In past articles, we have shown that there are more ways to earn a return than just buying a stock. We have discussed absolute returns, relative returns, even returns from announced mergers and acquisitions (risk arbitrage). In this article, we zero in on another approach: investing in stubs, spin-offs and liquidations.
Stubs are created through the leveraged buy-out process. As the name implies, leveraged buyouts (LBOs) are transactions in which the buyer uses debt to fund the acquisition of a company. Usually, the LBO group will buy all of the target company’s publicly traded equity. However, occasionally it will leave a small portion (usually 10 to 15% of the float) in the public market to avoid having to book “goodwill” (purchase price in excess of book value), which eventually must be written off against earnings. Shares of this small portion of equity remaining in public hands are called stubs.
Because we analyze securities in much the same way as LBO specialists—looking for undervalued assets and focusing on how much free cash flow a company generates—many of our portfolio holdings have been targeted by LBO groups. We have our cake in the form of premiums paid by LBO groups to buy portfolio companies. Every now and then, we get to eat it too, by holding on to stubs that allow us to participate, along with the LBO group, in realizing a portfolio company’s full upside potential. Our risk arbitrage operations—buying deal stocks at a modest discount to the purchase price to earn respectable annualized returns when the deal closes—also give us the opportunity to take advantage of fundamentally attractive stubs.
The Power of the Stub
Let us give you an example from the Gabelli files. On January 23, 1997, Amphenol, a leading electrical equipment manufacturer, announced that the prominent LBO group Kohlberg Kravis Roberts & Co. (KKR) was purchasing 90% of its equity for $26 per share in cash. The remaining 10% would remain in public hands—a classic stub. We thought the deal price was a little skinny, valuing Amphenol at around 15 times earnings, when its competitors were trading at 17 to 18 times earnings in the market. Believing we might see a better bid from a competing suitor and/or KKR, we bought Amphenol stock at $25.50. At this price, we could earn a modest 6% annualized return on our investment even if no higher bid materialized. We also had the option of holding on to all or part of our Amphenol position via the stub. Either way, the downside risk was limited and the upside potential appeared attractive.
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