Saturday, 17 January 2015

Special situation value investing: The case of Metro Baltic Horizons By Olly Wilcock

Special situation value investing: The case of Metro Baltic Horizons

When seeking opportunities value investors desire stocks with a hefty margin of safety, catalyst driven upside, performance independent of wider markets and comprehendible downside risk. Opportunities fitting these criteria do not arise often so patience is important. Earlier this year however an opportunity arose concerning Metro Baltic Horizons (LN:MET), a small property development company. Through this example, which ended favourably, I will highlight some of the key aspects of special situation value investing.
Metro Baltic Horizons used to be a successful property company in Eastern Europe. However at the start of the year it just held €6m cash. This was due to a long history of corporate troubles from various sources. Under the new board, led by Ronan Reid, MET had no ongoing operations. It’s only explicit aim was to return cash to long-suffering shareholders.
Margin of Safety
In investing a margin of safety is the difference between the intrinsic value of a stock and its market price. Value investors seek a stock priced well below their intrinsic valuation of it in order to ensure capital preservation. It is difficult to ascertain intrinsic value, however cash per share is probably the best form of a margin of safety as cash is more liquid than any other asset.
In early March MET traded at 12p per share, however held 17p per share in cash. Therefore it arguably traded 41% below intrinsic value. MET spent €500k a year to function, so by next year the net asset value would be 16p. Regardless of future eventualities, the investor had a tangible margin of safety in the investment, effectively buying 16p cash for 12p.
A catalyst is an event that transforms the performance of a stock, normally on a short time scale. MET’s catalysts came in the form of potential legal winnings: The current board blamed previous auditor and board failings through negligence, fraud and deception for the company’s desperate decline from successful property fund to merely a cash shell. Therefore the current board embarked upon two court cases against the previous auditors and a group of prior directors. The combined value of the arbitrations claims was £30m (106p per share). On average International arbitrations are said to take two years to complete. Proceedings began in October 2012, so by March 2014 an outcome was anticipated sooner rather than later.
Simply put If MET won the court cases, or there were out of court settlements, shareholders would win big. Even just 10% of the claims figure would double the company value. With MET hiring law firm Jones Day and Leona Powell QC as legal advisors, it was clear that management were serious about these cases. With a big catalyst and a clear margin of safety on offer this was therefore an opportunity with an attractive risk-reward profile.
Inevitably there were risks and uncertainties involved in the situation. Most obviously, MET may have had a weak legal claim, thereby losing court cases and burning through its cash pile. However given the cash per share excess in this offering even this outcome could have been a catalyst. This is because a poor result would likely compel management to finally wind up the firm and pay out to shareholders.
Second there was time horizon uncertainty. Whilst MET announced legal proceedings in October 2012, there was no concrete information on when an outcome would be reached. Investors had been kept in the dark as to the progress of the proceedings. Indeed some were beginning worry whether the new management were any better than the previous value-destroyers. That said investors knew that there was four years left of funding, providing cash was spent at the same yearly rate, before the margin of safety was eroded. This seemed like enough time for a result. Given that two years had already passed since legal proceedings had been announced, investors felt that a game changing announcement was imminent.
The Result
On 28th March 2014 MET released a statement announcing that it had reached an out of court settlement with former directors. MET agreed to dismiss all claims against the directors in exchange for £2.5m (9.5p per share). On this day the stock rose ~70%. Then on the 6th May 2014 the company announced a £425k settlement with its former auditors, adding a further 1.6p to the company’s assets. Later that month the firm proposed a suspension of share trading and a plan for return of cash to shareholders. Shares purchased before 28th March rose 84% over the period.
Screen Shot 2014-12-07 at 13.43.05
Figure 2: MET Share Price 21/02/2014-23/05/2014
In sum this article has shown the dynamics of a special situation opportunity from a value investment point of view. MET had a strong margin of safety to give investors piece of mind in preserving capital, but also offered possible upside thanks to the legal catalyst. It is important to note that not every special situation will work out as favourably for investors. However as can be seen from this case study with the correct assessment of risk and reward there are interesting opportunities still cropping up that can be well exploited by adopting a value investing approach.
Take-home points
  • Margin of safety: stocks which clearly trade below intrinsic value
  • Catalysts: What are the key reasons the trajectory of a stock is going to change?
  • Risk: Does the margin of safety outweigh the risks and uncertainties inherent to the situation?
  • 80/20 rule: 80% of information can usually be amassed in 20% of the time, so at some point an investor must accept they cannot know everything, trust their judgement, and swing the baseball bat (or move on)
Margin of Safety. Seth Klarman
One up on Wall Street. Peter Lynch
The Intelligent Investor. Ben Graham
London Stock Exchange MET Regulatory News Service

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