Book #1: You Can Be a Stock Market Genius
The title is somewhat corny, but the information contained in the book is invaluable.
As I referred to in the prior post, my reading will be focused on authors who have done very well over the long term. The first author is one that has been recommended to me multiple times and who I’ve found to be very intelligent. This author is Joel Greenblatt, and he has done very well for himself over the past two decades.
Despite his fund only being open for 10 years, having wrapped it up in 1995 (continuing on as a family office), his returns were stellar. His fund Gotham Capital (named after the city in the Batman comics) achieved some of the highest compounded annual growth rates of any fund I’ve seen, even better than Buffets returns in the years of his early partnership. His annualized return over the period came out to 50% annualized. There aren’t many funds in the value sphere that have achieved these returns, let alone a managing partner who is willing to describe exactly how he did it.
Now, for most of us here, a book like this can seem somewhat useless. After all, many readers might only have a few hundred to a few thousand dollars to throw at any investment ideas outside of the typical retirement accounts. Greenblatt counters by saying smaller investors actually have higher odds of finding, and successfully investing in, opportunities he describes in his book.
Part of this ability for smaller investors to take advantage of these special situations is exactly because of how larger asset management companies have structured their risk parameters. It is due to these rules that special opportunities are possible.
Greenblatt discusses four spaces for investment ideas that can lead to above average market returns (testifying that these were the sole drivers of his alpha). They are as follows:
Spinoffs, Partial Spinoffs and Rights Offerings
Risk Arbitrage and Merger Securities
Bankruptcy and Restructuring
Recapitalizations and Stub Stocks, LEAPS, Warrants and Options
As the majority of these areas are more difficult to execute in, I will cover only spinoffs in this article. Those are where he believes the majority of returns can be found by those with less than stellar understanding of the financial markets. I will also discuss both Stub Stocks and LEAPS in my next article, as I’ve utilized these to great effect and find them somewhat easier to understand. Risk Arbitrage, Merger Securities, Bankruptcies and Restructurings I can discuss via email if any of you would like further information.
Spinoffs, Partial Spinoffs and Rights Offerings:
Greenblatt believes that this area can be one where small investors spend their entire lives researching and ultimately outperforming all other money managers on the planet. In his own words, “everyone can play the spinoff game. Spinoffs are easy to spot. You can pick and choose from a large number of opportunities. The bargains will keep coming - just because of the way the “system” works.”
Spinoffs are just what they sound like. Imagine one company with a lot of different divisions (some would call such a company a conglomerate). The stock has been languishing for many years, despite having a business segment that has been absolutely crushing growth. Despite this business having one segment absolutely killing it, there are other business segments driving the less than stellar returns. In some instances, the only way to show the market what this business is truly worth is to spin it off as a separate security. It is in these instances that Greenblatt believes superior investment returns can be found.
Now in high profile spinoffs of the last few years, many haven’t performed as well as investors had hoped (think of the AT&T spinoff of Warner Brothers). While many aspects of this spinoff can be used as cause for it not to do well, such as the massive levels of debt, some of these areas of concern are exactly the cause of above average returns.
Let’s look at the debt example. I apologize on going deep into the numbers, but this is an investment publication, so numbers will come in to play at least once per post.
Suppose a billion-dollar hotel operator originally took on debt to build the hotels. Once finished the business then operates them as their brand name business (Hilton, Marriott and Wyndham are a few that came to mind with this model in the beginning).
The construction business involves billions of dollars of debt, long lead times, and low absolute returns. Servicing the business is one with little overhead, low operating costs (other than labor), and no need for massive capital injections. It would be logical for such a business to spinoff the service business and have the hotel business operate as a separate entity.
Spinoffs such as these were prevalent both in the 80’s as well as in the past decade, with many of the casino stocks spinning off their real estate into things called “REITs” or Real Estate Investment Trusts. In essence, the casino stocks take over the operation of the hotels from the REITs and the REITs collect the dividends. As banks give larger leverage to real estate owners separated from the operations of the businesses themselves, this allows much more financial leverage, and higher returns for the REITs, providing more value to the shareholders.
Such an example in the book (of which there are many) is the Mariott spinoff of Host Marriott and Marriott International. The idea was to do the same as the REITs of today. Their idea was to saddle the “crap company” (Host Marriott) with all of the real estate and a great deal of the debt while allowing the great company (Marriott International) to operate as a pure service company, thus obtaining the higher multiples the market was giving to such companies.
Overall, the terms of the deal allowed the Marriott family to continue to own 25% of both companies (as owners in the original company maintain ownership in both companies post-spinoff). Host Marriott would be given a 600m line of credit if needed from the “good” Marriott company, Marriott International in case of needed funding down the line (as Host Marriott was the so called “bad” Marriott).
Now to get to the fun part, the conclusion of the trade. Overall, it took about 12 months for the deal to close. Throughout the period from announcement to close, the news of the deal was on the front page of the Wall Street Journal (WSJ for short) at least a few times a week.
When the transaction finally closed and the two companies began trading separately, large funds offloaded their shares of Host Marriott causing it to fall substantially in its first few trading days (due to their standards of ownership).
Within four months of the deal closing, the “bad” company tripled in value, due to the leverage placed on their balance sheet and the outlook for the business being much more favorable than expected. Mix a more favorable outlook post-spinoff with a bunch of forced institutional selling and you’ve got a recipe for fantastic stock appreciation.
Many more specifics are given about the transaction, most of which I didn’t go into here. I’d highly recommend you purchasing the book if you would like to learn more about these transactions.
Overall, Spinoffs are a ripe area for any individual investor. The big funds and financial world are created in a way where any new entity post spinoff can be a lucrative investment for those willing to take the time to research the new company. In Greenblatt’s words, only three things are necessary for a large gain in any spinoff transaction:
Institutions don’t want it (with reasons not being due to its investment merits).
Insiders want it.
A previously hidden investment opportunity is created or revealed.1
I meant to write about the book in one post, but I felt there were too many important points to cover in one post. As such, there will be at least two more posts relating to this book, covering the areas I feel would be of most use to the individual investor.
Feel free to reach out if you have any questions about the book. It was a fantastic read and I look forward to reading it at least a few more times over the next couple years to solidify my understanding.
Lastly, don’t feel like this information can’t be known to investors without an inside scoop. As all of this was occurring, the information was readily available on the front page of major investment newspapers. In further posts I will dive deeper into how I find my investment opportunities and where I look for alpha. For now, the only resource that you should be familiar with is the Wall Street Journal. You’ll be able to find more opportunities with that one publication than with any higher priced option.
A word about his last point. In the Marriott example, Host Marriott would trade at about $5 per share. Combine this with the debt per share of $25, and essentially the entire value of the corporation would be around $30 per share (to get to this measure, simply divide total debt by total share count, and add it to the current share price to obtain the value per share).
This would mean that if the Host Marriott company saw a reasonable 15% increase in the value of its assets, the stock would essentially double in price (15% * $30 = $4.50 change, add it to the stock value of $5 and you have a return of 90%). As insiders held a large % of the spinoff and parent company, it’s doubtful that they would structure a company to completely fail. these two data points led the author to a fantastic return in a very short amount of time.