Investing books are
always popular because everyone is looking for that silver bullet that will
lead them to riches. Knowing this the book industry publishes a lot of trash
about getting rich in the stock market…Having said that, there are however some
real gems out there if you hunt for them. One really outstanding book that has
greatly influenced the way I’ve invested over the years has been, You Can be a
Stock Market Genius by Joel Greeblatt…Its an awful title to an outstanding
book…Below is a pretty good review on it to give you an idea of what it’s
about.
Originally published in 1997, “You Can Be A Stock Market
Genius” remains popular today and is enthusiastically endorsed in a number of
reviews on the internet. The author, Joel Greenblatt, ran hedge fund
Gotham Capital racking up a 50% average annual return over a 10 year period
spanning the mid 80’s to the mid 90’s. “You Can Be A Stock Market Genius”
reveals how he did it and suggests that a motivated individual could do it too,
even if he wasn’t all that smart. Mr. Greenblatt has since acknowledged
in subsequent books that these methods require more work than the average
individual investor can muster. His two subsequent books “The Little Book
That Beats the Market” and “The Big Secret for the Small Investor” suggest
stock screening methods that outperform the market without much effort from the
individual.
I was enthralled with the book when I first read it in 1998
and have 14 years of experience since then implementing some of the
strategies. I’ll tell you my own experience later but first let me
summarize the chief ideas in the book. First, when a
small individual investor goes up against professional portfolio managers, it’s
no contest. The professional portfolio manager doesn’t have a chance.
The intelligent and competent professional’s performance is strangled by the
billions of dollars he has to invest. Liquidity demands limit him to
choosing among the largest and most followed stocks. The individual, by
contrast, has a universe of 10,000+ stocks to choose from including many
smaller companies that are inefficiently priced. Mr. Greenblatt points
you in the book to the microcap space to look for mispriced securities.
He goes further than
that, however, pointing you to specific situations where microcaps are
especially likely to be undervalued. In particular, there are
certain situations where securities are dumped into the brokerage accounts of
investors who didn’t buy them and don’t really want them. This can result in indiscriminate selling
and a temporarily depressed stock price. A large company spinning off a smaller subsidiary to its stockholders
is his favorite example. The spinoff security just shows up in
brokerage accounts all over the world at the same time. Investors didn’t buy the security, they
likely know little about the company, and in some cases may not even be allowed
to own it. A large-cap mutual fund, for example, may receive a
microcap spinoff that their charter forbids them to own. The value of the
spinoff compared to the value of their investment in the parent may be small so
they’re motivated to sell it without even investigating its fair value. Company management doesn’t want to promote
the new spinoff company until after their stock options are priced.
At the same time investors are selling indiscriminately, therefore, there’s
also a dearth of information available for prospective buyers.
A second special situation is
companies emerging from bankruptcy. Many debts are reduced in
bankruptcy and some of the debt is replaced by issuing new shares to the former
creditors. These new shareholders
are in the business of loaning money and not owning equities so when the equity
securities are issued to them they may want to sell perhaps
indiscriminately. A third special situation arises
from company buy-outs. In merger agreements, warrants or bonds
or other securities are sometimes issued to sweeten an offer. If you own
shares in some large company that gets bought out, for example, you might
receive $90 a share in cash and some 5-year warrants to buy additional shares
of the acquiring company. The tradeable warrants may be worth only a few
dollars. Many investors will just
dump the relatively low-value warrants indiscriminately. Mr.
Greenblatt covers a number of other special situations including divestures and
recapitilizations and discusses the use of options and LEAPS to provide
leverage.
The book is full of specific examples of these situations
from Mr. Greenblatt’s Gotham Capital days. He includes his thinking that
went into his decision to buy and later the decision to sell. Mr. Greenblatt believes in personal
motivation. He likes to see generous option packages to incentivize the
management team of a new spinoff, for example. The very best
situations arise when Wall Street doesn’t want the new security but the
management or major owners do. He cites specific examples involving
spinoffs that Wall Street dumped but insiders (Malone and Hilton) wanted that
became big winners.
The book is dated in one respect. The method that Mr.
Greenblatt suggest to find these special situations is to read a lot.
Articles in the Wall Street Journal or other publications pointed him to these
situations while at Gotham Capital. There are other ways today that are
easier although reading a lot is still a good idea for any investor. A search of SEC filings for form 10’s will
bring up a list of recent and upcoming spinoffs for example. There
are free websites that maintain such a list as well. Divestures can be found with a Google search. I use the term
“definitive agreement to sell” in the search and have results e-mailed to me
daily.
I’ve had great success implementing two of Mr. Greenblatt’s
methods. A large company spinning
off a micro-cap happens a few times a year and almost always results in an
undervalued security. Let it trade for at least two weeks before buying
as prices nearly always fall initially. Divestures often uncover a successful and undervalued remaining company
just as Mr. Greenblatt explains in the book. I’ve made a lot of money on
these situations over the years. Recapitalizations seem to be very
rare these days, and I’ve never invested in such a situation. I have come
across an occasional merger security but never invested in one. Mr.
Greenblatt acknowledges in the book that the bankruptcy emergence situations
didn’t seem to be as profitable as they once were. The problem, he
explains, is that hedge fund managers now buy up the debt before the company
emerges from bankruptcy. The issued equity doesn’t go to a bank but
rather to a sophisticated hedge fund that knows what it’s worth. I’ve
invested in a few bankruptcy emergence situations with pretty mixed results.
I heartily recommend the book. It’s both an
interesting and humorous read while providing very valuable ideas and specific
advice on what to look for in special situations.
Mark Vonderwell
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