This Man Is The REAL Father Of Special Situations by Jae Jun
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Buffett was known to have run a special situation segment of his portfolio.
During his partnership years, this is how his allocation looked like.
Buffett called them workouts - because he wasn't the father of special situations. Maybe he wanted to rebrand the term to workouts(?).
Anyways, it worked out so well for him that he kept a large portion in special situations during good and bad times. It's what helped him achieve ridiculous gains when the market and everything else was crashing around him.
If you aren't familiar with special situations, here's a quick definition:
"The essence of a special situation is an expected corporate (not market) development, within a time period estimable in the light of past experience"
To read an early article by the man who taught special situations to the world, click to download this PDF of the article, or see below.
Special Situation Investing
Security Analysis, 1951 edition (Pages 729 – 734) by Benjamin Graham
Special situations are the happy hunting grounds for the simon-pure analyst who prefers to deal with the future in terms of specific, measurable developments rather than general anticipations.
The article below was published in the fourth quarter 1946 issue of the Analyst’s Journal.
The period 1939-1942 was a heyday for operators in special situations and undervalued securities. During these years the trend was unfavorable to those owning standard issues, and the brokerage business was on the quiet side. By contrast, many bargain industrial stocks scored substantial advances—especially since the early war years brought proportionately greater business improvement to the secondary companies than to the leaders. In addition, quite a number of railroad and utility reorganizations were taking shape, and developing good profits for those who had bought their issues at unpopular times and consequently at basement prices.
By 1942 many in Wall Street had come to believe that the only real and dependable income was to be made in special situations. As usually happens, this generalization proved wide of the mark. In the ensuing four years there have been good profits in almost everything, and the spectacular returns have lately been shown in essentially speculative, as distinct from ?special,? operations. But perhaps enough interest remains in the latter type of activity to warrant an article on the subject.
The Meaning of Special Situations
First, just what is meant by a ?special situation?? Convention has not jelled sufficiently to permit a clear-cut and final definition. In the broader sense, a special situation is one in which a particular development is counted upon to yield a satisfactory profit in the security even though the general market does not advance. In the narrow sense, you do not have a real ?special situation? unless the particular development is already under way.
This distinction is readily apparent by reference to the wide fields of bankrupt corporations and preferred stocks with large back dividends. In the former case, ?the particular development? would be reorganization; in the latter, it would be discharge of the arrears, usually by a recapitalization. Many practitioners will say that a company in trusteeship does not constitute a special situation until a reorganization plan has actually been submitted; similarly, there must be a definite plan on foot for taking care of dividend accumulations. Thus, American Woolen Preferred may have had interesting possibilities for years because of its very large back dividends, but it became a true special situation only when the buyer knew that a plan of repayment had been or was soon to be announced.
There is a logical and important reason for favoring this narrower definition of a special situation. By doing so we are able to conceive of these commitments in terms of an expected annual return on the investment. As will be seen, such a calculation involves quite a number of estimates in each case, and thus the final figure bears little resemblance to the bond yields taken out of a basis book. Nevertheless, this technique is valuable as a guide to the operator in special situations, and it gives him an entirely different attitude toward his holdings than that of the trader, speculator or ordinary investor.
In one respect, however, the calculation goes beyond the lore of the yield book. If we are willing to make the necessary assumptions, the attractiveness of any given special situation can be expressed as an indicated annual return in per cent with allowance for the risk factor. Here is a general formula:
Let G be the expected gain in points in the event of success;
L be the expected loss in points in the event of failure;
C be the expected chance of success, expressed as a percentage;
Y be the expected time of holding, in years;
P be the current price of the security.
Then
Indicated annual return = GC – L(100% - C)/YP
We may take as a current example the Metropolitan West Side Elevated 5s selling at 23. It is proposed to sell the property to the City of Chicago on terms expected to yield in cash about 35 for the bonds. For illustrative purposes only (and without responsibility) let us assume (a) that if the plan fails the bonds will be worth 16; (b) that the chances of success are two out of three—i.e., 67% (c) that the holding period will average one year. Then by the formula:
Indicated annual return = 12 x 67% - 7 x 33%/1 x 23 = 24.7%
Note that the formula allows for the chance and the amount of possible loss. If only possible gain were considered, the indicated annual return would be 34.5%. (Sequel: The purchase was affected, and the bondholders have since received $33.5 in cash, retaining also “stubs” currently worth about $5.)
Full PDF below.
In the article it contains a formula to calculate the "Indicated annual return".
Being a fairly optimistic person (bad in the markets because hope and optimism is a killer), I tend to overestimate the probabilities of success.
In the formula where it says to enter the expected probability, my max will be 60% going forward.
Although current market conditions have made special situations tougher, the underlying lessons are the same.
Go ahead and find out the identity of the father of special situations and practical details of how to apply the methods in the PDF.
Until next time :)
Jae
