You Too Can Be A Stock Market Genius

December 4th, 2010
Tags: Joel Greenblatt.

You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits was written by Joel Greenblatt, founder of the hedge fund Gotham Capital. I recently had a chance to read it and found it to be the best book I have found yet on the topic of value opportunities created by different market events, including:

Greenblatt’s Initial Advice:

Do your own work
- Studies have shown the aggregate record of research analysts to be quite poor due to behavioural and institutional biases.
- The best opportunities exist in areas that are not covered (they are less informationally efficient), so you’ll have no choice but to do your own research
Pick your spots
- When it comes to the stock market, you can always choose your battles. Only swing at the perfect pitches, since there are no penalties for missing a good pitches – only penalties for swinging at bad pitches.
- Focus on companies in your circle of competence.
Diversification is not a magic formula for avoiding risk
- Put money in the bank rather than buying more stocks simply for the sake of diversification
- It is better to hold a more concentrated equity portfolio of companies that you truly know than to invest in more stocks aiming for diversification.
- Don’t screw up a perfectly good portfolio by diversifying your way to mediocre returns!

Spin-offs and Rights Offerings

Spin-Offs
- Company takes a part of its business and separates it, distributing or selling shares usually to the parent’s existing shareholders
- Stocks of spinoffs significantly and consistently outperform the market
- Once the spinoff shares are distributed, the bulk are immediately sold without regard to price or fundamental value
  - Often the size is too small for institutional investors to bother with
  - Funds may have to sell them because they aren’t part of the index they track
- Studies show the second year after the spinoff has the best returns.
- A common attribute of spinoffs is tremendous leverage. The corporation may spin it off to transfer debt away. Trick is to get a huge discount due to selling pressure that makes up for the leverage.
Partial Spin-off
- Helps raise capital, but creates a data point that allows for the identification of value opportunities in the parent company.
- Market now values the spun-off portion, which allows you to know the value of the portion retained by the company. Now you can figure out the value of the parent company less the amount of the spin-off retained, for a net figure. Compare this to earnings less retained portion of income.
Rights Offerings
- Give shareholders a right to buy more shares to not dilute their positions as the company raises more capital.
- Shareholders can often sell these rights and do so for next to nothing.

Risk Arbitrage and Merger Securities

Risk/Merger Arb: buy stock in a company subject to announced takeover; short the acquiror
- Deal may not go through (regulatory, financing, extraordinary events. Discovery during due diligence)
- In event of merger breakup, target price drops back to normal.
- Greenblatt says the market is just too competitive in merger arb. There really aren’t any deals left. It is highly informationally efficient, and the returns don’t justify the massive risk associated with the long/short positions diverging.
Merger Securities
- Equity, bonds, etc. used as partial payment or as a sweetener
- General rule: no one wants merger securities. Most people immediately sell them, so you can pick them up on the cheap!
- Search through merger filings for the portion that explains the consideration being provided. Look for securities in addition to the cash/stock transfer. There will be all sorts of esoteric things (e.g. Contingent Value Rights)

Bankruptcy and Restructuring

Buying stock of bankrupt companies will almost never make money.
Bonds may be good, since they often trade at 20 – 30 cents on the dollar
Bank Debt – there is a community of brokerage firms that specialize in trading the bank debt of companies in distress.
Emergence from bankruptcy
- When a company emerges from bankruptcy, its new shareholders are its old creditors who have taken shares as partial repayment. These parties have no interest in being shareholders, and often dump their stock!
- The new share information will be available before it trades in an SEC-filed Registration Statement.
- Must exercise extreme caution in choosing those companies where you expect the new business model and capital structure will work – it hasn’t at least once in the past!
- Start with companies that failed due to too much debt. This problem is rectified by bankruptcy
Corporate Restructurings
- Focus on those restructurings where the business is selling off or closing a division to stanch losses, pay off debt (e.g. will improve bottom line)
  - Where the earnings will improve after the fact, the stock price should increase.

Recapitalizations and Stub Stocks, Warrants, and Options

Recapitalization: changing balance sheet to include more/less debt, equity
- “Leveraged Recap” is done to create high levels of leverage, with the remaining equity being called “stub stock”
- Investing in the stub stock is like investing in a publicly traded leveraged buyout. Huge potential returns, though high risk due to leverage.
- There aren’t many leveraged recaps going on right now, so opportunities are slim.
Warrants
- Warrants are essentially options issued by the company itself
- Stocks of spinoff companies can move dramatically after the spinoff. Warrants and options may be good plays, since they are priced based on Black-Scholes, but the actual movement will be binary, rather than probabilistically assigned via standard deviation.
Options
- Buying options is like borrowing to buy stock, but with protection. It is equivalent to investing in a leveraged recap.
- Usually if a spinoff takes place before an option expires, upon exercise the option holder is entitled to receive shares in both the parent and the spinoff as if he had owned stock on the spinoff date.

Frankly Speaking