Editor's note: Not every fallen business is headed for disaster. Today's essay is the second part of Bryan Beach's review of the SPAC market, adapted from a recent Stansberry Digest (and originally published in his Stansberry Venture Value newsletter). Read on to learn the six key reasons these companies tend to fall... and why the current setup in this overhyped market could lead to outsized gains.
Raising money for an unknown purpose isn't exactly an easy sell...
As I explained yesterday, 19th-century industry titan Henry Villard was only able to pull it off because he spent years establishing a reputation as a rainmaker... and people were lining up to invest alongside him.
That's how Villard established the first of what would now be known as a special purpose acquisition company ("SPAC").
Most sponsors today need to entice investors with deal-sweeteners like warrants and stock rights – goodies that allow investors to buy discounted shares in the future, should the stock appreciate.
If the sponsors don't find a target within two years, they return the investors' cash, plus interest. So for those early investors, it's a no-risk venture.
But more important, even if they redeem the shares, investors get to keep the warrants and stock rights free and clear. (If too many investors choose this option, it can force the sponsors to walk away or go through another round of fundraising called private investment in public equity, or "PIPE.")
Some SPACs soar right out of the gate, such as Virgin Galactic (SPCE) and DraftKings (DKNG). Both went public via SPAC in late 2019... Both soared... And both gave back most of their gains over the next couple years.
Most SPACs don't bother "booming" at all... They fall right away.
According to a study by the Harvard Law School Forum on Corporate Governance, the average SPAC return is negative 3% in three months, negative 12% in six months, and negative 35% in 12 months after listing on a public exchange. And keep in mind, this study is somewhat dated. These dismal returns are from before the SPAC bubble burst.
Of course, these are averages... Smart speculators can make good money picking out the SPACs that have the best chances for post-merger greatness. But as a group, newly merged SPACs face price pressure from the start.
What's behind these lackluster results? There are a few reasons why SPACs tend to fall after going public – including some SPACs that are rare hidden gems...
1. SPACs are often lousy, overvalued, or both.
Sponsors have an outsized motivation for finding a deal – any deal. If they don't, they basically get nothing for their efforts.
They'd rather own 20% of a lousy company than 20% of nothing.
This competitive SPAC landscape is also why sponsors are willing to recruit celebrity "strategic advisers" – like professional basketball legend Shaquille O'Neal, former football quarterback and activist Colin Kaepernick, tennis star Serena Williams, and political superstars Arianna Huffington and Paul Ryan – to their management teams.
They know that good companies will be hearing from loads of SPAC suitors... And being able to "partner" with someone famous is a selling point.
In 2020, it was undeniably a seller's market. And sponsors were willing to do – or pay – anything to get a deal done.
But just because some SPAC sponsors overpaid doesn't mean the stock market will continue to do so. If the sponsors overpaid for the target, Mr. Market will quickly drive shares down.
2. No loyalty from early investors.
Remember those free goodies I mentioned above? Those warrants and rights are an effective way to get investors to pour money into the pre-deal SPAC. But as I said, investors get to keep these goodies – even if they dump the shares right as the merger happens.
Los Angeles Times business columnist Michael Hiltzik describes these dynamics well...
If the announced deal produces yawns, the SPAC investors can redeem, getting back their original investments, pocketing their risk-free interest earnings, and holding onto their warrants in case the merged company is a winner.
That's risk-free leveraged upside.
And when these early investors bail out, the sponsor needs to find new money to fill in the gap. This is where the second round of PIPE comes in.
PIPE allows mutual funds and other institutional investors to buy preferred shares or other instruments that offer more juice than the typical common share. But that also leads to more costs... and more shareholder dilution.
Here's how one veteran SPAC participant summed up these dynamics in Institutional Investor magazine...
You're giving a free warrant. But the kind of people interested in free warrants are hedge fund arbitrageurs. So you can raise capital, but once you identify a target, you have to raise money all over again.
With all these shares sloshing around from arbitrageurs, early opportunists, and PIPE investors – to say nothing of the sponsor who may be able to dump her 20% stake at any moment – it can take Mr. Market more than a year to digest the "true" value of a company.
3. Dilution isn't "free."
Once a SPAC finds a merger target, it almost always debuts at $10 per share. That's not to say every SPAC is intrinsically of equal value. The sponsors essentially adjust the shares outstanding to land at a $10 share price.
One thing you'll often hear about SPACs is that, unlike traditional initial public offerings ("IPOs"), there are no expensive investment banker fees. This is true, in a sense. Nobody is writing a fat check to a bank to take the company public. But there are still costs... Nothing is free.
According to the aforementioned Harvard Law School study titled "A Sober Look at SPACs"...
The dilution embedded in SPACs constitutes a cost roughly twice as high as the cost generally attributed to SPACs...
For each share purportedly worth $10, there is $6.67 in cash and $3.33 in dilution overhanging the merger.
Our own analysis showed slightly less dilution... We got back to somewhere between $2 and $3 worth of dilutive costs.
But no matter how you do the math, the fact is that the "true" baseline for a post-merger SPAC is around $7 or $8 per share... not $10. So it makes sense that shares fall out of the gate.
4. Unmet expectations.
Much like an IPO, a SPAC management team will introduce the business to early investors with a kind of "road show" to drum up interest.
