Warren Buffett (Trades, Portfolio) used the "workouts" strategy to get more “steady absolute profits” year over year than the Generals strategy. In the Jan. 18, 1964 Partnership letter, he described the strategy:
“Workouts” - These are the securities with a timetable. They arise from corporate activity - sell-outs, mergers, reorganizations, spin-offs, etc. In this category we are not talking about rumors or "inside information" pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in the paper. The risk pertains not primarily to general market behavior (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialize. Such killjoys could include anti-trust or other negative government action, stockholder disapproval, withholding of tax rulings, etc. The gross profits in many workouts appear quite small. A friend refers to this as getting the last nickel after the other fellow has made the first ninety-five cents. However, the predictability coupled with a short holding period produces quite decent annual rates of return."
In years of market decline, the returns generated by these stocks provided a strong hedge to the market’s performance. In years of market upswings, they were a drag on performance. Buffett believed this category could also provide the same level of outperformance over the Dow that Generals did.
M&A arbitrage
At the time, Buffett did lots of merger and acquisition arbitrage bets. These happen when a deal is on the table and all parties have approved it, but there is still a differential between the stock price and the deal price. Back then, discounts were reasonable. Today, they are extremely small (could be 1% to 3% for a six-month deal) and could represent a serious risk if the deal ultimately doesn’t go through. For example, if each trade gives you 2% and at the 11th trade makes you lose 20% because the deal doesn’t close, then there goes all the accumulated earnings.
You can be a stock market genius
Today the workouts or special situations strategies have evolved and investors are focused on other kinds of corporate events. In Joel Greenblatt (Trades, Portfolio)’s classic book, “You Can Be a Stock Market Genius,” he presents several examples of operations, like spinoffs, rights offerings or bankruptcy proceedings, where the presence of forced institutional selling creates significant investment opportunities with uncorrelated supra-normal returns. I strongly recommend reading the book.
Over the past 15 years, for example, the Bloomberg U.S. Spin-Off Index has returned 999.4%, while the S&P 500 Index returned 203.9%. The same return differential can be found in other developed or emerging markets.
The edge
The really great feature of this strategy is it allows investors to capture upside returns with downside protection in any market environment.
The strategy could simply be defined as fixed percentage of a portfolio. Or it could be dealt as a residual category, where an investor allocates it to the percentage of the portfolio that hasn’t found investable Generals opportunities. It could also be managed to control the level of fear and of higher market valuations by assuming a higher percentage of the portfolio in those times. Generally, M&A arbitrage and spinoff opportunities will present themselves more in bull markets, while rights offerings and bankruptcy proceedings operations will occur more frequently in bear markets.
I will leave you with an example from the January 1964 letter, which is the Texas National Petroleum investment. The situation was a sellout followed by a liquidation proceeding:
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"This situation was a run-of-the-mill workout arising from the number one source of workouts in recent years -- the sellouts of oil and gas producing companies.
TNP was a relatively small producer with which I had been vaguely familiar for years.
Early in 1962 I heard rumors regarding a sellout to Union Oil of California. I never act on such information, but in this case it was correct and substantially more money would have been made if we had gone in at the rumor stage rather than the announced stage. However, that's somebody else's business, not mine.
In early April, 1962, the general terms of the deal were announced. TNP had three classes of securities outstanding:
(1) 6 1/2% debentures callable at 104 1/4 which would bear interest until the sale transpired and at that time would be called. There were $6.5 million outstanding of which we purchased $264,000 principal amount before the sale closed.
(2) About 3.7 million shares of common stock of which the officers and directors owned about 40%. The proxy statement estimated the proceeds from the liquidation would produce $7.42 per share. We purchased 64,035 shares during the six months or so between announcement and closing.
(3) 650,000 warrants to purchase common stock at $3.50 per share. Using the proxy statement estimate of $7.42 for the workout on the common resulted in $3.92 as a workout on the warrants. We were able to buy 83,200 warrants or about 13% of the entire issue in six months.
The risk of stockholder disapproval was nil. The deal was negotiated by the controlling stockholders, and the price was a good one. Any transaction such as this is subject to title searches, legal opinions, etc., but this risk could also be appraised at virtually nil. There were no anti-trust problems. This absence of legal or anti-trust problems is not always the case, by any means.
The only fly in the ointment was the obtaining of the necessary tax ruling. Union Oil was using a standard ABC production payment method of financing. The University of Southern California was the production payment holder and there was some delay because of their eleemosynary status.
This posed a new problem for the Internal Revenue Service, but we understood USC was willing to waive this status which still left them with a satisfactory profit after they borrowed all the money from a bank. While getting this ironed out created delay, it did not threaten the deal.
When we talked with the company on April 23 and 24, their estimate was that the closing would take place in August or September. The proxy material was mailed May 9 and stated the sale 'will be consummated during the summer of 1962 and that within a few months thereafter the greater part of the proceeds will be distributed to stockholders in liquidation.' As mentioned earlier, the estimate was $7.42 per share.
Bill Scott attended the stockholders meeting in Houston on May 29, where it was stated they still expected to close on Sept. 1.
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The ruling was received in late September, and the sale closed Oct. 31. Our bonds were called Nov. 13. We converted our warrants to common stock shortly thereafter and received payments on the common of $3.50 Dec. 14, 1962, $3.90 Feb. 4, 1963, and 15 cents on April 24, 1963. We will probably get another 4 cent in a year or two. On 147,235 shares (after exercise of warrants) even 4 cent per share is meaningful.
This illustrates the usual pattern: (1) the deals take longer than originally projected; and (2) the payouts tend to average a little better than estimates. With TNP it took a couple of extra months, and we received a couple of extra percent.
The financial results of TNP were as follows:
(1) On the bonds we invested $260,773 and had an average holding period of slightly under five months. We received 6 ½% interest on our money and realized a capital gain of $14,446. This works out to an overall rate of return of approximately 20% per annum.
(2) On the stock and warrants we have realized capital gain of $89,304, and we have stubs presently valued at $2,946. From an investment or $146,000 in April, our holdings ran to $731,000 in October. Based on the time the money was employed, the rate or return was about 22% per annum.
In both cases, the return is computed on an all equity investment. I definitely feel some borrowed money is warranted against a portfolio of workouts, but feel it is a very dangerous practice against generals.
We are not presenting TNP as any earth-shaking triumph. We have had workouts which were much better and some which were poorer. It is typical of our bread-and-butter type of operation.
We attempt to obtain all facts possible, continue to keep abreast of developments and evaluate all of this in terms of our experience. We certainly don't go into all the deals that come along -- there is considerable variation in their attractiveness.
When a workout falls through, the resulting market value shrink is substantial. Therefore, you cannot afford many errors, although we fully realize we are going to have them occasionally."
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