Business Spotlight

Understanding Special Situation Investing

By SIDDHARTH MEHROTRA (Proprietor) CLIENTSFIRST

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SIDDHARTH MEHROTRA
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In the markets, the exquisite union of a suitable price and irresistibly attractive valuation of an efficiently-managed company is a fervent wish of most investors. This is because well-managed companies bought at attractive prices tend to reward investors in the long-term. However, it is rare for a good stock to be available at an attractive price. The only window of opportunity one gets is when a company goes through a rough time and at that time most investors do not wish to own the stock despite its attractive pricing. Alas, they forget that adversity too contains hidden opportunities. Savvy investors make use of such market situations and load up on a stock with a view to make money in the medium to long term. This investment style is called “Special Situation” investing.

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What is Special Situation Investing?

Special situation investing is all about buying stocks of companies which have strong fundamentals but are going through a tough phase. This idea can be explained with a few examples.  

Then, there is another instance. A company X acquires a company B. Post the acquisition, the share price of the company X falls as authorities flag regulatory concerns in the business of company B and hence the stock price of X sees a sharp correction. But fundamentally, there is no problematic aspect in the business of company X. This is another instance of special situation investing.

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Lastly, a blockbuster product of an FMCG MNC company going through rough weather due to regulatory action. That pulled down the company’s share price and threw an opportunity to buy its shares to discerning investors. Given that the company’s business fundamentals were otherwise strong, savvy investors would make use of this opportunity despite the current adversity the company is facing, making it another example of special situation investing.

Situations which Trigger Special Situations

Many a time, investors assume that a good company cannot go through a rough phase in its operations. But there are developments which are not directly the result of the decisions taken by the company. Sometimes, companies backed by good management, robust processes and with a bouquet of products and services go through temporary phase of regulatory challenges, fierce competition, adverse macro-events unrelated to their business or even adverse sector-specific developments.

Due to such unfavourable developments, the share price of such companies fall. But these are largely short-lived corrections. What doesn’t kill you makes you stronger holds true for such companies. Fundamentally strong companies tend to overcome such situations and emerge as winners. Investors must remember this important fact when considering to invest in companies which may be going through a temporary rough phase.

But wait! there is a flip side too. Not all companies quoting at attractive valuations are worthy of investments. Some are value-traps. An investment in these companies may lead to permanent erosion of capital. Then, how does one figure out a special situation case? First, thoroughly understand why a company is available at an attractive price. Second, is the stressor going to be temporary or a permanent one.

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Typically, when the business situation of a company returns to normalcy after a challenging period, its valuation also reverts to its mean. Subsequently, the company continues on the path of growth. But the moot question which emerges here is, how many investors are competent enough to select the right businesses at a right price? Many investors may lack the skill-set, time or willingness required to identify the right companies.

A dedicated mutual fund scheme can be of great help for investors looking to benefit from special situations. Such funds tend to have portfolios concentrated portfolio of companies and are market cap and sector agnostic in nature. When investing in such a scheme it is better to opt for the Systematic Investment Plan (SIP) or Systematic Transfer Plan (STP). These routes of investing in mutual funds help to mitigate risks and reduce the urge to time the market. To make meaningful returns, investors must have three to five years of time-frame in mind when they decide to invest in such type of scheme. 

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