PDF Summary:You Can Be a Stock Market Genius, by Joel Greenblatt
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Investing firms can overwhelm laypeople with their sheer range of options. But according to hedge fund manager Joel Greenblatt, none of these options are necessary for the amateur investor to earn above-market returns. On the contrary, in his 1997 book You Can Be a Stock Market Genius, Greenblatt argues that an approach called special-situation investing can yield lucrative returns that outperform the vast majority of investing funds.
To outline this approach, Greenblatt examines an array of uncommon situations in the corporate world that spawn various promising securities (financial assets that you can buy and sell) at bargain prices—including spinoffs, stub stocks, and orphan equities. In this guide, we’ll discuss the value-based foundations of special-situation investing before proceeding to the special situations that Greenblatt examines. Throughout the guide, we’ll also discuss the risks associated with some of these special situations and update his arguments with research that’s appeared since the book’s 1997 publication.
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In a similar vein, Greenblatt discusses partial spinoffs, which occur when a parent company only spins off a portion of a division or subsidiary and keeps the rest. He argues that partial spinoffs can present promising investment opportunities—both in the partial spinoff and in the parent company.
Investing in partial spinoffs, Greenblatt points out, can be lucrative for the same reason it can be lucrative to invest in spinoffs: Shareholders receive unsolicited shares of stock in the partial spinoff and thus have an incentive to sell these shares at a low price. However, Greenblatt contends that the best investment opportunities from partial spinoffs often involve investing in the parent company. He reasons that when a partial spinoff occurs, the market not only prices the spun-off division, but also allows us to calculate the value of the parent company minus the entire spinoff.
(Shortform note: According to experts, different types of investors are attracted to the parent of a spinoff versus the spun-off subsidiary. They point out that, because spinoffs are smaller companies with more potential for growth, they attract more aggressive investors who aren’t afraid of the greater volatility of a small company. By contrast, because parent companies who spin off subsidiaries are larger and more stable, they tend to attract more conservative investors.)
The information we gain from partial spinoffs is valuable, Greenblatt explains, because we normally can’t tell whether the isolated parent company is mispriced since its share price normally includes the value of all the parent company’s subsidiaries. Thus, partial spinoffs allow us to identify underpriced parent companies.
To illustrate, Greenblatt discusses his decision to invest in Sears after its 1993 full spinoff of Dean Witter and its 20% spinoff of Allstate—its two main subsidiaries. At the time, Sears stock cost $54 per share. The Dean Witter spinoff gave Sears shareholders $15 per share in Dean Witter stock, while the Allstate spinoff gave Sears shareholders $29 per share in Allstate stock. Thus, by purchasing Sears stock, you were effectively purchasing Sears’s department-store business at $10 per share ($54 minus $15 minus $29).
Greenblatt points out that this price constituted a massive bargain—Sears’s department-store business was trading at a large discount to its sales, especially compared to other similar businesses. He writes that, after he purchased Sears stock, it jumped about 50% in the next few months, generating a massive profit.
(Shortform note: Sears’s spinoff of Dean Witter and partial spinoff of Allstate weren’t its only significant changes in 1993—Sears also underwent substantial restructuring, closing 100 department stores and cutting 50,000 jobs. Consequently, the stock might not have risen 50% because its spinoffs shed light on an underpriced parent company, as Greenblatt suggests, but rather because these restructurings created a leaner company.)
How to Profit From Orphan Equities
Finally, Greenblatt turns to so-called orphan equities—the new stock of companies that emerge from Chapter 11 bankruptcy proceedings. He maintains that orphan equities can be lucrative investments because their initial owners are former creditors with incentive to sell.
Greenblatt first clarifies that when a company survives bankruptcy proceedings, new shares of its stock are issued and distributed to the company’s former creditors—those who hold the debt that the company can’t repay. For example, if Netflix were billions of dollars in debt to banks and declared bankruptcy, then these banks would be compensated with newly issued Netflix stock if Netflix survived bankruptcy—after all, if Netflix were bankrupt, it wouldn’t be able to pay the banks back in cash.
