Why do we gravitate towards Special Situation investing?
When everything is special and unique
In recent years, we have progressively moved from Graham type of investment to other style of investing. The issue is that we realise that a lot of the Graham type companies we own looks cheap and remain cheap.
Graham type investment also often get us into illiquid position.
Sometimes, we feel a bit silly as what has been seen in our Hanwell trade. Majority investors are buying and we are selling to them all for the sake of lessening our risk as the share price may have reduced liquidity in the future.
As full time investors, we are pragmatic and soon decide to gravitate towards what seems to be working for us.
Growth companies seems to work and we had incorporate a category Building a "Unrecognised Growth" Portfolio. We had some modest success there.
Another areas which continue to leverage on is Special Situation type of investing covered in our past articles in Building a Special Situation Portfolio #1 and #2.
Under Special Situation Investing, we had been educated by the First Ship Lease management that they will try to return capital back to shareholders. Every dividend that we received help to reduce risk within our position. At one time FSL constitute almost 20% of our portfolio, it constitute less than 2% now. We had managed to pare down our position during periods of liquidity brought about by the dividends.
The beauty of special situation investing is that the formula is never fixed like Graham type of investing. We are limited by our imagination on what could possibly happen and then weigh the possibility of it happening.
The more special situations embedded in the stock pick, the higher the chance of something good happening to the share price. The higher the possibility of the special situation happening the better.
If the two or more special situation are distinct and are mutually exclusive, the chance of each happening improves.
If they are non-mutually exclusive, that is fine too!
For special investing, there is no such thing as too much of a good thing for the more the merrier, the higher the possibility the better.
Known Downside:
Since we have a thesis in our head on what is possibly going to happen, then we could make intelligent decision.
If the special situation did not turn out to what we had expected, we could have sold regardless of the movement of the share price.
If it is down, we are out because of a good reason.
If it is up, we can say thanks to our lady luck.
Unlimited Upside:
And for the first time, we can entertain a drift in thesis.
For a Special Situation could easily drift into an Unrecognised Growth type of company and eventually become an Industry Leader. This drift in thesis allow us to hold the shares of the company for a long time allowing compounding to happen.
This almost never happen to us in Graham Style investing for we are always looking at exit once we hit fair value (never at exorbitant prices) or when the market get too exuberant.
Conclusion:
We are very tempted to just drop Graham type without a special situation for we do not have any idea on why a company is unwanted other than being cheap. It is just too easy to find cheap stocks on the market nowadays and we really do not know how long they would stay that way. We can never be certain if a Graham play turn out to be a value trap, trapping us with ever lower share price.
Going forward, all recommendation in whatever investment basket above will have a Special Situation angle to it. Special Situation investing also allow us to make decision in a Bayesian probability model which appeal very much to us intellectually. While we are often reluctant to drop what had worked for us for so long, we cannot deny that Special Situation Investing is our “new normal”.
We will be going 100% into Special Situation for all our baskets except for Unrecognised Growth Portfolio.
Cyclical and Turnaround Portfolio
Graham Portfolio
Industry Leaders Portfolio
We wanted to train ourselves to have more conviction in our ideas and Special Situation is something we can clearly hammer on.
While this may be a departure from our more diversified investing style of the past, we think that we can get significantly more upside, within a shorter timeframe, lesser chance of permanent loss and allow for possibility of better compounding over the long term.
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Our thoughts is that Deep Value works but we will give more allocation to Deep Value coupled with a Special Situation. The catalyst and optionality which are not price into such situation makes the upside more violent and quicker. In addition, we are trying to move away from a diversified portfolio towards a more concentrated portfolio. That require tons of conviction which Special Situation + Deep Value can give to me unlike just Deep Value... The ability to entertain a drift in thesis is a plus as well.
Changing styles is often a difficult consideration. Too stubborn, and you end up losing money for decades. Too fickle, and you end up as a performance chaser that gets whip-sawed around.
My deep value component of the portfolio has similarly underperformed my expectations in the past 3-4 years (mid single digit CAGR). After some thoughtful considerations, I'm still allocating the same weight to the style, because it's worked so well for me for >10 years. Will probably rethink again if the underperformance persists for another 3-4 years.
I see it this way, Buffett is probably still a great investor despite a 10-year underperformance, because he had outperformed for 40-50 years. Similarly, I'll cut the deep value style more slack since it's done so well for me for a long time, while the poor performance has been short relatively speaking.