The Secret Places of Stock Market Profits

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This article provides a summary of Joel Greenblatt’s book, You Can Be a Stock Market Genius. Joel Greenblatt is a value based fund manager who runs Gotham Asset Management who has produced annualized returns of over 40%. In this book, he details some of the special situations that smaller investors can use to exploit market inefficiencies.

Spin-offs:

A spin-off is when a company separates a division or portion of itself into a separate public company. Usually, owners of the company receive shares in the new spin-off based on a ratio of existing shares in the current parent company. This was my favorite idea from the book because spin-offs on average beat the market by >10%. So just by limiting your stock purchases to spin-offs (even if you have no skill), you give yourself a 10% head start on the market. I did a deep dive analysis with back testing here.

One reason Spin-offs have good returns is that the leaders’ compensation can be more closely coupled to company performance. When the spinoff was a small part of a larger company, big efforts by people running the division may have a very small effect on the overall stock price. By making the company smaller, there is more motivation and ownership by the executives. A good way to see if a particular spin-off will do well is to look for what insiders are doing. If they are buying parent company stock ahead of the spin-off, taking payment in options, or receiving restricted stock, it is a good sign that there interests are aligned with shareholders.

Another potential benefit of a spin-off is that its price may drop out of the gates. The stock can drop if it is too small for institutional investors, or if it is different enough from the parent company. In both cases there can be sell-offs in the first week or so while investors unload shares that they don’t really want. This presents a buying opportunity for us.

Additionally, separating companies allows each entity to be properly valued. If the parent is best evaluated using a multiple of its assets (say a utility) and the spin-off is best evaluated based on free cash flow, it can be tricky to evaluate them together. By separating them it can “unlock” hidden value that was there all along.

Merger Risk Arbitrage:

A cooperate merger is when someone offers to buy all of a company. Typically the offer price is above the current market price of the companies out standing shares. A current example would be Elon Musk buying Twitter. Heading into the book this is one area I thought he might recommend.

The problem with this approach is that it typically has asymmetric gains and losses. Once the deal is agreed to, people typically bid up the share price to near the closing price of the merger. You can buy and wait for the gap to fully close once the acquisition goes through. The problem is that the gap is typically small, so there isn’t much to be had in the way of profits. If the deal falls apart, you stand the risk of the stock price falling back to its original value before the merger agreement. So, your upside is limited, and your downside is the reverse of the merger premium paid.

There are various reasons deals fall apart (share holder activism, anti-trust suits, issues with financing, etc). Greenblatt walks through an example where an amusement park was set to be acquired by a larger company. The deal seemed like a slam dunk, but the park’s main pavilion fell into a sink hole. The deal ended up eventually going through, but at a lower price and over a longer time period than initial expected.

Bankruptcy:

The idea here is pretty simple. Companies that are coming out of bankruptcy will often reach settlements with creditors that involve payment in stock or bonds of the new company. The creditors don’t really want the new bonds or stock so they sell indiscriminately. This can drive prices down and present a good buying opportunity. For me personally, there is too much risk with this approach. Some of the new stocks go to 0 and if the company has failed to pay its debts previously, there is a decent chance that it will happen again. There also isn’t necessarily the same benefit that you get from spin-offs, where on average they beat the market.

Stubs and LEAPs:

A stub stock is when a company uses increased leverage to return cash to share holders. The new stub stock typically trades at a lower valuation, but you typically receive a cash payout as part of the stub creation. The new stub stock is burdened with more debt. The increased leverage can increase returns, but it also has more inherent risk. The extra debt can also be a benefit to share holders because interest payments are deducted from taxes, allowing more money into the hands of shareholders. These types of deals aren’t very frequent anymore, and they don’t offer the same halo effect as spin-offs.

Long term call options (LEAPs) have a similar prosperities as a Stub stock. A call option is the right to purchase 100 shares of a company at a strike price before a certain date. In the case of long term options, this is usually over the course of a year or two. For this right, you pay a premium that is considerably less than the cost of your shares. In short, you can receive the appreciation of 100 shares for a fraction of the cost of all 100 shares. The risk is that you lose all your premium, if the stock doesn’t appreciate above its strike price. This sounds bad, but your potential downside is less than if you had bought 100 shares, since you can only lose the value of the premium and not the total price of the stock. This can be especially powerful if you have a company that is deeply undervalued or if you think there is some risk of the stock going to 0.

Conclusion:

Going forward, I plan to look at Spin-offs more closely. Given the fact that on average they beat the market by >10%, even with no skill in picking, it should improve my returns. In some instances, I will consider using LEAPs to increase returns. I plan to avoid Mergers (unless the price spread is quite wide), and bankruptcies because they don’t provide as much benefit as a category and can increase risk.

Note that this article does not provide personal investment advice and I am not a qualified licensed investment advisor. All information found here is for entertainment or educational purposes only and should not be construed as personal investment advice.