Lessons From Warren Buffett: Asset Allocation Formulas are Pure Nonsense

Lessons From Warren Buffett: Asset Allocation Formulas are Pure Nonsense

June 13, 2021Lessons From Warren Buffett, Value Investing, Warren BuffettValue Investing, Warren Buffett

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Rebalancing your portfolio is something that is constantly preached by the financial industry, and if you don’t do it yourself, they are happy to create an account or a fund that does it for you automatically. However, Warren Buffett scoffs at the whole concept and sees it to be more about marketing than good investing.

“The idea that you have, you know, you say, ‘I’ve got 60 percent in stocks and 40 percent in bonds,’ and then have a big announcement, now we’re moving it to 65/35, as some strategists or whatever they call them in Wall Street do. I mean, that has to be pure nonsense,” 

Warren Buffett said at the 2004 Berkshire Hathaway Annual Meeting. 

“What you ought to do is have (as) your default position is always short-term instruments. And whenever you see anything intelligent to do, you should do it. And you shouldn’t be trying to match up with some goal like that. . . . But so much of what you see when you talk about asset allocation, it’s just merchandising. It’s a way to make you think that if you don’t know how to determine whether it should be 60/40 or 65/35, that you need these people. And you don’t need them at all in investing.”

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© 2021 David Mazor

Disclosure: David Mazor is a freelance writer focusing on Berkshire Hathaway. The author is long in Berkshire Hathaway, and this article is not a recommendation on whether to buy or sell the stock. The information contained in this article should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results.

Source

https://mazorsedge.com/lessons-from-warren-buffett-asset-allocation-formulas-are-pure-nonsense/

Book Review of You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits

Book Review of You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits

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I’ve always wanted to read “You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits” by Joel Greenblatt since I knew about the book some years back, yet have somehow never managed to do so. Well, I finally dug in and I’m glad that I did.

This is an excellent book, written in a humorous, straight-forward, easy-to-read style that is great reading.

Books on special situation investing are rare. Martin Whitman has books on bankruptcy investing, Guy Wyser-Pratte has a book on Risk Arbitrage. Greenblatt goes through a few areas: spinoffs, mergers, restructuring, options, etc. and explains why these are good hunting grounds for bargains due simply to their very nature.

It also reminds me about David Einhorn’s investment philosophy that they look at where something might be cheap, and then analyze the situation to determine if it is indeed a bargain.

Overall a very good read, highly recommended.

On Diversification

After purchasing 6 or 8 stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small.

Overall market risk will not be eliminated merely by adding more stocks to your portfolio.

On Buying and Selling

Buy when

It’s relatively cheap

There’s limited downside

It’s undiscovered

Insiders are incentivized

You have an edge

No one else wants it

When to Sell

For special situations, trigger to sell may be a substantial increase in the stock price, or a change in the company’s fundamentals (e.g. company is doing worse than you thought).

When you make a bargain purchase because of a corporate event, determine what kind of company you’re buying. If the company is an average company in a difficult industry, sell once the stock’s attributes become more widely known. If the company is a good company, you can hold for the long-term.

Spinoffs

Why Invest in Spinoffs

A study done by Penn State covered a 25-year period ending in 1988, and found that stocks of spinoff companies outperformed their industry peers and the S&P500 by 10% per year in their first 3 years of independence. The parent companies outperformed the companies in their industry by more than 6% per year during the same 3 year period. [“Restructuring Through Spinoffs,” Journal of Financial Economics 33 (1993). Patrick J. Cusatis, James A. Miles, and J. Randall Woolridge.]

The largest stock gains took place in the 2nd year after the spinoff. This is likely due to 2 reasons: it takes some time for the selling pressure to wear off, and it takes a year for the entrepreneurial changes and initiatives to kick in.

With the market averages returning ~10% per year historically over the long-run, spinoffs can return ~20% per year.

The management of the spinoff is freed from a corporate parent, and has more accountability, responsibility, and direct incentives (e.g. stock options).

The whole motivation behind a spinoff is to increase shareholder value.

Why Do Spinoffs Occur

Unrelated businesses can be separated so that each can be better valued by the market. The valuation metrics used for each unrelated business can be different, hence is the combined entity may not be appropriately valued.

Separate out a ‘bad’ business so that a ‘good’ business can show through. Establishing a more focused management team for each entity is better for both.

Give value to shareholders for a business that can’t be easily sold. The division may be in an unpopular but cash-generating business. In that case, debt can be loaded onto the spinoff to create more value to the parent.

Tax considerations favour a spinoff rather than a sale. Under certain conditions, a spinoff can be a tax-free transaction, compared to a sale where the gains are taxed and dividends are taxed again.

A spinoff may solve a strategic, antitrust, or regulatory issue, allowing other transactions to occur. E.g. a parent holding a division in a highly regulated industry may have problems getting itself acquired.

Why Are Spinoffs Sold Down

Shareholders mostly were invested for the parent’s business.

Spinoffs are much smaller than the parent, which is too small for an institutional portfolio.

Many funds can only own S&P500 companies. A spinoff from an S&P500 company will be sold.

Insiders prefer a low initial price because their stock options are set based on the stock price after a day of trading, a week, a month or more. Do check the SEC filings for when the mangement’s stock options will be set.

Buying Before or After the Spinoff

In general, if institutional investors are interested in a parent company because an undesirable business is being spun off, they will wait until the spinoff is completed before buying the parent.

