Why You Need Event-Driven Stocks

 | Mar 07, 2013 | 11:00 AM EST
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By choosing to invest in a particular security, one question that must be asked is what is the catalyst, the mechanism by which a stock appreciates? To a value investor, the answer is usually that value is its own catalyst. You buy something for $20 that is worth $50 and over time, due to the generation of cash flows, the gap between price and value narrows.

Yet another catalyst -- one that doesn't come around often but is lucrative -- is the existence of a specific event or potential event that will unlock value. Call them event-driven catalysts. The most generic form is merger arbitrage: a stock trades at $8 that is being acquired for $10 at a future date. You bet that this buyout "event" happens, thereby booking a 25% gain based on the occurrence of this event. Event-driven catalysts can take many different forms. These are a few names with underlying event-driven catalysts or the potential for catalysts.

Dell (DELL) is a perfect example, and the story got better Wednesday with news that Carl Icahn has acquired 10% of the company and opposes founder Michael Dell's $13.65 go-private offer. In fact, Icahn has all but promised a long proxy fight and years of litigation if Dell proceeds with its buyout. Dell now has undeniable opposition from not only Icahn but also its largest shareholder, Southeastern Asset Management. Icahn wants Dell to pay a $9 special dividend and suggests that after the dividend, Dell would still be worth nearly $14 a share. Dell shares now trade for $14.30, significantly higher than the takeout price. I believe Dell's proposed buyout at the current price is dead and shares will continue to climb higher.

J.C. Penny (JCP) has an underlying event that could occur if operating performance doesn't improve this year. The JCP board has already expressed displeasure with current operations and there are suggestions that the board will put the company up for sale if things don't improve soon. JCP shares trade for $14.50 while its two largest shareholders (and board members), Bill Ackman of Pershing Square and real estate mogul Stephen Roth, have a cost basis of more than $20 per share. JCP owns iconic real estate in Manhattan that could fetch a pretty penny in a yield-starved market. If shares continue to slowly trend downward, JCP could become a bargain based on break value and asset sales.

Small-cap Digital Generation (DGIT) is a name I touted when shares were trading above $9. After reporting sub-par quarterly results a couple of weeks ago, the shares fell below $7. I added to my stake below $7 as I felt DGIT's core online advertising infrastructure was worth vastly more than the company's $200 million market-cap. A few days ago, Digital's executive chairman, Scott Ginsburg, revealed that he had bought more than 270,000 shares in the open market at prices between $7 and $8 a share. Ginsburg already owned more than 8% of the company and this commitment of nearly $2 million is very significant. Digital could be a mini Dell in the making: Its strong cash-flow generation would make a very attractive buyout even at prices nearly double today's share price.

Every stock investment needs a catalyst -- it's the reason you invest. Often, that catalyst is driven by the price paid for the value of a company's future growth. But event-driven catalysts can be very lucrative as they provide an opportunity for a nice return in a relatively short period.

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