Although it would be difficult to estimate the chance of realization quantitatively, I think they are a combination of both the catalyst and the margin of safety. For example, a stock trading below net-cash value even after a liquidation announcement certainly has a higher probability of realization than a company trading below net-cash but with no announcement made regarding liquidation or strategic alternatives.

I know it sounds intuitive, but I am mentioning this because Ben Graham developed a formula for arbitrage and special situations that takes into account the chance of realization. A portion in Security Analysis book appendix (1950s edition) actually discusses the use of the formula.

Ben Graham’s risk-arbitrage formula to determine optimal risk/reward is:

Return= CG-L(100%-C)/YP

Where:

• C is the expected chance of success (%).
• P is the current price of the security.
• L is the expected loss in the event of a failure (usually original price).
• Y is the expected holding time in years (usually the time until the merger or liquidation takes place).
• G is the expected gain in the event of a success (usually takeover price o liquidation value).

The answer is that costs related to winding down operations should be included to the extent that they are real costs. Severance, pension, and similar liabilities are all real costs, and so should be included (most notably termination payments to management). We don’t explicitly calculate them because we’re looking for situations where the margin of safety is so large that those costs are negligible relative to that upside.

G

Green

I notice that you don’t factor in any costs related to winding down operations. I guess this will be negligible for larger companies and ones with a huge margin of safety. But I wonder if this is something that should be discounted for some of the smaller ones. Although total liabilities is fully accounted for, is there a possibility of severence, pension, and similar liabilities that can crop up during a liquidation?

I just bring up this thought because your mistake last year seems to have been the oversight of off-balance-sheet liabilities. Being a total newbie to liquidations and financial analysis in general, I wonder if there can be sizeable liabilities not mentioned anywhere in the financial statements. I suspect in Graham’s days we never had pension liabilities or environmental liabilities like the present.

The reverse chronological posting is kind of confusing but maybe it takes some time to get used to it…

SOAP looked particularly good to us because it was one of the most deeply discounted net cash stocks we’d found (it was trading at about 40% of its net cash value) and management had taken steps to shut down part of the business so that its ongoing business was small in comparison to its net cash position. This meant it was unlikely to dissipate that cash quickly. We had no real idea about how effective Mark Nelson and Mithras would be, but we thought he had a *good* chance. That seems to be working out well, but I don’t think we could have predicted that at the start.

Contrast SOAP with AVGN, our best performer. AVGN was also deeply discounted (about 53% of net cash – not as deep as SOAP) but had a high historical cash burn rate, which meant there was a real risk that it could burn through its net cash value. We had no idea how effective BVF would be, but BVF has been an absolute revelation. Although its not yet finished, we think the campaign has been run superbly.

We’re not sure yet what the lesson is, but it certainly helps to have a simple situation (i.e. a stock trading at a discount to net cash).

How do you suggest we determine the chances of realization from the beginning? Is it a question of the stock or the catalyst (or some combination of both)?