This removes the risk of the spinoff transaction not being completed, and the need to sell the unwanted spinoff.

It has the tendency to drive up the price of the parent’s stock immediately after a spinoff.

Hence it is usually worthwhile for you to buy stock in the parent before the spinoff takes place.

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Spinoff Example #1: Marriott

Situation

Announcement date: October 1992.

Marriott Corporation to be split into Host Marriott and Marriott International.

Host Marriott will hold the unsalable hotel properties with almost all of the debt.

Marriott International will hold the hotel management service business with the huge income stream.

Stephen Bollenbach (the CFO that came up with the plan, and who turned around Donald Trump’s gambling empire) will be CEO of Host Marriott.

Marriott International will extend a $600M line of credit to host Marriott.

The Marriott family will hold 25% stakes in both companies.

Opportunity

Institutions would not want it. Host Marriott looked so awful that few institutions would do further research. It is small (10-15% of the original $2B market cap) and highly leveraged. It is in a different business compared to what they were mainly investing in.

Stephen Bollenbach is going over to Host Marriott, not Marriott International.

Host Marriott had $20-25 per share of debt, with $3-5 per share of equity. A 15% move on the asset side can double the stock.

Host Marriott has a lifeline of $600M from Marriott International.

How it played out

SEC filings: June/July 1993.

Spinoff date: End September 1993.

Insiders had huge vested interest with 20% of Host Marriott’s stock.

Host Marriott tripled in 4 months from spinoff.

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Spinoff Example #2: Briggs & Stratton

Situation

Announcement date: May 1994.

Briggs & Stratton (small gas-powered engines used in outdoor power equipment) to spinoff off Strattec Security (automotive-lock division).

Opportunity

Strattec was less than 10% of Briggs & Stratton’s total sales and earnings. Briggs & Stratton is a S&P500 company.

Insiders will hold 12% of the new company.

Comparables for Strattec are at P/E of 9 to 13 based on Value Line’s “Auto Parts (Original Equipment)” group. Earnings seem to be going 10% higher.

Strattec is the largest supplier of locks to GM, supplies almost all the locks to Chrysler, and may supply locks to Ford. The Ford opportunity can increase sales by more than 16%.

Strattec seemed to have a strong niche with quality products at competitive prices.

How it played out

SEC filings: November 1994, January 1995 (more details)

Spinoff date: 27 Feb 1995.

Form 10 filed. Did not require a shareholder vote.

Traded at $10.50 to $12, the low-end of the industry P/E range for several months, and the price did not take into account (1) the Ford business, (2) Strattec’s market niche, (3)

upcoming 10% profit increase.

Traded to $18 before the end of 1995, a 50%+ gain.

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Spinoff Example #3: Home Shopping Network (HSN)

Situation

Announcement date: April 1992 (Smart Money magazine)

To spinoff Silver King Communications to hold its 12 UHF TV broadcast stations.

HSN management believed that the broadcast stations should be valued on a cash flow basis, while HSN being a retail company should be valued on an earnings basis. The high amortization each year on the broadcast stations was hurting the overall earnings of HSN.

Silver King’s operating earnings was ~$4M, cash flow was ~$26M, free cash flow was ~$23M.

HSN will shift $140M of debt to Silver King and be relieved of $12.6M in annual interest costs. HSN’s reported earnings will go up by $8.6M ($12.6M of interest saved – loss of Silver King’s operating earnings).

Opportunity

Stock price was just over $5 despite being a high flyer in the 1980s.

The value of the spinoff was small (every 10 shares in HSN will receive 1 share of Silver King), yet it has a ton of cash.

Spinning off Silver King (broadcast is regulated) makes HSN more saleable.

How it played out

SEC filings: August 1992

Spinoff date: January 1993

Silver King traded at $5, less than 5x cash flow, for a few months. Traded at $10-$20 over the next year due to speculation that it will join with others to form a 5th TV network.

HSN went up instead of going down on the day of the spinoff, leading to a one-day gain of 12% for HSN shareholders.

Another HSN spinoff Precision Systems traded below $1 for several months, went to $5 within a year, and $10 over the next 2 years.

HSN and its rival QVC Network both doubled in the next year.

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Spinoff Example #4: American Express

Situation

Announcement date: Jan 1994

To spinoff Lehman Brothers to remove volatile earnings.

Amex will be left with 2 businesses, the travel related business (charge card, travel agency, traveler’s check) business and Amex Advisors business (financial planners, annuities, mutual funds).

Lehman is estimated to be worth $3 to $5 per Amex share (at $29)

Opportunity

Amex would earn $2.65 per share in 1994 without Lehman Brothers, so the post-spinoff Amex can be bought for less than 10x earnings at $24-$26.

Amex comparables have P/E in the low teens.

Amex Advisors was growing at 20% for almost 10 years.

How it played out

Amex rose $1.60 the first day after the spinoff.

Amex went to $36 in the first year after the spinoff, for a 40%+ gain.

Warren Buffett bought 10% of Amex 6 months after the spinoff.

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Partial Spinoffs

Why Do Partial Spinoffs Occur

To get the market to value a particular division independently, while still retaining management control.

Why Investigate Partial Spinoffs

If the shares are distributed to the shareholders of the parent company, it works the same as a full spinoff. If the shares are sold to the public through an IPO, indiscriminate selling is not likely so the opportunity is not as good.

