When you think of a soaring stock, you might think of a company linked to a hit consumer product, a medical breakthrough, or an industry-disrupting innovation. Spin-offs, bankruptcy processes, liquidations, and other special situations may not come to mind so quickly—but these corporate events can have a big impact on stock prices.
Corporate events often lead to forced selling pressure, limited research coverage, and market inefficiencies that can lead to a greater probability of a security’s being mispriced—and this has the potential to create opportunities for a disciplined, patient, and opportunistic investor.
For example, consider the case of the May 2012 corporate spin-off from energy company ConocoPhillips. A spin-off—where a parent company transfers some of its assets to form an independent company that it distributes to its shareholders—can be a catalyst for improved performance. The management team of the newly independent company may have increased control and direct ownership of the new entity. The new structure may make them more willing and able to cut superfluous costs and go after adjacent markets—all of which could benefit shareholders over the long term. At the same time, the spin-off may experience less research coverage and have fewer natural buyers, as passive strategies may be forced to sell the new stock if it is not listed in the same index as the parent company.
In May 2012, ConocoPhillips spun off its refinery and chemicals business as a separate entity—Phillips 66. While Phillips 66 remained in the same index as its integrated oil parent, some holders of ConocoPhillips sold the spin-off early on. They had owned the parent because they wanted to invest in an integrated oil company, and had no interest in owning a refining and chemicals company. This created an interesting entry point for long-term fundamentally driven investors who believed that refining margins would hold over time and that the market was not appreciating the long-term value of the chemicals business that would be unlocked by the entrepreneurial Phillips 66 management team. For the refining and chemicals spin-off, early-selling dynamics and an advantageous business mix relative to competitors helped make the spin-off a success, with the price of the stock rising from roughly $30 per share to $70 per share in less than a year.
“Phillips 66 was a case where the stock price suffered early on due to misunderstanding of the business mix, initially weaker research coverage, and selling from an active large-cap investor base that hadn’t yet taken a deep dive into the spin-off and sold it off early as it was inconsistent with parent ConocoPhillips’s integrated oil thesis,” notes Arvind Navaratnam, who led the design of Fidelity’s event-driven funds and is manager of the Fidelity® Event Driven Opportunities Fund (FARNX). “For investors who could take a long-term view and understand the company’s refining margins over time, the asset value of the chemical division, and event dynamics, it was a great buying opportunity.”
Event-driven investing explained
When a corporation experiences an important company-specific event, such as a spin-off, merger, acquisition, or emergence from bankruptcy, it can have a big impact on the price of a company’s stock and that of any related entity. In the wake of the event, the stock price may not trade in line with the fundamentals. For example, an index delisting or emergence from bankruptcy may result in forced selling from index funds or from recently equitized former creditors. In the case of mergers and acquisitions, there may be a mispricing based on the probability of a transaction closing that is not fully appreciated by the market.
For a long time, hedge funds have taken advantage of these types of corporate events to try to add value to their portfolios. Now these strategies are becoming more accessible to individual investors, with professionally managed mutual funds and exchange-traded funds (ETFs).
|Types of investable events|
|Index deletions||Declaring bankruptcy||Corporate restructuring|
|Index additions||Emerging from bankruptcy||New Management|
|13D filings*||Liquidations||Dividend increases|
|Mergers||Form 4 filings**||Dividend reductions|
|Acquisitions||Management changes||Share buybacks|
|* Provides notification that a person or group acquired more than 5% of any class of a company's shares. ** SEC form company insiders must submit detailing transactions they conduct involving that company.|
Here is another example. Delphi, an American multinational automotive parts manufacturing company filed for bankruptcy in 2005. The company emerged from bankruptcy in 2009 and was listed in 2011 as a much leaner and more profitable company. The newly restructured company listed its initial public offering at $22 per share and, because it shed liabilities, sold unprofitable businesses, and reduced costs through the bankruptcy process, the company’s stock price nearly tripled in value within two years of its IPO.
