Special Situationitis

There is a disease in the value investing community.  It can be deadly to your investment returns.  We have identified Patient Zero, however, there is no known vaccine and given the recent crackdown on pharmaceutical prices, we do not think a suitable one will be developed in the near future.  Rapid spread through contagion occurs most frequently in well-known message boards, including both Value Investor’s Club (VIC) and Corner of Berkshire and Fairfax (COBF).  However, in-person contact has also been observed.   Infected patients can be identified by clear verbal cues, including but not limited to, the following:

  • We look for structural mispricings (read: we don’t have any idea what the business does, but Greenblatt talks frequently about spin-offs, so we look at all the spin-offs).
  • Sure, I don’t really understand their main assets, that’s why it is only a small position (any reference to “it’s only a small position” is a clear sign of infection).  
  • The company’s financials are a train wreck, but there was recently a 13D filing.  
  • Given how cheap it is priced, any good news will cause it to re-rate.
  • Let me tell you about my sum of the parts valuation.
  • There are so many different potential catalysts, there is no downside in this stock.  
  • No analysts cover the stock
  • The setup….(the patient is clearly infected)

Special Situationitis is a disease that afflicts both budding and even more mature value investors.  My current scientific belief is this virus is caused by close contact with both an early version of a cigar butt seeking Warren Buffett and Joel Greenblatt’s You Can Be A Stock Market Genius.

Now that I have had a chance to make jokes I can laugh at, let’s discuss.  

A lot of incredibly bright people discuss special situations and have done well in some cases with these investments.  In fact, this is partially the problem, it is so hard to look away when smart people are talking.  On the other hand, I think a focus on special situations creates a cart before the horse situation that frequently ends in poor investment results.  Let me say upfront, that this disease frequently infects me at times, but like Buffett, I have a 1-800-Special Investors Anonymous. My sponsor is John.  Incidentally, he calls me just as often with the same affliction.  

The disease is not difficult to cure or prevent, but its eradication has proved virtually impossible. Special Situationitis causes a short-term memory lapse with investors who forget that they are investing in businesses, not situations.  The solution, of course, is to insist on an understanding of the business itself.  That may sound simple and perhaps obvious, but frequently the discussion centers more on game theory than the underlying business.  The bulk of the analysis centers on the special situation aspect of the investment with a throw-away nod to what the business actually does (sometimes the throw away nod doesn’t even occur).  

The best way to avoid Special Situationitis is to focus on the underlying business.  If you like the business and would invest without the investment being in the special situation bucket, then the investment has potential.  If the main attractiveness of the investment is the special situation nature of the investment, it should be an easy pass.  It may not be sexy, and John and I feel like we are beating a drum that no one is hearing, but the business itself is the most important aspect of an investment, not the situation or the general market levels.

A few examples of special situations:

There are numerous categories of examples.  One is net-nets.  In Buffett’s day, a net-net had a mediocre business with lots of cash.  Today, companies with more cash (and this “cash” usually includes inventories and accounts receivables) than their entire market cap are usually horrible businesses or run by management whom you expect to steal from the company, but somehow hope management won’t steal “all” the cash.  Failed pharma companies certainly fall into the second category.  

LeapFrog qualifies for the first category.  This company made handheld electronic learning devices for kids.  After the introduction of the iPad and mini-iPad, this company quickly became a net-net, holding about as much cash and accounts receivable as the entire market value.  I looked at this company more than once.  Every quarter the company lost just enough money to basically match the market cap decline over the past quarter.  Why buy a single-use LeapFrog when you can get an iPad for about the same price and use it about 100x more.  The competition LeapFrog faced from Apple was obvious, in fact, Mr. Market should have been even more harsh in its forward looking valuation.  The company probably should have traded at 50% of its cash position after the introduction of the iPad because the company torched 50% of its cash trying to pretend it had a competitive product.  Eventually the company was sold for about its net cash position.  

This next point is where avoiding these situations is hard.  There is some investor somewhere who wrote an annual letter describing his special situation investment process that led him to LeapFrog at about 50 cents and how he correctly analyzed the situation and bought a dollar bill for 50 cents.  Within months after his purchase, this letter surely continues, the market correctly realized the value of the dollar bill and a private buyer picked it up for its “intrinsic value.”  However, that same investor would have had the same thesis at $2, $1.5, and $1.  Usually, the special situation investors who make money are really just the ones who arrive last and are paid first as they exit without having to bear the horror that is typically “special situation investing.”  This highlights the problem that some late investors appear “right” but are more lucky on their timing.  Repeat special situations investors are truly a rare breed.  

