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Special situations look like a particularly good spot to be in these days. Why? I’ll explain below…

But first, it may help to take a minute to explain what a special situation is. It’s actually an old concept. The best definition may be that of the great Ben Graham – famed value investor and mentor to Warren Buffett.

Back in 1946, Graham gave his definition of a special situation. “In the broader sense,” he wrote, “a special situation is one which a particular development is counted upon to yield a satisfactory profit in the security even though the general market does not advance.”

In other words, a special situation is an investment in which some event – or catalyst –promises to make you gains in the stock, even if the overall market goes nowhere. This doesn’t mean special situations are immune to market forces. Of course they aren’t. But as Graham says, in the typical special situation, “the result depends upon corporate developments, and not on market price.” More of your gains are tied to whether or not your catalyst comes through or not. Ideally, as Graham writes, you want to be in a situation where “if your deal works out, you are sure to make a profit, but if it doesn’t, you may still make a profit.”

There are many such opportunities, but they are often difficult to find. I have identified a number of them for the subscribers of my investment service, Mayer’s Special Situations.

A few of these stocks have already delivered gains. Others are still in the wait-and-see phase. AEP Industries (NASDAQ:AEPI), for example, is the target of a large activist shareholder who has proposed that the company put itself up for sale.

Clearly, a sale is not essential to make AEPI a profitable investment. Perhaps management will, as they’ve hinted, buy back lots of stock, instead. The point is that the something out of the ordinary is happening – something that could produce a sizeable profit for shareholders.

Joel Greenblatt, a successful investor who devotes a lot of attention to special situations, wrote a book entitled, You Can Be a Stock Market Genius. This book is like a handbook of special situation investing. “The underlying theme to most of these investment situations is change,” he writes. “Something out of the ordinary course of business is taking place that creates an investment opportunity.”

Again, the list of what those out-of-the-ordinary things are is long – spinoffs, mergers, restructurings, asset sales, distributions and more. “The great thing is,” Greenblatt writes, “there’s always something happening.”

As a result, special situations are a rich vein to mine. We don’t have to cover the whole field. We just have to find one or two a month and we’ll have plenty of ideas, probably more than we need. For me, many of the best special situations reside in out-of-the way stocks that are simply too small for me to recommend to my large base of Capital & Crisis subscribers.

Getting back to Graham, he also makes an interesting historical observation about special situations that I think is relevant to our own market today. In the years 1939-42, the overall market was not so hot. As Graham put it, “During these years, the trend was unfavorable for those owning standard issues [the big blue chips]… By contrast, many bargain industrial stocks scored substantial advances – especially since the early war years brought proportionately greater business improvement to the secondary companies than to the leaders.”

The idea being that if the market is going to be sluggish and the economy tepid – as I think ours will be – then you don’t want to own the elephants or the headline companies. Generally speaking, you don’t want to own the biggest companies, because they are the market. They are most exposed to the economic winds. It is more difficult for a very large company to grow faster than the economy, for instance.

The smaller companies that occupy some niche have less binding them. Doubly so for the special situation that has some future “event” that could unlock value embedded in the stock. Special situations, I like to think, come with their own onboard motors. And that’s why special situation investing is particularly attractive right now.

Chris Mayer
for The Daily Reckoning

The Daily Reckoning