Street Capitalist: Event Driven Value Investments

The term special situations is a vague one, but is used often in investing. Many value investors will allocate a certain percentage of their portfolio to special situations, these are usually investments based on corporate balance sheet events.

Below are some great insights from a Financial Times article on Luke Newman, manager of F&C’s Special Situations Fund:
MANAGED FUNDS SERVICE: Strength in special situations

Newman believes the best opportunities are found in companies that are in the process of recovery or a turnaround.

Companies under new management or companies in an environment that has recently become open to consolidation provide strong value.

Young industries also are regularly undervalued and Newman says that he’s “trying to find companies that could remain at growth levels ahead of their competitors… Online gaming continues to look like very very good value to me because there are so many regulatory hurdles to be crossed in the US. The longer the status quo remains, the better the value.”

Unfashionable markets are also appealing and Newman says,“I like to invest in companies that have a contrarian feel to them” in order to find industries where a number of companies may have been neglected by analysts and thus trade at a discount to NAV.

Newman also invests with macro-economic trends in mind, he is “looking to increase the fund’s exposure to oil equipment companies as he thinks they will see rising profits as oil groups such as BP and Shell send business their way.” and is “bullish on consumer stocks in the UK as a play on all the speculation that interest rates will have a big impact on consumer spending levels within the country.”

The Non-Farm Payroll numbers that came in on the extreme short side, with Payroll forecasts ranging from 35,000 to 140,000. The actual numbers were -4,000. This was the first time since the numbers were negative since August 2003.

This is unequivocally bad news for the dollar, raising the probability that the Fed will cut interest rates on or before its next meeting on September 18 to almost 100 per cent
-Michael Woolfolk, at Bank of New York Mellon.

This unexpected negative number is a shock to many and certainly helps show the possibility that the US mortgage market problems are affecting our economy.

All of this is now leading to the market pricing in a 25bps-50bps rate cut for the September 18th meeting.

What does this mean for the market?

The dollar and US equities will definitely be weaker, especially as some view this latest report to be yet another indicator for an impending recession.

Economies with close ties to the US are also at risk, this means that the Mexican Peso is likely headed downward. Mexico sends more exports to the U.S. than any other Latin American country, so its economy is heavily tied to the well being or our own.

Evidence of Mexico’s weakness has already been seen with price movements on the Peso. On Friday, the peso weakened 0.8 percent to 11.1412 per dollar at 5:07 p.m. in New York, the biggest decline since Aug. 15.

Areas of Strength

EUR/USD - according to the Financial Times, the fact that the ECB still remains hawkish on raising interest rates, their distance from the mortgage market troubles, and the overall economic strength as reported last week makes this attractive.

JPY/USD - Fearing adverse market conditions abroad, it is the general belief that carry trades will unwind, pushing up the Yen versus most other currencies.

“Investors are likely to continue to try to reduce their exposure to risk,” said Toru Umemoto, chief currency strategist at Barclays Capital in Tokyo in an interview today. “This is likely to reduce capital outflows by Japanese investors.”

Umemoto was ranked the most accurate yen forecaster in 2006 according to a survey completed by Bloomberg News and is accompanied by Bank of Tokyo - Mitsubishi UFJ, Mizuho Corporate Bank Ltd. and Daiwa Securities in being bullish on the yen.

Today the European Central Bank President Jean-Claude Trichet made the announcement that they would not be raising rates — leaving interest rates at 4%, in spite of the recent projections for inflation to rise in the euro-zone.

Trichet is attributing this inaction to the current credit turmoil and the dual roles of the ECB, to combat inflation but also to keep money markets functioning. The ECB injected $57.49 billion into money markets and announced the creation of a three month “longer term refinancing operation” in order to “support” the “normalization of the functioning of the euro money market”.

Important Considerations:

The lack of a rate cut today is not a sign that the European economy is weak. Rather, it is more a decision to allow the ECB to wait and gather more information in regards to recent market volatility.
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Today we saw the release of The Federal Reserve’s beige book covering mid-July through late August. Overall, the report indicated that the economy is continuing on a pace of modest expansion.

The release reaffirmed the Fed’s belief that the current credit-market movement has only had a limited effect on the economy beyond housing according to its regional business survey.

The Fed reported that “credit availability and credit quality remained good for most consumer and business borrowers”

The St. Louis and Kansas City districts reported “a moderate pace” of expansion
The Minneapolis, Chicago, and Cleveland Districts reported an economic expansion at a “modest rate”
Philidelphia and San Fransico both reported expansion but at slower rates.
The Dallas, Richmond, Atlanta, and Boston districts all reported slower expansion rates.

Most Districts reported that manufacturing activity expanded during late July and early August. New York, Richmond, Minneapolis, and San Francisco indicated solid growth. Philadelphia, Chicago, and St. Louis stated that manufacturing expanded but at a slower pace. Manufacturing was stable to increasing slightly in Cleveland, Kansas City, and Dallas, but was described as mixed in Boston and Atlanta.
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One of my fundamental beliefs is that consumer spending drives our economy, this is a lasting lesson from Joseph H. Ellis’ wonderful book Ahead of the Curve. With the current turmoil of the housing and credit markets, I have become extremely interested in determining what sort of effect we may see in real consumer spending (PCE).

Today I stumbled across Housing, Credit and Consumer Expenditure, John N. Muellbauer from the Jackson Hole 2007 Symposium on the Calculated Risk blog. Muellbauer’s study analyzes data over the last few decades to see how the development of credit markets affect consumer expenditures.

The findings were mostly in line with my expectations. Nations with less developed credit markets tended to have “high aggregate household saving rates” (Muellbauer, 8 ) because of a low quantity of loans offered to first-time home buyers. When real estate markets appreciated in these countries, those aspiring to own homes were forced to save more of their income, resulting in a consumer spending decline. This kind of situation changed in the 1990s “largely due to a shift in the mortgage credit supply to first time buyers,” (Muellbauer, 30) leading to the ability to take out risky home equity loans and increase consumer spending. First-time home owners did not need to ssave as much, and existing home owners were able to take out more debt at rates which appeared more attractive, contributing to a rise in consumption.In the US, policy makers created a situation where there was incentive to engage in this reckless behavior.
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