Tuesday, October 5, 2010

Sell While You Can

Investors in undervalued small-cap companies are occasionally offered significant premiums to their share prices by potential acquirers. The most recent example discussed on this site is that of Nu Horizons. When such an offer occurs, the investor may be tempted to wait for a better offer or wait for the share price to converge with the offer price. This is likely to be a mistake.

As an example, consider GTSI Corp (GTSI), a provider of IT solutions to government customers. It had looked undervalued for a number of months, but was never discussed on this site because of its reliance on a single customer. (Having only a few customers is a source of revenue risk.) Nevertheless, because of the extremely low stock price, some value investors may have considered the risk-reward to be compelling.

These investors were rewarded last month when an offer to buy GTSI was revealed, sending share prices 40% higher. Unless one is a merger arbitrage expert, this was the opportune time to exit for the value investor. But for those who held out for a higher offer price, the news would not be good.

On Friday, the customer on which GTSI is reliant announced that GTSI would be suspended from new business due to violations in how it has performed work in the past. Since this source represents around 75% of GTSI's revenues, this is a major blow to the company's future earnings if it is not quickly rectified. The offer to purchase the company was withdrawn, and GTSI's shares subsequently fell below its pre-offer level.

If the investor is an arbitrage expert and can understand the downside risk versus the upside return of such investments, perhaps remaining in post-offer GTSI shares made sense. For the vast majority of owners of GTSI, however, there was no need to stay in such a risky company (due to its revenue risk as a result of its customer concentration) once the price point was no longer compelling.

The investor should allocate his capital in a manner consistent with his investing strategy. If putting large amounts of capital at risk (which is what a decision not to sell amounts to) for a 5% - 10% gain is not consistent with the investor's strategy, holding on for an arbitrage gain is probably a mistake. A good rule of thumb for the investor is to consider whether he would buy into such an arbitrage situation, or whether he is simply staying in because he already owns the stock. If the latter, the investor is likely better off putting the appreciated capital to work on his next undervalued idea.

Disclosure: None


Dominic Nadeau said...

I think you make a good point here. I added NUHC to my portfolio after reading your articles. When the purchase offer at 7$ was posted, I called my broker to tell him I accepted. But shortly after I sold at 6.9$. I thought "what the hell with 10¢, I'll do better than wait 1-2 months for 10¢ a share in another stock" and sold. But your rational thought is better and I'll keep it in mind next time!


Paul said...


Thanks for not posting that one on your site until now!

By the way, when can we expect q3 results for you fund? I'm always looking forward to that...and I'm hoping you'll let me invest someday. I'm gonna keep bothering you until you do. :)

Saj Karsan said...

Thanks, guys!

Results will be out Friday, Paul.