By knowing the market value of the division, it allows you to know the market value for the rest of the parent’s company.

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Partial Spinoff Example #1: Sears

Situation

Announcement date: Sep 1992.

Sears to sell a 20% in two subsidiaries, Dean Witter (including Discover) and Allstate Insurance, and distribute the remaining 80% interest to shareholders some time in 1993.

20% in Dean Witter was sold in Feb 1993.

20% in Allstate was sold in Jun 1993.

In July 1993, Dean Witter was at $37, Allstate at $29, Sears at $54.

80% in Dean Witter distributed in Jul 1993.

Opportunity

Subtracting the value of Dean Witter and Allstate from Sears meant that Sears retail business was valued at $10 or $11.

Subtracting away Sears Mexico, Sears Canada, and Coldwell Banker, leaves $5 a share or a market cap of $1.5B for a retailer with $27B in sales and little debt.

Possible to long Sears and short Allstate to just capture the Sears portion (when the 80% of Allstate was not yet distributed).

How it played out

Sears was up 50% over the next several months.

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Spinoffs via Rights Offering

Why Investigate Spinoffs via Rights Offering

The parent has chosen not to pursue other alternatives that require the directors, as fiduciaries, to seek the highest possible price for the spinoff’s assets.

There is a general tendency for a spinoff to be offered at an attractive price in a rights offering. A telltale sign of a bargin is the inclusion of oversubscription privileges for investors who purchase spinoff stock to buy more shares if the rights offering is not fully subscribed.

With oversubscription privileges, insiders can own more of the spinoff by discouraging other investors from exercising their rights.

Always try to figure out what’s in it for the insiders!

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Rights Offering Example #1: Liberty Media

Situation

Announcement date: Jan 1990

Tele-Communications (TCI) was the largest cable operator, and wanted to spinoff its programming assets and minority interests in cable TV systems to lessen the regulatory pressure.

Mar 1990: Announcement that a rights offering will be used. The spinoff will be scaled down.

Oct 1990: Spinoff is scaled down again.

Nov 1990 and Jan 1991: Value of spinoff assets down to $600M (vs. $15B in TCI)

Liberty Media reported a $20.4M loss for year ending Sep 1990.

TCI shareholders receive 1 transferable right for every 200 shares they owned. Each right, together with 16 shares of TCI can be exchanged for 1 share of Liberty Media.

This puts the price of Liberty Media at $256 with total of 2M shares.

Opportunity

2M shares was too illiquid for institutional investors [intentional].

The number of Liberty shares issued would be equal to the number of rights exercised, even though the assets will remain the same.

Any rights not issued will be replaced by preferred stock owned by TCI which gave money to Liberty at very good terms.

John Malone, CEO of TCI chose to receive his compensation in the form of stock options for 100,000 shares of Liberty.

The $20.4M loss did not include the equity stake in other companies, which is the bulk of Liberty’s assets.

Forbes, Bear Stearns, and Lehman all recommended not to participate in the rights.

How it played out

TCI’s Chairman Bob Magness and CEO John Malone bought up all the shares of Liberty, with Malone owning 20% of Liberty.

TCI’s clout was used to make sure Liberty thrived.

Liberty split its stock 20 for 1 less than 1 year after the rights offering.

Liberty went up 10x in less than 2 years.

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Risk Arbitrage

Risk arbitrage is not recommended

A deal may not go through for a number of reasons (regulatory, financing, extraordinary changes in the business, discoveries during the due diligence process, personality problems, people changing their mind, etc.), resulting in large losses.

Deals can take 1 to 18 months to close, tying up the money.

Risk arbitrage is now a very competitive business making the spread low.

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Close Shave Example #1: Harcourt Brace Jovanovich / Florida Cypress Gardens

Situation

April 1985, Harcourt Brace Jovanovich (HBJ) announced an acquisition agreement with Florida Cypress Gardens..

Each share of Cypress Gardens will get 0.16 share of HBJ.

Potential annualized gain of 50%.

For every Cypress Gardens stock bought, shorted 0.16 HBJ stock.

Risks

Shareholder approval risk is low: For Cypress Gardens, the Chairman owned 44% of stock outstanding. For HBJ, the deal is so small that no shareholder vote is required.

Deal made sense because both are in the same business..

No financing risk because the offer is in common stock.

No regulatory issues.

No antitrust considerations.

What happened

The main pavilion of Cypress Gardens fell into a sinkhole (physically).

Cypress Gardens announced that the deal can be affected.

HBJ stock had already climbed by 17.1%.

If the deal is called off, the loss could be 59%. If Cypress Garden dropped further due to damaged facilites, the loss could be 85%.

How it played out

The short in HBJ was covered.

The purchase price was reduced but still allowed a small profit.

Final loss was 13.3%.

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Close Shave Example #2: Combined International / Ryan Insurance Group

Situation

July 1982, Combined International agreed to acquire Ryan Insurance Group.

Chairman of Ryan Insurance was to be the new CEO and Combined’s founder Clement Stone was to step down.

Risks

Ryan and his family owned 55% of Ryan Insurance Group, so no shareholder approval risk for Ryan.

The upside is $2, downside is $14, but the deal looked relatively riskless.

What happened

Clement Stone changed his mind about giving up his company during Combined’s shareholder meeting.

How it played out

Stone and Ryan managed to iron things out at the end of the day after the market had closed.