(Shortform note: Although Greenblatt focuses on orphan equities that arise in the wake of bankruptcy proceedings, “orphan equity” is normally a catch-all term for any stock that nobody wants to own. For example, when investors quickly sell stock in spinoff companies, this stock is likewise considered an orphan equity. Further, when one company purchases another using its own shares as currency, these shares can become orphan equities if their new shareholders quickly dispose of them.)
Thus, much like in the aftermath of spinoffs, many of the company’s new shareholders will own stock that they didn’t choose to purchase. As Greenblatt relates, many of these creditors care only to recoup their losses. Thus, orphan equities often trade at bargain prices since many of their former shareholders are interested in selling quickly. Greenblatt even points out that, according to a 1996 study, orphan equities historically outperformed market indices by about 20% over their first 200 days on the market.
(Shortform note: In a 2015 study, researchers found that orphan equities between 2000 and 2010 didn’t deliver the same magnitude of returns as in the 1996 study cited by Greenblatt. On the contrary, they found that orphan equities’ median return during the first 200 days was 0%. Compared to the S&P 500’s—which, between 2000 and 2010, had average returns of about -1% annually—this median return represents a slight overperformance, but not the 20% that Greenblatt cites.)
Finding the Best Orphan Equities
Greenblatt recognizes, however, that stock in recently bankrupt companies is often deservedly low—these companies went bankrupt, after all. So, to distinguish between fairly priced orphan equities that are unpromising investments and genuinely underpriced orphan equities, he endorses Warren Buffett’s advice: Look for companies with sound underlying business models.
In practice, this advice means looking for companies that went bankrupt because of short-term mistakes rather than underlying business defects. Specifically, Greenblatt recommends favoring companies that went bankrupt because they took on too much debt and couldn’t pay it off. Such companies, he argues, often go bankrupt because of a single mistake—for example, overpaying for an acquisition, or not growing fast enough to repay their debt—rather than a systemic business flaw.
How Warren Buffett Evaluates a Company’s Business Model
Greenblatt takes a negative approach to evaluating business models: He seeks out companies that didn’t go bankrupt because of an underlying business flaw. By contrast, Buffett takes a positive approach, considering three criteria when gauging a company’s business model. In The Warren Buffett Way, Hagstrom outlines these three criteria:
Simplicity: Buffett prefers companies with simple business models that he understands since it’s easier to make informed investing decisions when you understand a company.
Predictability: Buffett prefers companies that have had consistent business models because such companies are less likely to venture into unknown territory and make costly mistakes.
Competitive advantage: Buffett prefers companies that have a sustainable edge over the competition since you can trust these companies to continue exploiting that edge in the future.
So it stands to reason that you should prefer orphan equities whose companies are simple, predictable, and have a competitive advantage. Because companies that exemplify all three likely won’t go bankrupt, however, you may have to compromise on at least one of these criteria.
Investing in Evolving Companies: Acquisitions and Restructurings
In addition to the new investment opportunities arising from spinoffs and bankruptcies, Greenblatt also discusses how pre-existing companies undergoing significant changes can yield lucrative investments. In this section, we’ll discuss two such changes: acquisitions and restructurings.
How to Profit From Companies Undergoing an Acquisition
Acquisitions occur whenever one company purchases a majority of another company’s stock from its shareholders, thus giving the acquiring company controlling interest in the acquired company. Greenblatt argues that acquisitions can create promising investment opportunities because so-called merger securities are often sold at bargain prices.
Merger securities, Greenblatt explains, are securities given to shareholders of the acquired company in addition to cash. For example, if Apple decided to purchase Microsoft at the start of 2023, then Apple might pay Microsoft shareholders (say) $275 per share, in addition to $10 per share of five-year Apple bonds that return 6% annually.
(Shortform note: The term “merger securities” is somewhat of a misnomer, since there’s a distinction between mergers and acquisitions. While mergers refer to the creation of an entirely new company from two existing companies, acquisitions refer to a parent company purchasing another company and subsuming it into the parent company. However, merger securities can arise following a merger or an acquisition.)
