Workouts Work Out In Down Markets – Part 4

January 25, 2008 by Joe Ponzio

There have been a lot of great questions regarding workouts over the past week of the Workouts Work Out In Down Markets series (beginning here). Some visitors jumped into the comments and posted free resources to track upcoming mergers, acquisitions, and going private transactions.

We all have that looming question in the back of our heads: Can I really make low-risk money when all these smart people are seeing the same deals and passing?

The Risks

First off, there is no such thing as “risk-free” – only risky or intelligent. (U.S. Treasuries are intelligent if they provide the best value for your money. They aren’t risk-free if the U.S. falls.) Intelligent investors, like smart poker players, bet big when the odds are in their favor, regardless of the actual outcome of any single move. How can you ignore a single loss and move on? Simple – only put your money in when the odds are in your favor. In the short-term, anything can happen; in the long-run, the odds say that you will make money.

That’s the point, right?

All Those Smart People

There are a lot of smart people putting money into the markets. Wall Street’s ultimate goal: make you feel stupid or scared so you feel compelled to give them your money to manage. And what have all of these smart people accomplished? When you consider that the large majority (upwards of 80% or 90%) have lost to the markets over time, it’s not necessarily a smart move to listen to them or follow them into and out of positions.

You don’t have to engage in workouts – especially if you are not comfortable with (or don’t have the time to invest in) ripping apart deals, reading reports and proxy statements, etc. That said, you are certainly smart enough to do so – and beat Wall Street in the process.

So, Why Don’t I Just Engage In Workouts?

Simple: Low-risk workouts, like underpriced, wonderful companies (Buffett calls these “generals”), are few and far between. When your generals are running up in price, your workout positions often struggle (or fail) to keep up. When your generals or the markets are dropping or doing nothing, workouts can help keep your portfolio afloat and compound your returns.

Engaging in workouts, however, is very time-intensive for a moderately small payoff. Add taxes into the mix, and you are getting very little for a considerable amount of work. So, is the payoff worth it? Well, if your job is to analyze thousands of deals and hundreds of annual reports each year, workouts are often worth the effort.

If you are casually investing for your own portfolio and only intend to spend a few hours a year on your investments, workouts may not be for you. (And don’t feel bad about it. Intelligent investing does not imply investing in ever deal available.)

Should I Use Margin On My Workouts?

Buffett has said:

When you combine ignorance with leverage you get some pretty interesting results.

If you are blindly speculating on workouts, you most certainly should not use margin. If, however, you are approaching each workout in a rational, well-researched manner, you may consider using leverage like Buffett mentioned in his January 1962 letter to partners:

I believe in using borrowed money to offset a portion of our work‐out portfolio since there is a high degree of safety in this category in terms of both even results and intermediate market behavior…Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs.

A prime example of this (in my recent use) was the Tribune workout. On December 19, 2007 – just two days before the going private transaction was complete – Tribune’s CEO, Dennis FitzSimons, resigned. The market took that as bad news and pummeled the stock from $33 and change to $30 and change.

Had these “investors” bothered to read the details of the deal rather than look at price alone, they would have known that the CEO intended to step down when Zell took over. While the smart people were seeing turbulence and an upset applecart, I saw the tell-tale sign that the transaction was done and Zell was stepping in.

I tripled my position on Tribune using nothing but margin (though it still worked out to be less than 20% of the entire portfolio) and we were able to turn a 10% gain into a 30% gain.

So, should you use margin? Only if you know the deals inside and out and can act quickly and decisively when noise creates opportunities.

There’s A Class Action Lawsuit Against On Behalf Of The Shareholders!

There’s almost always a class action lawsuit filed the second a workout transaction is announced. That’s why companies cover their bases by bringing in outside analysts to determine a price and by shopping the deal to a number of buyers.

If the steps are followed properly (they often are) and a majority of shareholders approve, the class action lawsuit is little more than a shot-in-the-dark advertisement for the filing attorneys.

Why Do I Keep Missing Out? The Premium Dries Up Too Quickly!

When looking for workouts, look to find deals that were announced more than six months ago. Recently announced workouts have a long way to go before closing. The “older” ones are approaching their closing dates and, as often happens, have likely been forgotten by Wall Street.

Remember, on Wall Street, yesterday’s news is old news.

Is This Deal Too Good To Be True?

From time to time, the markets overlook a “done deal” and you have the opportunity to make a handsome return. You simply need to know why the deal might be grossly mispriced. Is the transaction too small for people to notice? Is there something hiding in the deal that adds risk?

Though the majority of workouts have the potential to provide a consistent return, you may run across a grossly mispriced workout from time to time. Remember: the transaction, not the price, is the tool.

Well, that’s the skinny on workouts. I know – there are a ton of unanswered questions looming out there. You have to remember that investing is both art and science. There is no universal checklist to analyze all workouts, just like there is no universal spreadsheet to analyze all companies (even though they may be floating around).

You have to look at each company and opportunity. The formula is always the same; still, the input will greatly affect the output.

A Note From Joe Ponzio

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