Book: You Can Be a Stock Market Genius
Author: Joel Greenblatt
Despite a rather lousy title, it is an excellent book. It steers clear off the standard analysis of public equities, and introduced me to areas of the securities market (spinoffs, merger arbitrage, recapitalizations etc.) that I knew very little about.
Reasons to investigate these areas: First off, Greenblatt admits that opportunities in the areas he highlights in the book are rare, but backs this up the fact that diversification via a large number of securities in portfolio is not what it is made out to be (8 stocks give you roughly the same amount of diversification as do 500 stocks). But, the returns vs. the risk in these areas, on average, can be significantly better than investing in public equities, on average.
The obvious question is that why would returns would persist in this area when it is admittedly known that spinoffs have significant returns. Greenblatt explains that the reasons are built into the system–(a) the process is a fundamentally inefficient way of distributing the new stock to the wrong people (the parent company stockholders) who sell it indiscriminately without regard to price or fundamental value (because the holders have mandate that require them to hold stocks of a certain size and the spinoff will likely be too small to warrant the effort of analysis by the largest shareholders). (b) Once the spinoff is done, the new stock options etc. more directly compensate the new management which increases their incentive to show better results; in fact, according to a Penn study, most of the gains in the spinoffs came in the 2nd year, not the 1st. (c) Often the spinoffs created have a significant amount of leverage (because this is an incentive on the parent company’s part to palm off some of the debt), which helps returns when the trajectory turns positive.
A big criterion to look for is insiders’ ownership: are they incentivized alongside the new shareholders, and is there a plan for them to acquire more? It is also important to note that in a spin-off no arms-length transaction happens when the stock option price for the management is being decided. The lower the option price, better it is for the management, which is why one is unlikely to hear bullish pronouncements from the company before the spin-off is executed. To sum, insiders have a very one-sided control in creating a new publicly-traded company.
Rights Offering: Occasionally, instead of merely distributing shares of the spinoff to the shareholders, parent company may give its shareholders the right to buy stock in its subs/divisions, and Rights Offering is one way to accomplish this; this is often used by companies seeking to raise additional capital. The obvious question again is that where is the opportunity to benefit from is coming from since in this case the existing shareholders are NOT indiscriminately selling the stock, and are instead actively buying the rights of the company. The difference is that in any other way of raising capital, the company is required to seek the highest possible price, but that is not the case in a Rights Offering. One telltale sign of a bargain price is the presence of oversubscription privileges in the offering; management seeking to increase their ownership often include this, and it can be a strong sign that it could be a good investment.
Greenblatt says that Merger Arb is best left alone by most people. It is not a surprised that the majority of fraud that was committed in the 80s by Boesky and guys was in this area; it is very hard to trade in this area with public knowledge, and people with insider knowledge can almost always trump them and can easily manipulate the public-side investors by leaking news, if they wanted to (while wishing away jail time and fines). For public-side investors, this is not a good deal from a risk-reward perspective and one has to monitor news at all times to see which way the winds are blowing. Finally, this space has become very crowded in the recent past.
Merger Securities: Greenblatt says that the one place that one’d like to be involved in the merger arb business is the area of merger securities (used when the acquirer has exhausted all the other ways of paying for the acquisition); as a general rule, no one wants merger securities, and they’re often sold right away, and this indiscriminate selling creates a great buying opportunity.
Bankruptcy and Restructuring:
In early stages of bankruptcy proceedings, there is so little information, and the field (like merger arb) is so crowded that is not worth getting involved in. But, once the company emerges from bankruptcy proceedings, the holders of bank debt, bond debt and trade claims don’t usually get paid in cash but are instead given securities in exchange for their pre-bankruptcy claims. Now, this is not a long-term investment because companies that go into bankruptcy are often in unattractive industries, and often don’t have capital to compete even after shedding debt obligations, which is why the holders of the new post-bankruptcy securities are likely to sell these securities soon after.
Recapitalizations, LEAPs and Options:
In a recapitalization, a company may buy back their equity securities in exchange for debt or preferred securities, and investors who were holding the stock would likely not want these securities and sell them without much thought. This is a familiar piece, but the other reasons recaps are interesting because this is like investing in equity of a leveraged buyout where the immense leverage can work in investors’ favor if the operations improve. These are also called stub stocks. In this section, Greenblatt also talks about LEAPs and Warrants that can be used in a similar way.
The following are investing letters followed on the street –
The Turnaround Letter
Dick Davis Digest
Form 10 – used to supply information on a spin-off
Form S4 is used for securities being offered in a business combination, exchange offer, recapitalization/restructuring.
Additional Information on IPOs (not from this book)
I found some additional information that was not mentioned in this book, but in Excess Returns, but thought that the writing was most relevant here, so I am adding it here. It talks about the rare IPOs where the issuers have an incentive to settle at a relatively bargain price: (a) privatization of government-controlled companies, and (b) de-mutualizations.
Additional Information on Turnarounds (not from this book)
I found some additional information that was not mentioned in this book, but in Excess Returns, but thought that the writing was most relevant here, so I am adding it here. Turnarounds are rarely acquired (as management is usually not thinking about selling at the time when they’d have to accept a much lower price), so it is important to understand the long-term stable-cash flow value of the investment. A very important signal for turnarounds is when management changes, and a well-respected executive takes over as this not only means that operations will improve but also that this experienced executive thinks that the turnaround will actually take effect. Other key signals are when the market stops ignoring further bad news (which means that the bottom has been hit), bonds (if, any) stabilize, insiders begin buying and no further dividends are cut.