Greenblatt points out that merger securities trade at bargain prices for two reasons. First, similar to spinoffs and orphan equities, individual investors receive merger securities that they didn’t want. In the previous example, Microsoft shareholders were interested in owning Microsoft stock, not five-year Apple bonds. Consequently, these shareholders will often seek to pawn off merger securities, even if that means selling them for less than their true value.
(Shortform note: In addition to purchasing merger securities directly, other experts point out that investors can profit by investing in the stock of companies that are likely to issue merger securities later on—for instance, companies undergoing an acquisition. Profit opportunities arise, they argue, because the market sometimes fails to accurately value potential merger securities. In turn, investors can practice merger arbitrage by purchasing stock in companies likely to issue merger securities, then selling the stocks and merger securities separately to profit from this mispricing.)
Second, Greenblatt notes that institutional investors typically aren’t allowed to keep these securities, because their investment funds stipulate that they can only invest in stocks. Returning to the previous example, institutional investors in Microsoft would likely be prohibited from keeping the five-year Apple bonds. The upshot is that these institutional investors have no choice but to sell merger securities, even at bargain prices.
(Shortform note: Investment funds aren’t the only institutional investors that can inadvertently acquire merger securities—for instance, pension funds and insurance companies that own stock in a company being acquired can also be given merger securities. In the case of pension funds, they may likewise have to sell these securities because they have a specific ratio of stocks to bonds that they must adhere to.)
How to Profit From Companies Undergoing a Restructuring
While acquisitions enlarge an existing company, restructurings (the process of closing or selling an entire division) cut the size of an existing company. According to Greenblatt, corporate restructurings can yield lucrative investment opportunities for two primary reasons: They rid companies of unpromising divisions and they indicate that management is shareholder-oriented.
Greenblatt first writes that, when companies close an entire division, it’s typically because that division is underperforming. Consequently, the value of the remaining business becomes more salient after the restructuring. For instance, suppose that Meta (formerly Facebook) realized that Reality Labs—its division responsible for producing virtual reality headsets—was hemorrhaging money and thus decided to close it. In so doing, Meta would actually increase its annual earnings, and thereby increase its earnings per share (a company’s net profit divided by its number of outstanding shares). In turn, Meta’s stock would become a more attractive investment than it was before the restructuring.
(Shortform note: In addition to cutting underperforming divisions, companies choose to restructure for a wide variety of reasons. For example, companies might sell a profitable but ancillary division if they believe it detracts from their overarching strategy. Alternatively, companies might sell a profitable division in the name of reverse synergy—the belief that selling the division to an outside company will yield more value than keeping the division in-house.)
Further, as Greenblatt points out, companies that jettison a whole division normally have shareholders’ best interest in mind. After all, companies don’t take the decision to restructure lightly—it’s a painful choice that requires them to cut their losses and admit that a significant aspect of their business has failed. Thus, you can be confident that restructured companies will act in shareholders’ best interest, rather than persisting in unsuccessful business plans that will decrease shareholder value.
(Shortform note: In The Warren Buffett Way, Hagstrom relates Buffett’s belief that investors should seek shareholder-oriented companies. He thus lists several proxies for identifying shareholder-oriented companies, like those undergoing a restructuring. For instance, he argues that companies that transparently report their financial performance have shareholders’ interests in mind, unlike those that attempt to obscure middling performance through byzantine financial reports. Similarly, he recommends investing in companies that allocate capital (that is, distribute earnings) in a way that maximizes shareholder value rather than those that blindly acquire other companies at a breakneck pace.)
Investing in Leveraged Companies: Stub Stocks and LEAPS
Having seen how evolving companies can give rise to promising securities, Greenblatt turns to consider the more specialized opportunities that arise when companies are heavily leveraged—in other words, when they take on debt. In this section, we’ll discuss why highly leveraged stub stocks are desirable investments and then examine how long-term equity anticipation securities provide similar benefits to stub stocks.
How to Profit From Stub Stocks
Stub stocks, Greenblatt clarifies, emerge whenever a company chooses to recapitalize—that is, when it pays shareholders either cash or other securities so it can repurchase large quantities of its own stock. Greenblatt argues that stub stocks provide a favorable investment opportunity because they amplify companies’ increases in earnings while limiting downside risk.