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Merger Securities

Why Investigate Merger Securities

Retail investors don’t understand complicated securities and will just sell.

Most institutional investors do not have the mandate to hold both stock and bond investments, and even if they can, merger securities are unlikely their top choice.

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Merger Securities Example #1: Super Rite Foods

Situation

Super Rite Foods was 47% owned by Rite Aid Corp.

Jan 1989, Chairman and management of Rite Aid Corp wanted to take Super Rite private in a LBO transaction.

Other parties made bids for Super Rite, and the final bid consisted of cash, preferred stock with 15% yield, and warrants for 10% of the company.

Opportunity

Face value of preferred was small, likely indiscriminately sold.

Value of warrants per Super Rite share was even smaller.

Management projections in the proxy showed that the company will have free cash flow of $5 per share in 3 years, making the shares worth $50 each.

Warrants were trading at $6 and allowed one to buy shares at no cost.

How it played out

Decided against buying Super Rite shares in case the deal collapsed.

Super Rite went public 2 years after the deal closed.

Warrants trading at $6 were valued at $40.

Preferreds were trading at 50-60% of face value, and sold for 100% of face value at the IPO.

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Merger Securities Example #1: Paramount Communications / Viacom

Situation

Sep 1993, Viacom agreed to purchase Paramount for stock and cash.

Feb 1994, Viacom won bidding war again Barry Diller and bought 50.1% of Paramount.

Jul 1994, Paramount shareholder meeting closed the deal. They were given Viacom stock, debentures of Viacom, Contingent Value Rights (CVR), and Viacom warrants.

Opportunity

CVR gave a backstop to the value of Viacom shares.

The warrants can be exercised using the debentures.

How it played out

The debentures traded at 60% of face value.

Effectively the warrants + debentures gave the right to buy Viacom stock for 5 years at $42 even though the stock was at $32.

Buying both warrants and debentures was a winning trade.

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Bankruptcy

Why Investigate New Common Stock of Company Emerging from Bankruptcy

Company’s past performance, new capital structure, management’s future projections for the business, are contained in the registration or disclosure statement. Many new shareholders may not care to read.

Stock issued to banks, former bondholders, and trade creditors, are not interested in being long-term shareholders, so they will sell quickly.

Wall Street generally ignores the stocks of companies coming out of bankruptcy.

Some companies are too small to justify vultures’ time and effort.

Study by Edward Altman, Allan Eberhart, and Reena Aggarwal found that stocks emerging from bankruptcy outperformed the market index by over 20% during their first 200 days of trading. [“The Equity Performance of Firms Emerging from Bankruptcy,” New York University Salomon Center and Georgetown School of Business Working Papers, May 1996.]

Quality of Companies

Companies got bankrupt because they are in difficult, unattractive, uncompetitive businesses or have lack of capital. Quality of the companies are not good.

Stick with good businesses, companies with a strong market niche, brand name, franchise, or industry position.

Types of Companies to Investigate

Companies that went bankrupt because they were overleveraged due to a takeover or LBO.

Operating performance of a good business suffered due to a short-term problem.

Earnings of a company involved in a failed LBO grew slower than hoped.

Companies that filed for bankruptcy to protect itself from product-liability lawsuits (e.g. Walter Industries).

Companies that shed unprofitable business lines when coming out of bankruptcy (e.g. Toys R Us).

Plain cheap stocks compared to similar companies in the same industry.

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Bankruptcy Example #1: Charter Medical Corporation

Situation

Dec 1992, stock at just over $7.

Operates 78 psychiatric hospitals and 10 conventional medical-surgical hospitals.

Emerged from bankruptcy few months ago with still a sizable debt load.

Opportunity

Based on comparables, it should be trading closer to $15.

Plan to control costs, step up marketing for new patients, and increase outpatient psychiatric services, appear to be going well.

Plan to sell its conventional hospitals to reduce leverage.

Was going to earn $2.50-$3 of free cash flow per share.

How it played out

Conventional hospitals were sold for a good price.

Wall Street discovered the sotck.

Stock tripled.

Bankruptcy Tips

As a general rule, don’t buy the common stock of a bankrupt company.

If you want to invest in the bonds, bank debt, and trade claims of bankrupt companies, quit your day job.

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Restructuring

Why Investigate Restructuring Situations

Sale of a major division may create a more focused enterprise which benefits shareholders.

Companies that pursue restructuring are often among the most shareholder oriented.

Two ways to play

Invest after a major restructuring has been announced. There is ample time because it takes time for the market to fully understand the ramifications.

Invest in a company that is ripe for restructuring. This is much more difficult to do. Look for a catalyst to set things in motion.

Type of Restructuring Situations to Go For

Limited downside

An attractive business to restructure around

Well-incentivized management team

Magnitude of the restructuring is significant relative to the size of the total company

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Restructuring Example #1: Greenman Brothers

Situation

Wife was impressed with Noodle Kidoodle store set up by Greenman Brothers

Greenman Brothers is a marginally profitable distributor of toys, housewares, and stationery.

Stock just above $5, book value of over $8.

Most assets were in cash, receivables, and recently purchased inventory that could be readily sold.

Opportunity

Huge upside – Did not seem that market is giving any value to the new Noodle Kidoodle. The upside if successful can be huge.

Limited downside – If the assets of the distribution business sold for $6 (assuming a 25% haircut on book value of $8), you still get the Noodle Kidoodle business for free.

