Let’s say you woke up one morning, turned on your local business news, and heard billionaire hedge fund investor Bill Ackman talking about special purpose acquisition companies (SPACs). He emphasized how excited he is about SPAC IPOs.
Assuming you loved everything Ackman had to say — who wouldn’t? He’s brilliant and rich — would you know how to go about finding SPAC IPOs (initial public offerings) to buy?
Consider this statistic: There have been 392 SPAC IPOs since 2009. Over the past 12 years, the average IPO size has gone from $36 million in 2009 to $$370.4 million in 2020. That’s a ten-fold increase in the average size of a SPAC.
More daunting than the average size is the number of IPOs available for your investment consideration. In 2009, you had all of one SPAC to choose from. According to SPACInsider, there has been 166 year-to-date through October 29, 2020.
In addition to the 166 SPACs in 2020, another 61 have filed for an IPO. That means out of 227 possible SPACs, only 19 have either announced a combination or have completed a combination.
So how do you narrow the field from 208 potential candidates? And even if you can find a good investment, how will you decide if it meets your needs?
- Don’t Put All Your Eggs in One Basket (Long-Term)
- Do Have a SPAC Focus (Short-Term)
- Do Figure Out Your Holding Period (Long-Term)
- Will You Buy Before or After Combination’s Been Announced? (Short-Term)
- What’s Your Expected Rate of Return? (Long-Term)
- Are You Buying Individual SPACs or SPAC-Related ETFs? (Short-Term)
- Don’t Commit Too Much Capital to SPACs (Short-Term and Long-Term)
For those looking for a little direction from your SPAC investing, here are seven tips to help you meet both your long- and short-term investment goals.
Don’t Put All Your Eggs in One Basket (Long-Term)
Diversification or di-worsification? Legendary portfolio manager Peter Lynch coined the latter term in his book One Up On Wall Street.
“Initially described in Peter Lynch’s book, ‘One Up On Wall Street’ (1989), as a company specific problem, the term diworsification has morphed into a buzzword used to describe inefficient diversification as it relates to the entire investment portfolio,” states Investec wealth manager Patrick Duggan.
“Owning too many investments can confuse you, increase your investment cost, add layers of required due diligence and lead to below average risk-adjusted returns.”
So, if you are considering SPAC investing, it’s a good idea to come to some agreement with yourself as to how many SPACs you will buy. Because the acquisition target is unknown — at least if you invest in SPACs before they find a company to combine with — unless you are extremely confident of the management team of each of your choices, it’s probably a good idea to limit the number of SPACs to a handful.
Furthermore, to find more than a handful of SPACs worth investing in, you’ll need a long runway to evaluate all of them. Fortunately with SPACs, you might have as long as 24 months to do so.
Do Have a SPAC Focus (Short-Term)
In early October, I provided investors with seven tips to pick the next big SPAC IPO. These tips were meant to help you get dialed in about evaluating SPACs. They weren’t tips to consider for your long-term portfolio health.
That said, the section on choosing SPAC IPOs with a laser-like focus on a specific industry or sector was worth 20 points out of 100. Only an SPACs management team accounted for more points.
“It’s not enough to say the SPAC will look at businesses earning between $100 million and $500 million in adjusted EBITDA with enterprise values of $1 billion or more,” I wrote on Oct. 7.
“It’s got to have an industry or sector in mind, one where the officers and directors have a tangible advantage over other SPAC IPOs when finding a target company.”
There’s a reason for this.
In the opening, I mentioned that there was one SPAC in 2009. If you were looking to invest in a SPAC back then, industry and sector information was irrelevant. However, in 2020, there are 208 choices available.
How long do you think it would take you to go through all 208 if you didn’t have a way to cut down on the numbers? There are few sources of SPAC information that break down the IPOs into sectors and industries.
A focus will save you time in the short-term and money in the long-term.
Do Figure Out Your Holding Period (Long-Term)
This tip ties in with having an expected rate of return before entering the SPAC game.
Just as you should for any investment, it’s a good idea to establish a holding period before buying a SPAC. Generally, given the nature of these investments — they remain relatively flat until a target has been announced because their sole asset is cash — your holding period should be at least 18-24 months, the length of time most SPACs set for finding a target.
Until then, SPACs hold your cash in trust, generally earning a relatively low rate of interest, say 1% or less. So, you’re initially investing in short-term treasury yields, parking your capital. Then, once the target is announced, your SPAC shares will start to experience greater volatility as investors get on and off the stock based on their opinions about the tentative combination.
You might decide to hold until a combination is announced and the share price jumps on the news — Lordstown Motors (NASDAQ:RIDE) jumped 21% on Aug. 3 when DiamondPeak Holdings (SPAC) announced its merger with the electric truck manufacturer — or hold until the merger is completed.
However, by holding until the combination is completed, you run the risk that the SPAC’s shareholders vote against the combination.
Another possibility is that you don’t buy a SPAC until after it completes the transaction and trades under the target company’s corporate name. But once again, you should have a holding period in mind.
As they say in the Boy Scouts, “Always be prepared.”