First, to see what a stub stock might look like, imagine that at the beginning of 2023, when trading at $85 per share, Amazon distributed $60 per share in bonds to its shareholders to repurchase Amazon stock. In theory, because Amazon returned $60 of its value to its shareholders, this should drop the value of Amazon stock to $25 per share ($85 minus $60). Thus, the remaining Amazon stock trading at $25 would be a stub stock.
(Shortform note: Although Greenblatt writes as if stub stocks are a separate investment opportunity from spinoffs, other experts often classify the parent companies of spinoffs as “stub stocks” once isolated from their subsidiaries. For instance, if Berkshire Hathaway decided to spin off all of its subsidiaries, then these experts would consider the remaining Berkshire Hathaway stock a stub stock.)
In practice, however, Greenblatt explains that the valuation of stub stocks is messier. For example, let’s suppose that Amazon was earning $5 per share while trading at $85, meaning its price-earnings ratio (the ratio of its share price to its earnings per share) was 17. If Amazon’s stub stock traded at $25 per share, that would mean Amazon’s new price-earnings ratio would be 5 ($25 divided by $5). In reality, such a large price-earnings ratio drop is unlikely. Rather, because Amazon would have to take on debt to distribute $60 bonds, its price-earnings ratio would suffer a smaller drop—say, from 17 to 12. Thus, the real share price of the stub stock would be $42 (because, as we’ll explain below, Amazon’s post-recap earnings per share would drop to $3.50, and $3.50 times 12 is $42).
(Shortform note: While price-earnings ratios are impacted by a company’s debt, they are also notoriously sensitive to external market conditions. For example, in an excessively optimistic bull market, popular stocks can reach price-earnings ratios north of 50. Alternatively, in a pessimistic bear market, price-earnings ratios can dip below 10.)
Why Stub Stocks Are Lucrative
Stub stocks create lucrative investing opportunities, Greenblatt explains, because they allow companies to distribute their earnings in a more tax-efficient manner, thus amplifying underlying increases in value. In the previous example, Amazon would have to pay interest on the bonds distributed to shareholders, and this interest is tax deductible. Thus, if Amazon’s earnings increase, it will pay proportionately less tax on these earnings because its interest payments cut into its taxable earnings. In turn, Amazon will lose less of its earnings to taxes, which will yield a significant share price increase assuming its price-earnings ratio remains stable.
To see this argument in practice, let’s assume that in the previous example, Amazon’s tax rate was 50% while earning $5 per share and trading at $85 per share before recapitalizing. Because its $5 earnings per share is post-tax earnings, Amazon would have been earning $10 per share in pre-tax income. Now, if Amazon’s pre-tax earnings increased 50% to $15 per share, that would make its true earnings per share $7.50, after tax. So, assuming the same price-earnings ratio of 17, Amazon’s new share price would be $127.50 ($7.50 times 17)—a commensurate 50% increase in share price from $85 per share.
However, after the recapitalization, if Amazon is paying $60 in bonds at (say) 5% annual interest, then it owes shareholders $3 annually that it can subtract from its pre-tax earnings of $10, resulting in $7 in taxable earnings and thus $3.50 in true earnings per share. So, even if Amazon’s pre-tax earnings increased 50% to $15 per share initially, they would only be taxed for $12 per share after subtracting the $3 interest payments—in other words, they would only be paying $6 per share in taxes. Thus, their true earnings per share would be $6 ($15 in pre-tax earnings minus $6 in taxes and $3 in bond distributions). Assuming a post-recap price-earnings ratio of 12, as specified above, Amazon’s share price should catapult to $72 ($6 times 12). Because Amazon’s stub stock was initially trading at $42 per share, this signifies a 71% share price increase, even though Amazon’s pre-tax earnings only increased 50%.
(Shortform note: In addition to recapitalizations, corporations use a wide variety of legal strategies to decrease their taxable income and thus increase shareholder value. For instance, accelerated depreciation allows corporations to deduct a large portion of the depreciation of their capital expenditures (like factory equipment) upfront. Additionally, some companies attempt to offshore their profits, meaning they register their intellectual property in a subsidiary incorporated in another country with lower tax rates to maximize their post-tax earnings.)