Catalyst – If Noodle Kidoodle is to grow, it needs funds. Funds can be obtained either by borrowing or by selling the distribution business.

Business available to restructure – The distribution business.

How it played out

Bought before May 1994.

Stock traded between $4 to $7.

Noodle Kiddole stores did well, and distribution business did worse.

May 1995, Greenman announced the possible sale of its distribution business and free up capital to grow Noodle Kidoodle.

Stock moved up to $11 in 2 months and $14 within 4 months.

Greenblatt sold between $10-$11.

Noodle Kidoodle was later bought over by Zany Brainy for $4.50 in Apr 2000.

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Restructuring Example #2: General Dynamics

Situation

Jun 1992, General Dynamics announced it would buy back 13M shares (30% of shares outstanding) through a dutch auction tender.

After announcement, stock rose to $71. In Feb 1991, stock price was only at $25.

Opportunity

Tender document disclosed that management was not selling any stock back. This meant that insiders think the stock was still undervalued. The buyback will benefit those who held on.

The restructuring plan called for selling of non-core businesses by end 1993. Subtracting the expected cash proceeds from the stock price showed that the continuing core businesses would be at a 40% discount to other defense contractors.

How it played out

Jul 1992, company repurchased 13M shares.

Two weeks later, Warren Buffett announced he acquired 15% of General Dynamics.

For next 2 months, stock traded between $75 and $80.

By end 1993, the stock had given over $50 of dividends, and share price was at $90. The total of over $140 meant the stock had effectively doubled in 18 months.

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Recapitalizations and Stub Stocks

Why Do Recaps Occur

To ward off a hostile takeover or give value to shareholders, a company converts equity to debt or other securities. It either repurchases a large portion of its own common stock in exchange for cash, bonds, or preferred stock, OR it borrows money and distributes cash dividends.

Result of a recap is usually a highly leveraged company that is still owned by the original shareholders. The common stock after the recap is known as the stub stock.

Tax advantages of a leveraged balance sheet (i.e. tax shield due to debt interest).

The total value of the recap package (value of the debt + stub stock) is usually greater than the original pre-recap price of the stock.

Why Invest in Recaps

Investors of the pre-recap stock generally don’t want the company’s debt and preferred securities. These newly issued securities are sold indiscriminately, so they work the same way as merger securities.

Investing in the stub stock is like investing in the equity portion of a publicly traded LBO.

There is almost no other area of the stock market where research can be rewarded as quickly and as generously as in the careful analysis of stub stocks.

Any increases in earnings are amplified due to the small equity base, so the percentage impact on the stub stock price is much greater. With earnings exceeding interest expense more comfortably, a higher P/E can be justified, pushing the stock price even higher.

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Stub Stock Example #1: FMC Corporation

Situation

Feb 1986, FMC Corporation announced plans for a recap to fend off a potential takeover.

FMC shareholders will get a cash distribution of $80 + 1 new share in the recapitalized company. management and employees were to receive 5.66 shares in the recapitalized company for each share they own.

May 1986, proxy statement filed with shareholder vote scheduled end-May 1986.

Opportunity

Management was foregoing the cash dividends, so they are betting their fortunes on the success of the recapitalized company.

By management projections, FMC was expected to earn after-tax FCF of $4.75 per share. Pre-tax earnings were expected to exceed annual interest expense by 2 to 1. At a multiple of 10x FCF, the stock could be ~$50 per share.

FMC stock was trading at $97, meaning a stub stock can be ‘created’ at a price of $17.

How it played out

The stub stock hit $40 a year after the recap.

It touched $60 a few months later just before the October 1987 crash, then fell to $25 during the crash.

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LEAPS (Long-Term Equity Anticipation Securities), Warrants, Options

Options

Listed options expire the 3rd Friday of each month.

Price of options include the intrinsic value (amount the option is in-the-money) + imputed interest for the amount that could have been earned on the strike price that the option buyer did not have to put up + value of the insurance of not losing any more money if the stock falls below the strike.

Options vs. Stub Stocks

Similarity

Both are levered bets on the future of the company.

You only lose the amount you invested.

Differences

Options have limited life.

Stubs have unlimited life.

Why LEAPS

LEAPS can emulate a stub stock investment because of its long-term nature (up to 2.5 years).

2.5 years is often enough time for the market to recognize the results from a corporate change (spinoff, restructuring), turnaround in fundamentals (earnings gain, resolution of one-time problems), or for plain cheap stocks to be discovered or to regain popularity.

LEAPS can be traded on hundreds of companies, while stub stocks are limited in number.

LEAPS can be investigated as a potential investment vehicle while looking into an investment opportunity.

LEAPS is better than leveraging through borrowed money because with LEAPS, you are essentially borrowing the entire purchase price of the stock, paying only the interest charges at a B or BB investment rating, and you don’t have to pay off the principal of the loan if the investment didn’t work out, plus you can participate dollar for dollar in the upside.

Warrants

Warrants are issued by the underlying company,

Warrants usually have a longer time-to-expiration than typical call options. Newly issued warrants can have expiration dates that are 5, 7, or 10 years away.

Why Options Can Be Mispriced

Option traders and quants view stock prices as numbers and not as prices of shares in actual businesses.

The historical price volatility used to calculate option prices do not take into account the impact of extraordinary corporate transactions on companies (e.g. spinoffs, restructuring, merger).