Buy Before or After Combination Is Announced? (Short-Term)
The most important ingredient of a successful SPAC is the management team running it.
“Investing in SPAC IPOs has everything to do with the management team behind the investment vehicle. It’s all about the jockey and little to do with the horse,” I wrote in October.
“That’s because the typical SPAC has between 18-24 months to find a target company to merge with. If the management doesn’t have the expertise to source attractive combinations and a deal isn’t found, the money raised and kept in the trust will be returned to investors, with accrued interest payable.”
Finding companies to buy is not an easy task. That’s why you see a lot of private equity investors entering the SPAC arena. Therefore, the safer route would be to buy a SPAC once it has completed its combination.
Now, from a profit point of view, you’re likely giving up some appreciation by doing this, which means you might want to revisit why you’re investing in SPAC IPOs in the first place. If you can’t say in a single sentence why you’re investing in SPACs, you might want to pass on doing so.
What’s Your Expected Rate of Return? (Long-Term)
When you invest in SPACs, there are three things to consider when it comes to performance. You’ve got to consider the historical performance of IPOs, SPACs, and the equity markets in general.
Let’s assume that you expect an 8% annual return over the next decade from your overall investment portfolio. How does that jive with the three categories mentioned in the previous paragraph?
According to University of Florida finance professor Jay Ritter, who specializes in IPOs, he found that the average first-day performance of companies going public between 1980 and 2018 was 18%. That would certainly do the trick.
However, that’s the average over almost 40 years. What if you choose a stinker IPO? There go your plans for 8% returns.
As for SPACs, their long-term performance is much worse than traditional IPOs.
According to Renaissance Capital, of the 223 SPACs since 2015, 89 have completed a merger. Of those 89, the average loss has been -18.8%. By comparison, the average aftermarket return of traditional IPOs since then is 37.2%, more than 55 percentage points greater.
Finally, between 1957 and 2018, the S&P 500 generated an average annual return of just under 8%. That’s a good performance over 61 years. You might want to consider whether it doesn’t make more sense to buy the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) than to speculate on the success or failure of a particular SPAC.
Are You Buying Individual SPACs or a SPAC-Related ETF? (Short-Term)
For the average investor who doesn’t like to play around with their investment capital, investing in a SPAC-related ETF is the smarter play. The downside is that the current ETF focused on SPACs doesn’t do the idea justice.
Before the good people at Defiance ETFs send me a nasty email, let me explain what I mean.
The company launched the Defiance NextGen SPAC Derived ETF (NYSEARCA:SPAK) on Sept. 30, 2020. I actually recommended SPAK before its launch date in early September, along with nine other new stocks for your portfolio. However, the recommendation came with a caveat.
“I would prefer to see it pick the SPACs before combinations happen, but that’s something to discuss for another time. That said, this could garner significant interest from investors who want an easy way to play new stocks like SPACs,” I wrote on Sept. 8.
Out of the 35 current holdings, only a handful are pre-combination and still looking for a merger target. The rest have either combined and changed names or have announced a combination.
In a year when 208 SPACs are looking for a target, I would like to see an ETF that invests 100% of its assets in pre-combination SPACs.
Well, that gets back to my point that you ought to understand why you’re investing in SPACs in the first place. I would invest in SPACs as a bet on the management team in place. Someone like Bill Ackman and Pershing Square Tontine Holdings (NYSE:PSTH) comes to mind.
To invest in stocks, post-combination is merely investing in stocks, which I realize contradicts my earlier tip that investing post-combination is the safer route to go.
So, if you’re like me and believe that a good SPAC bet is based on the management team, individual SPACs make more sense. That doesn’t mean you shouldn’t invest in SPAK. It’s definitely the easier of the two choices.
Don’t Commit Too Much Capital to SPACs (Short-Term and Long-Term)
This last tip relates to my first tip about diversification.
In recent years, asset allocation choices have grown exponentially. Investors’ thirst for new products and ideas have met a fintech revolution that has made it that much easier for average investors to play a game once reserved exclusively for institutions.
Fractional shares, equity crowdfunding, cryptocurrencies, and many other products have appeared in recent years. The days of a 60/40 portfolio between equities and bonds is going the way of the Dodo bird.
“There is a shift away from the traditional 60/40, ‘we will get you into retirement safely’ model, partly because of lower return expectations,” Hanneke Smits, chief executive of BNY Mellon Investment Management, recently stated.
“If we have years ahead of low rates and perhaps also, in some sectors, anemic growth and companies that can’t cut expenses any further, you are going to have to come up with different models to get people going into retirement their desired outcomes.”
Let’s say you have an equities portfolio that allocates 60% to U.S. companies. And of that 60%, 50% is allocated to large-cap stocks, another 30% to mid-cap stocks, and the remaining 20% to small-cap stocks.
If you want to invest in individual SPACs, you might want to allocate a certain percentage of your small-cap holdings to these blank-check companies. Although SPACs are getting larger — Bill Ackman’s raised $4 billion — the average raise is still well within the small-cap stock criteria.
The point is: Don’t sink a lot of money into SPACs unless your risk tolerance is above-average because a lot can happen once a combination is announced, and it’s not always good news.
On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.