Greenblatt points out that, in addition to magnifying companies’ increases in earnings, stub stocks also minimize downside risk. For example, investing in Amazon after the recap means you could only lose up to $42 per share, whereas previously you could’ve lost up to $85 per share. Put differently, you’re only investing in Amazon’s much smaller equity portion of $42, rather than its much larger leveraged portion of $60, meaning your risk of loss is smaller.
(Shortform note: Although it’s true that stub stocks can result in lower losses per share, experts caution that stub stocks are often more volatile because it’s difficult to assess recapitalized companies. Consequently, stub stocks can deliver losses that are greater than normal stocks as a percentage of your investment. For instance, in 1987 stub stocks dropped 47% in value, compared to the 33% loss suffered by the overall S&P 500.)
How to Profit From LEAPS
Stub stocks, Greenblatt points out, are a relatively rare phenomenon. However, he writes that you can enjoy similar benefits to stub stocks by investing in long-term equity anticipation securities (LEAPS). According to Greenblatt, LEAPS are another investment vehicle that can yield outsized returns while minimizing downside risk.
First, Greenblatt clarifies that LEAPS are a type of call—a financial contract that gives its owner the right (but not the obligation) to purchase a security at a guaranteed price in the future. For example, if at the start of 2023 you believed Disney’s stock would rise from its price of $90, then you could purchase a call for (say) $1 to purchase a share of Disney stock at $90 anytime before April. If your prediction panned out, you could exercise your option to buy Disney stock at $90, sell it at its increased price, and profit handsomely. The only distinction between LEAPS and general calls is the time horizon—LEAPS provide you with the right to purchase a stock at a fixed price up to two and a half years in the future, whereas normal calls have shorter timeframes.
(Shortform note: Calls, such as LEAPS, are one of two types of options, the other type being puts. Whereas calls give their owners the right to buy a security at a guaranteed price, puts give their owners the right to sell a security at a guaranteed price. Investors who purchase puts believe a security’s price will drop before the put expires. For instance, if you purchased a put giving you the right to sell one share of Meta stock at $300 by the end of the month and Meta’s share price dropped to $250, you could earn $50 by purchasing Meta at $250 and exercising your right to sell it at $300.)
Like stub stocks, LEAPS can amplify increases in stock price to yield disproportionately large returns. Returning to the previous example, if you purchased 1,000 LEAPS at $1 each that gave you the right to buy Disney at $90 down the line, then you could earn $10 per LEAP if Disney stock rose to $100 per share. Thus, your initial $1,000 investment would return $10,000, a tenfold increase. By contrast, those who owned Disney’s common stock at $90 would earn a meager 11% return on investment in the same period.
Greenblatt also points out that purchasing LEAPS drastically limits your potential loss. For example, imagine that in the previous example, Disney stock instead crashed to $50 per share. Disney’s shareholders would therefore lose $40 per share, while you would only be out the $1 cost per LEAP. In other words, you lose no more money if Disney stock drops from $90 to $88 per share than if it drops from $90 to $50 per share. LEAPS thus provide better downside protection than owning common stock.
The Potential Downsides of LEAPS
Greenblatt offers an unambiguously positive portrayal of LEAPS, according to which they not only deliver greater returns but also minimize risk. However, other experts caution that LEAPS have an array of disadvantages that Greenblatt doesn’t mention. For example:
LEAPS are consistently more expensive than short-term calls with the same strike price (the price at which you have the right to purchase shares), meaning you’re risking more money than you would by purchasing short-term calls.
LEAPS are sometimes unavailable for stocks you wish to invest in, meaning you have fewer options to invest in them.
LEAPS can lead to much larger percentage losses than owning the underlying stock, because you lose your entire investment if the stock doesn’t surpass the strike price, whereas owners of the common stock lose only a portion of their investment.
LEAPS deprive you of benefits afforded to common stock owners, such as dividend payments and voting rights.
For these reasons, LEAPS aren’t a magic bullet, even if they can deliver outsized returns in the right circumstances.
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