Strategy

Buy options that expire weeks or months after an extraordinary corporate transaction is consummated.

Option holder is entitled to receive whatever a normal shareholder would have received, as if he owned the stock on the date of the extraordinary corporate transaction.

In spinoffs, the parent company’s stock may make a dramatic move because investors had been holding back on buying the parent’s stock until the divestiture of the unwanted business was completed. The shares of the spinoff can also be a source of surprise.

In restructuring transactions, the date of a significant distribution of cash or securities, or the target date for the sale of assets, can correspond to significant price move in the underlying stock.

In mergers, the closing date of the merger can be the catalyst for extraordinary stock price moves. Once a merger is completed, the selling pressure (from risk arbitrageurs) is usually relieved. Shareholders of the acquired company, who had not already sold their shares earlier, tend to sell their shares of the acquirer’s company. After the selling pressure subsides, the acquirer’s stock can sometimes move up dramatically. This is most likely if the new stock issued in the merger is large relative to the pre-deal shares outstanding.

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LEAPS Example #1: Wells Fargo

Situation

Dec 1992, Outstanding Investor Digest (OID) carried an interview with Bruce Berkowitz on Wells Fargo.

Wells Fargo was beaten down because of its large exposure to commercial real estate loans during the real estate recession. It had $249 per share of commercial real estate loans compared to share price of $77.

Wells Fargo had taken loan loss provision of $27 per share a year earlier and $18 per share for the first 9 months of 1992.

Opportunity

Excluding the loss provisions, Wells was already earning $36 per share before tax. When the real estate environment returns to normal, loan loss provisions will drop to $6 per share, resulting in pretax earnings of $30 per share, and $18 of after-tax earnings. At 9x or 10x earnings, it can trade at $160 or $180 per share.

Wells’ accounting was very conservative

Loans classified “nonperforming” were still performing and giving good interest payments. 50% of these loans were still up-to-date on all payments.

Reserves for loan losses stood at 5% of the bank’s total loan portfolio, vs. 6% of loans classified as “nonperforming”.

Despite the large reserves for loan losses, it still had good capital ratios.

Wells Fargo had no losses over its 140-year history.

Wells Fargo Jan 1995 calls with strike $80 can be bought at $14. If the stock goes to $160, the profit is $66 on an investment of $14. Risk/reward ratio is 1 down 5 up.

Risk/reward ratio of the stock is 1 up 1 down.

How it played out

Wells Fargo earned ~$15 per share in 1994, over $20 per share in 1995.

Sep 1994, stock more than doubled to $160 per share.

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Options Example #1: Marriott Corporation

Situation

Spinoff was scheduled to take place on 30 Sep 1993.

Opportunity

Aug 1993, Marriott Corporation stock traded at $27.75. Oct 1993 calls with strike $25 can be bought for $3.125.

Investors who had been waiting to buy the “good” Marriott can do so in the 1st 2 weeks of Oct.

For the “bad” Marriott, the difference between a stock price of $3 and $6 is much closer than it appeared because of its huge debt — it corresponds to an increase in total assets of only 10%, rather a seemingly difficult increase of 100%.

How it played out

Days before the spinoff date, Marriott stock traded at $28.50, price for October 25 calls (i.e. strike $25) moved to $3.625.

By Oct 15, “bad” Marriott traded at $6.75, “good” Marriott traded up to $26. Option gave the right to buy one share of each at total cost of $25, so option value shot to $7.75.

Oct 30 calls could have been bought for $0.25 on 23 Sep, and were worth $2.75 three weeks later.

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Portfolio Management

Advice

Portfolio made up of 5-6 different spinoffs can make sense.

You can build a respectable portfolio of special-investment situations within a year if you only spot an attractive situation every 2-3 months.

Over a 2-year period, you will probably make 8-10 different investments.

If you have some other strategy, you can have special situation investments take up 20-30% of your portfolio.

Caution

Investing more than 10-15% of your portfolio in LEAPS is not advised.

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How To

Where to find special investment opportunities

Newspapers

Wall Street Journal (best)

New York Times (good)

Barron’s (good)

Investor’s Business Daily (good)

Regional business paper

Magazines

Forbes (best)

Smart Money (best)

Business Week

Fortune

Financial World

Worth

Money

Kiplinger’s Personal Finance

Individual Investor

Investment Newsletters

Outstanding Investor Digest

The Turnaround Letter

Dick Davis Digest

Copying the Masters

Michael Price (25% undergoing corporate changes)

Marty Whitman (special situations)

Richard Pzena (out-of-favor large-cap value stocks)

Tips

You only need one good idea every once in a while.

It’s better to do a lot of work on one idea than to do some work on a lot of ideas.

Primary sources of investment information

From 8K: Material event occurs, e.g. acquisition, asset sale, bankruptcy, change in control.

Form S1, S2, S3, S4: Registration statement for new securities. S4 is filed for securities distributed through a merger, exchange offer, recapitalization, or restructuring.

Form 10 (or Form 10-12B): Information on a spinoff distribution.

Form 13D: Owners of 5% or more disclose their holdings and their intentions regarding their stake. If it is for investment, check the reputation of the investor. If it is for control, it is a first sign of corporate change.

Form 13G: Institutional shareholders file this in lieu of 13D if it is for investment purposes only.

Schedule 14A: Annual proxy statement containing executive stock ownership, stock options, overall compensation.

