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Zig when others zag: What is event-driven investing?

The art of looking for mispriced securities and undervalued companies takes time and patience, portfolio manager Arvind Navaratnam says


Date: December 10,2014

There are no shortage of philosophies and techniques used by investors, but most of them have been in existence for decades or more. So it’s rare when we hear of something new.

Just such a rare situation took place in November when Fidelity Investments Canada launched the Fidelity Event Driven Opportunities Fund, a fund that is unique in the Canadian market and which is also offered in a corporate class version. So the first question is: What is event-driven investing?

Fidelity defines event-driven investing as seeking to uncover mispriced securities of companies because of special situation events such as spin-offs, index deletions, mergers and acquisitions, companies undergoing reorganizations, proxy fights and 13D SEC filings, which may be a precursor to events such as takeovers or company breakups.

The fund company notes that these events often have limited research coverage and can trigger automatic selling, offering an opportunity for active managers to invest in a down moment and generate superior returns for shareholders over the long term.

Arvind Navaratnam led the design of the funds’ investment strategy and serves as portfolio manager. He says a disciplined, patient and opportunistic investor can use event-driven investing to successfully gain an advantage. “You can get a phenomenal business at a fabulous price,” he says.

It would be easy to get the wrong idea of how this plays out. The fund is not managed by a day trader speculating on what companies are going to be taken over or added to a stock index.

“I sort the world by corporate actions. I don’t put a dollar to work unless historically that event has led to dramatic outperformance,” Mr. Navaratnam says. He also notes the average period he holds a stock is two years.

One of the primary events the fund capitalizes on is the deletion of a company from a major stock index, such as the Standard & Poor’s 500. It is estimated that more than $2-trillion of investment money “mirrors” the S&P 500, including through vehicles such as index funds and exchange-traded funds.

Mr. Navaratnam notes that when a company is removed from that index, it is hit with massive forced selling pressure, without regard for the company’s intrinsic value. That invariably drives down the company’s stock price. Mr. Navaratnam’s research has found the shares of these companies tend to enjoy a subsequent meaningful outperformance.

Mr. Navaratnam points to the example of RR Donnelley & Sons Co. – the Chicago-based printing firm. It was removed from the S&P 500 in December of 2012. The firm’s shares were hit with resultant forced selling – and like many companies being dropped from indices, it had the added disadvantage of being in an out-of-favour, “old economy” industry.

The market was expecting Donnelley’s sales and profit to fall by at least 10 per cent, but Mr. Navaratnam met with the company and became confident they would be be able to fare quite a bit better. That turned out to be the case, and in less than a year the firm’s shares had doubled in price.

One of Mr. Navaratnam’s other favourite events is companies “spinning off” one of their businesses. He has found that newly spunoff companies have a tendency to significantly outperform the rest of the market.

The first reason that happens is the company that has been spun off usually is not immediately added to a major index, so it is hit with selling pressure from investors who owned the original company.

Then two other factors come into play. The first is the entrepreneurship of the spinoff company’s management is given a chance to flourish. At the same time, management has an incentive to play down its financial forecasts, often because their stock options are based on the initial share price of the spinoff, which is affected by the financial outlook for the company. Those factors are often a recipe for strong performance after the spinoff takes place.

He points to the spinoff of Chipotle Mexican Grill Inc. from McDonald’s Corp. in 2006, as a great example of all of these factors coming together.

Eric Kirzner, professor of finance at the Rotman School of Management at the University of Toronto, thinks there is potential in event-driven investing. He sees it as a form of value investing, in that it is looking for mispriced securities and undervalued companies.

In that way he thinks it can be a valid approach, but he notes success will depend on the skill of the manager in assessing the price impact of the event and determining whether they have a mispriced candidate. As he puts it: “You have to be good at it.”

Like any investment, the assessment of the effectiveness of event-driven investing will be long-term performance. Mr. Navaratnam is a big believer in that philosophy.

“You have to be patient,” he says. “That is the best perspective. I don’t think in terms of if the market goes up or down next year how my fund will do. I use a systematic approach that I know works. And patience is my No. 1 tool.”

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