But in an IPO, the U.S. Securities and Exchange Commission ("SEC") strictly regulates any sort of projected numbers. However, there are no such regulations for a merger of two companies... And in a purely technical sense, that's what a SPAC is.
Management teams have been known to wildly exaggerate a business's prospects when trying to generate buzz... only to sheepishly scale back those estimates after the merged company's shares begin trading.
To give one extreme example, Romeo Power (RMO) debuted as a merged SPAC in late December 2020, guiding to $140 million in 2021 revenue. Three months later, it pared that guidance down by around 80%.
The SEC is making new moves to close this loophole. Until it closes, the share prices of SPACs that pare back projections will get pummeled. (More on this in a moment.) This is why investment banks like Goldman Sachs are starting to pull out of the space – taking even more fuel out of the overall SPAC bubble.
5. Historically, SPACs have had a lousy reputation.
Going back to at least the 1990s, the SPAC market has earned a reputation for harboring companies that were too underhanded or shady to go public through traditional channels.
This reputation was fair. Throughout the 1990s and 2000s, many investors lost their shirts investing in SPACs.
Mr. Market has a long memory. And in the five years since I first wrote about SPACs in my Stansberry Venture Value advisory, I've noticed that the market has these companies on a short leash. At the first whiff of bad news, investors throw up their hands and run away, assuming they've been bamboozled by the old SPAC curse.
I've noticed this playing out over and over as I track various online investor comment boards and the "Stocktwits" Twitter platform. Thousands of investors – many of whom were inexperienced in public markets, making bets with their stimulus checks while bored during the pandemic – got excited during the SPAC boom of 2021... and are now frantically selling in 2022.
That leaves us with the final reason SPACs fall...
6. Sometimes, SPAC babies are thrown out with the SPAC bathwater.
Given all the factors I've outlined, it makes sense that many SPACs quickly fall out of favor. But sometimes, shares of a perfectly good company plummet for no reason other than that it happened to go public via a SPAC merger.
That's what leads to our opportunity...
You see, not many decent companies have historically made it to the SPAC scrap heap. But all that changed in 2020 when the number of new SPACs exploded. In March 2022, more than 100 busted SPACs were on the scrap heap. That represents an incredible 50% of all recently completed SPACs.
Right now, Mr. Market is saying that half of all SPACs are headed for disaster. Yes, many of the companies on the scrap heap belong there. But almost certainly not half of all SPACs. And the percentage grows almost every time I rerun the numbers.
If you know what to look for and are willing to be patient, today's setup in SPACs could be a massively profitable opportunity. But keep in mind, not every beaten-down company is a good fit for my strategy...
Many dirt-cheap SPACs have earned their depressed valuations. Some are headed for $0. And in order to take advantage of today's unprecedented opportunity, you need to do things the right way – or not at all.
That's where my Stansberry Venture Value team and I come in...
We spend hundreds of hours analyzing SPAC data and other company information, using sources that go way beyond the standard trading tools. I'm talking about sources most people have never even heard of (let alone have access to).
If you don't know what you're doing, wading into SPACs could be a recipe for disaster. But with the right tools at your disposal, I believe this could be one of the most compelling stock-picking opportunities we've ever come across.
I hope you'll join us in taking advantage of it.
Good investing,
Bryan Beach
Editor's note: Bryan just went public with the SPAC strategy he has studied intensely for five years. The optimal window for today's unprecedented setup might only last a few weeks or months... But during that time, he believes some investors could score a series of winners soaring as much as 1,000% – if you understand exactly how to play this opportunity. Watch his interview now for the details.
Further Reading
Many investors are pulling their money out of stocks right now as fear sweeps across the market. And when folks are all moving in the same direction, it's scary to bet against them. But doing so could lead to massive returns... Read more here: Your Leg Up as an Individual Investor.
"Buying against the crowd is tough," Steve writes. When the market is in turmoil, it's only natural to be cautious. But by using this strategy, we can make solid gains off companies headed for the scrap heap... Get the full story here: Two Reasons Rich People Keep Getting Richer.
Investing in proven companies with strong business models is a better idea than gambling on high-risk assets. And this stable company has a lot going for it today...
THIS PANDEMIC-ERA DARLING IS A DARLING NO MORE
Today, we look at a company that's a victim of shifting macro trends...
When the COVID-19 pandemic hit, folks turned to e-commerce like never before... buying nonessential hobby items in particular. Now that the U.S. is reopening, consumers are flooding back to more brick-and-mortar retailers. And with inflation at 40-year highs, people are also choosier about their spending. Today's business is stumbling as these factors come together...
Etsy (ETSY) is a $10 billion e-commerce company. It has more than 7.5 million active sellers. Merchants can list all sorts of handmade items on Etsy, including jewelry, home décor, toys, and crafts. The site was a go-to during the onset of the pandemic... But now, it's struggling as folks go back to spending in stores (and as inflation cuts into shoppers' wallets). Year over year, Etsy's marketplace sales were down 2% in the latest quarter... And its adjusted earnings before interest, taxes, depreciation, and amortization ("EBITDA") – a measure of profitability – fell 13.5%.
As you can see, ETSY hit an all-time high in November 2021. Shares have fallen 72% since then and recently hit a new 52-week low. As these challenges continue, expect more pandemic-favorite stocks to take a beating...