Schedule 14D-1: Tender offer statement filed by an outside party.

Schedule 13E-3, 13E-4: 13E-3 is filed for a going private transaction. 13E-4 is the tender offer statement for a share buyback.

Secondary sources of investment information

Value Line Investment Survey

Individual company reports to get an overview of a firm’s historical operating and investment performance.

Industry valuation data for valuing spinoff and restructuring candidates.

Hoover Business Resources

Dow Jones News / Retrieval – Private Investor Edition, to review past news stories.

Free Cash Flow

Free Cash Flow = Net Income + Depreciation + Amortization – Capital Expenditures

In most healthy businesses, amortization is an accounting fiction. It is important to add back the annual amortization charges to get a true picture of a company’s cash-generating ability.

If a company is growing quickly, a high level of capital spending (with corresponding depressed free cash flow) is not necessarily bad. The high capital spending (relative to depreciation) should be traced to capex for expansion and not for maintenance capex.

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POSTED BY WHATHEHECKABOOM ⋅ JANUARY 16, 2011 

Source

https://whatheheckaboom.wordpress.com/2011/01/16/book-review-of-you-can-be-a-stock-market-genius-uncover-the-secret-hiding-places-of-stock-market-profits/

Specializing in Corporate Events: Spinoffs, Part Three

Specializing in Corporate Events: Spinoffs, Part Three

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Insider Tips: A Do-It-Yourself Guide

Insiders. I may have already mentioned that looking to see what insiders are doing is a good way to find attractive spinoff opportunities. (Okay, so maybe I've beaten you over the head with it.) The thinking is that if insiders own a large amount of stock or options, their interests and the interests of shareholders will be closely aligned. But, did you know there are times when insiders may benefit when a spinoff trades at a low price? Did you know there are some situations where insiders come out ahead when you don't buy stock in a new spinoff? Did you know you could gain a large advantage by spotting these situations? Well, it's all true.

Spinoffs are a unique animal. In the usual case, when a company first sells stock publicly an elaborate negotiation takes place. The underwriter (the investment firm that takes a company public) and the owners of the company engage in a discussion about the price at which the company's stock should be sold in its initial offering. Although the price is set based on market factors, in most cases there is a good deal of subjectivity involved. The company's owners want the stock to be sold at a high price so that the most money will be raised. The underwriter will usually prefer a lower price, so that investors who buy stock in the offering can make some money. (That way, the next new issue they underwrite will be easier to sell.) In any event, an arms-length negotiation takes place and a price is set. In a spinoff situation no such discussion takes place.

Instead, shares of a spinoff are distributed directly to parent-company shareholders and the spinoffs price is left to market forces. Often, management's incentive-stock- option plan is based on this initial trading price. The lower the price of the spinoff, the lower the exercise price of the incentive option. (E.g., if a spinoff initially trades at $5 per share, management receives the right to buy shares at $5; an $8 initial price would require management to pay $8 for their stock.) In these situations, it is to management's benefit to promote interest in the spinoff's stock after this price is set by the market, not before.

In other words, don't expect bullish pronouncements or presentations about a new spinoff until a price has been established for management's incentive stock options. This price can be set after a day of trading, a week, a month, or more. Sometimes, a management's silence about the merits of a new spinoff may not be bad news; in some cases, this silence may actually be golden. If you are attracted to a particular spinoff situation, it may pay to check out the SEC filings for information about when the pricing of management's stock options is to be set. In a situation where management's option package is substantial, it may be a good idea to establish a portion of your stock position before management becomes incentivized to start promoting the new spinoff's stock. Eventually, management and shareholders will be playing on the same team, but it's often helpful to know when the "game" begins.

There are very few investment areas where insiders have such one-sided control in creating a new publicly-traded company. Because of this unique quality, analyzing the actions and motives of insiders in spinoff situations is of particular benefit. Since all shareholders of a parent company either receive shares in a new spinoff or have the equal right to buy shares in a new spinoff, there are few fairness issues that come up when dividing assets and liabilities between parent and spinoff. There are, however, ways that insiders can use their relatively unchecked ability to set the structure and terms of a spinoff to gain an advantage for themselves. Of course, by focusing on the motives of management and other insiders you can turn this advantage for insiders into an advantage for yourself. This is particularly true when it comes to analyzing this next method of establishing a new spinoff company...(Rights Offerings)

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You Can Be a Stock Market Genius,

Joel Greenblatt

Specializing in Corporate Events: Spinoffs, Part Two

Specializing in Corporate Events: Spinoffs, Part Two

Case Study:

Host Marriott / Marriott International

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During the 1980s, Marriott Corporation aggressively expanded its empire by building a large number of hotels. However, the cream of their business was not owning hotels, but charging management fees for managing hotels owned by others. Their strategy, which had been largely successful, was to build hotels, sell them, but keep the lucrative management contracts for those same hotels. When everything in the real-estate market hit the fan in the early 1990s, Marriott was stuck with a load of unsalable hotels in an overbuilt market and burdened with the billions in debt it had taken on to build the hotels.

Enter Stephen Bollenbach, financial whiz, with a great idea. Bollenbach, fresh from helping Donald Trump turn around his gambling empire, and then chief financial officer at Marriott (now CEO of Hilton), figured a way out for Marriott. The financial covenants in Marriott's publicly traded debt allowed (or rather, did not prohibit) the spinning off of Marriott's lucrative management-contracts business, which had a huge income stream but very few hard assets. Bollenbach's concept was to leave all of the unsalable hotel properties and the low-growth concession business—burdened with essentially all of the company's debt—in one company, Host Marriott, and spin off the highly desirable management-service business, more or less debt free, into a company to be called Marriott International.

