganisation can still leave little for the equity that emerges. A holding company's discount can be a fair price for a genuinely low-quality collection of stakes. The event supplies the gap. It does not certify that the gap is real.
Check yourself
Why might a shareholder sell a spun-off company's shares without regard to price?
- They have concluded the shares are worth less than the market price
- A rule or mandate requires the sale, not a judgment on value
- They have found a better opportunity elsewhere
Show the answer
Answer: B.
A forced seller in a special situation is usually following a rule, such as an index's own membership criteria, not a view on the business.What tells a special situation apart from an ordinary idea trading below your estimate of its value?
- It always involves a larger company
- It carries a stated event that sets a date for the gap to be tested
- It always involves a company in financial distress
Show the answer
Answer: B.
A distribution date, a closing date, a tender deadline or a plan of reorganisation is the mechanism an ordinary idea does not carry.Does a forced sale mean the situation on the other side of it is safe?
- Yes, a forced seller guarantees the buyer a gain
- Yes, because the price can only move upward from there
- No, the underlying deal, business or plan can still go wrong
Show the answer
Answer: C.
A forced sale explains why a price gap exists. It says nothing about whether a deal will close, a plan will complete, or a business will hold its value.Sources
- Greenblatt, You Can Be a Stock Market Genius, 1997, on spin-offs, rights offerings, merger securities and bankruptcies as situations with a forced or an indifferent seller on the other side.
- Klarman, Margin of Safety, 1991, chapter 8, on Esco Electronics, a 1990 spin-off from Emerson whose holders sold trivial holdings, and throughout on relative performance pushing institutions into decisions unrelated to value.
What this leaves out
- The Esco Electronics prices are as Klarman reports them for 1990 and 1991; one case is not a general rule.
- A forced seller explains a price gap. It does not establish that the gap is real, or that a deal or a plan will complete as announced.
- Nothing here is advice about any security.