“There was little coverage of Delphi during its bankruptcy process, and many investors underappreciated the dramatic changes the company had made during those years,” says Navaratnam. “When Delphi came out of bankruptcy, it was a completely different company from when it filed—it was in more attractive end markets, more profitable, and less burdened with debt and pension obligations.”
Of course, simply buying every company that is emerging from bankruptcy, that is spun off, or that is part of another corporate event may not be enough to produce profits.
“These special situations create the potential to generate alpha—excess return,” says Navaratnam. “To capitalize on that potential, you need to do thorough research to identify mispricings in the market, understand industry dynamics, and partner with quality and properly motivated management teams, in an attempt to select the events most likely to lead to investment gains.”
Lower correlation with other asset classes
Because special situations are inherently focused on company-specific events instead of market events, corporate events over the long term tend to be less meaningfully sensitive to macroeconomic conditions—such as inflation, monetary policy, or interest rates—than are other investment types. This means that event-driven funds may have a lower correlation to other investments, which increases their attractiveness to investors seeking portfolio diversification. The addition of a lower- correlated equity fund to an individual’s asset allocation means that the parts of an overall equity portfolio are less likely to move in lockstep together. Additionally, diversifying the type of event strategies in a portfolio can further enhance the correlation benefit, because the strategies themselves are not perfectly correlated to each other.
Nevertheless, it is important to recognize that lower correlation does not mean lower volatility or risk. The sector exposure of these funds could vary significantly over time, driven by the prevalence of event opportunities. As a result, performance of event-driven investment strategies may fluctuate significantly over shorter time periods.
Differences in event-driven strategies
While all event-driven funds invest in corporate actions, their investment approaches can differ considerably, with varying degrees of risk, return, liquidity, and volatility. Investors who may be considering event-driven investments should understand the differences in these various strategies in order to choose the one(s) most appropriate for their portfolio objectives and time horizon.
- Long/short vs. long-only approach. Some event-driven funds allow short selling, which can increase potential return but may expose investors to additional risk. A long-only strategy offers the potential for longer-term capital appreciation and greater market exposure, but investors with short-term objectives should be aware of its potentially higher volatility.
- Pre-event vs. post-event investing. Depending on the particular corporate action, investments made in anticipation of an event can increase potential return, but they also increase the risk of losing money if the event does not unfold as expected. By comparison, investing in a corporate action after it has occurred can generally have less risk and uncertainty, but potentially less upside as well.
- Illiquid vs. liquid strategies. Event-driven investing in only illiquid securities (such as pure distressed debt) tends to offer more numerous opportunities when the economy is weak, because more companies are apt to become distressed. These distressed debt securities can increase in value as the economy recovers and business conditions improve. However, illiquid securities often cannot be easily sold or exchanged for cash without a substantial loss in value. Liquid securities, such as common stocks, offer greater trading flexibility and often have greater upside potential in bullish market environments.
- Single-event vs. multi-event funds. Funds that invest in a single-event category (e.g., distressed debt) will tend to profit if that particular event is experiencing a favorable market environment, but an “all eggs in one basket” investment approach rarely succeeds over time. Funds that invest in a cross section of corporate actions typically offer better diversification and less risk than a single-event strategy.
Event-driven investing is a growing market segment that may appeal to investors as part of a broadly diversified portfolio due to its potential for alpha capture and lower correlation. For investors with longer-term objectives and higher risk tolerance, the diversity and breadth of securities in this universe may offer an attractive capital appreciation opportunity with lower correlation to equity assets. On the whole, we believe that an event-driven portfolio that is invested in a diversified pool of long-only, post-event securities may provide an attractive balance of potential return, correlation, and liquidity.
Past performance is no guarantee of future results.
Investing involves risk, including risk of loss.
Diversification and asset allocation do not ensure a profit or guarantee against loss.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917