The second example is a spin-off that checked all the boxes.  I don’t need to write this one up much because I have some emails between John and me that can review the situation in real time.  

John wrote to me the following on 6/28/14, within a few days after the spin-off started trading:

John to Matt: [unedited]

I spent a lot of time in the last few days on Rayonier. I like the Timber company, and the spin co (RYAM) was interesting to read about. I decided to pass, at least for now. The main thing is that price of the product they sell, Cellulose Specialties, or CS, is at a multiyear high around $1800 per metric ton. I did some research and noticed that the price of this specific product was around $1200 in 2008 and about $900 in 2004. So it’s essentially double. I looked back at old RYN 10-Ks and noticed that RYAM’s volume of CS was very similar to the volume now, but its revenues and profits were only about half of what they are now. So like many other commodity companies, it is benefiting from a multiyear high in the product it sells.

Management says demand continues to grow, and thinks the price will climb, but I’ve noticed that new capacity has been coming into the market lately (probably because of the high price), and I realized that I have no idea where the price of CS will go.

However, I do think this is the best company in the field of CS producers (there aren’t many). So if the price dropped to around $1000 per metric ton, or some low level, the earnings would drop, but profitability seems to be very resilient. Margins were still mid teens, even when the CS price was much lower in the late 1990’s.

Other risks are customer concentration and I’m a little worried about one of the two plants going down (explosion, chemical spill)… I don’t know if that’s a realistic thing to worry about, but they only have two plants and each one is about $1 billion worth of replacement value.

Anyhow, it’s a company with historically (last 20 years) of stable margins and steady free cash flow. I think the last 5 years are abnormally high. It is a really hard business to get into, because the product they sell is unlike other commodity products… It’s very niche and a lot of RYAM’s advantage comes from their long term customer relationships. They tailor the product to exact customer specifications.

Just some final thoughts.

I did the smart thing after John’s email and agreed with everything he said.

Five months later, after the stock had declined 35% from its spinoff, I thought I would see if I had anything to add.  I wrote the following to John on 11/14/14:

RYAM

  1. Very capital intensive.  Even with the new plant online and running, they are spending 70-80m this year in capex…This is a really big ding in my book.
  1. High customer concentration.  They might not lose these customers, but I think the customers can exert a lot of pricing power with the threat of leaving.
  1. Cannot sell the company for 2 years (due to spin-off)
  1. Lots of environmental issues.  It looks like these are reserved for on the balance sheet, but it will still be an ongoing cash cost.
  1. I listened to the conference calls and they just didn’t strike me as particularly sharp, especially in regards to capital structure.  They advocate paying down debt, but when asked about share buybacks, he seemed to rule it out due to “acquisitive growth possibilities.”  Just didn’t seem well thought out to me.  
  1. Lots of non-gaap metrics, Ebitda is all over the place.  I know a lot of companies use this, but I think it is really strong with RYAM.  Anyway, to be honest, at this point, I think I am still only looking at it because of how much it fell recently and because of Abrams.  Without those two things, I would have passed.  Maybe I should again?  

[Note: David Abrams is a former partner at Baupost, and this article was written the same month as the RYAM spin-off.  Abrams filed a 13G disclosing a 5% stake in RYAM soon after the spin-off].

These are our unedited emails.  I cringe at the thought of being interested because a stock “has fallen a lot and because of Abrams,” however, I share these emails “as is” since these problems are the essence of special situation investing.  On the positive side, John and I both focused on the business itself.  John quickly identified that the CS commodity was basically at its peak or peak-ish price and new supply was coming online in response to the high prices, which would have the potential to decrease prices going forward.  Additionally, he recognized he was out of his circle of competence when it came to predicting the price of CS, which would be the main driver of this investment. This price decline in CS happened almost immediately after the spin-off (almost as if the parent company had foreseen it) and the price of CS has been on a downward trend since the spin-off.  Additionally, the customer concentration issue became an issue as RYAM and its main customer engaged in a full out lawsuit regarding their contract.  This lawsuit caused the stock to drop almost 40% in one day (down 85% since its spinoff), although it has recovered some since then (currently down 65% since spin-off).  

In summary, special situations are sometimes an interesting place to find value, however, these situations are often traps for investors who are attracted to the idea of a “special situation” without a clear understanding of the investment case in the business itself.  I have found special situations often allow an investment manager to “show off” his intelligence, which is often the goal of investors trying to raise assets under management.  You can’t sound smart pitching Apple at $90, but….

And this is the preview for the next company write-up, which is…..wait for it…a special situation.

Stay tuned.

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