According to the plan, Bollenbach would become the new chief executive of Host Marriott. Further, Marriott International (the "good" Marriott) would be required to extend to Host Marriott a $600-million line of credit to help with any liquidity needs and the Marriott family, owners of 25 percent of the combined Marriott Corporation, would continue to own 25-percent stakes in both Marriott International and Host. The spinoff transaction was scheduled to be consummated some time in the middle of 1993.

Keep in mind, no extensive research was required to learn all this. The Wall Street Journal (and many other major newspapers) laid out all this background information for me when Marriott first announced the split-up in October 1992. It didn't take more than reading this basic scenario in the newspapers, though, to get me very excited. After all, here was a case where in one fell swoop an apparently excellent hotel-management business was finally going to shed billions in debt and a pile of tough-to-sell real estate. Of course, as a result of the transaction creating this new powerhouse, Marriott International, there would be some "toxic waste." A company would be left, Host Marriott, that retained this unwanted real estate and billions in debt.

Obviously, I was excited about... the toxic waste. "Who the hell is gonna want to own this thing?" was the way my thinking went. No institution, no individual, nobody and their mother would possibly hold onto the newly created Host Marriott after the spinoff took place. The selling pressure would be tremendous. I'd be the only one around scooping up the bargain-priced stock.

Now, almost anyone you talk to about investing will say that he is a contrarian, meaning he goes against the crowd and conventional thinking. Clearly, by definition, everyone can't be a contrarian. That being said . .. I'm a contrarian. That doesn't mean I'll jump in front of a speeding Mack truck, just because nobody else in the crowd will. It means that if I've thought through an issue I try to follow my own opinion even when the crowd thinks differently.

The fact that everyone was going to be selling Host Marriott after the spinoff didn't, by itself, mean that the stock would be a great contrarian buy. The crowd, after all, could be right Host Marriott could be just what it looked like: a speeding Mack truck loaded down with unsalable real estate and crushing debt. On the other hand, there were a few things about this situation beyond its obvious contrarian appeal (it looked awful) that made me willing, even excited, to look a bit further.

In fact, Host Marriott had a number of characteristics that I look for when trying to choose a standout spinoff opportunity.

1) Institutions don't want it (and their reasons don't involve the investment merits).

There were several reasons why institutional portfolio managers or pension funds wouldn't want to own Host Marriott. We've already covered the issue of huge debt and unpopular real-estate assets. These arguments go to the investment merits and might be very valid reasons not to own Host. However, after the announcement of the transaction in October 1992 only a small portion of the facts about Host Marriott had been disclosed. How informed could an investment judgment at this early stage really be? From the initial newspaper accounts, though, Host looked so awful that most institutions would be discouraged from doing any further research on the new stock. Since a huge amount of information and disclosure was sure to become available before the spinoffs fruition (estimated to be in about nine months), I vowed to read it—first, to see if was going to be as bad as it looked and second, because I figured almost nobody else would.

Another reason why institutions weren't going to be too hot to own Host was its size. Once again, not exactly the investment merits. According to analysts quoted in the initial newspaper reports, Host would account for only about 10 or 15 percent of the total value being distributed to shareholders, with the rest of the value attributable to the "good" business, Marriott International. A leveraged (highly indebted) stock with a total market capitalization only a fraction of the original $2 billion Marriott Corporation was probably not going to be an appropriate size for most of Marriott's original holders.

Also, Host was clearly in a different business than most institutional investors had been seeking to invest in when they bought their Marriott shares. Host was going to own hotels; whereas the business that attracted most Marriott investors was hotel management. Though owning commercial real estate and hotels can be a good business, the Marriott group of shareholders, for the most part, had other interests and were likely to sell their Host shares. Sales of stock solely for this reason would not be based on the specific investment merits and therefore, might create a buying opportunity.

(Note: For reasons unique to the Marriott case, the spinoff was actually considered, at least technically, to be Marriott International—even though its stock would represent the vast majority of the value of the combined entities. For purposes of this illustration (and for the purposes of being accurate in every sense other than technical), it will be more helpful to think of Host—the entity comprising 10 to 15 percent of Marriott's original stock market valuation—as the spinoff.)

2) the Insiders want it.

Insider participation is one of the key areas to look for when picking and choosing between spinoffs—for me, the most important area. Are the managers of the new spinoff incentivized along the same lines as shareholders? Will they receive a large part of their potential compensation in stock, restricted stock, or options? Is there a plan for them to acquire more? When all the required public documents about the spinoff have been filed, I usually look at this area first.

In the case of Host Marriott, something from the initial press reports caught my eye. Stephen Bollenbach, the architect of the plan, was to become Host's chief executive. Of course, as the paper reported, he had just helped Donald Trump turn around his troubled hotel and gambling empire. In that respect, he seemed a fine candidate for the job. One thing bothered me, though: It didn't make sense that the man responsible for successfully saving a sinking ship—by figuring out a way to throw all that troubled real estate and burdensome debt overboard—should voluntarily jump the now secured ship into a sinking lifeboat, Host Marriott.

"Great idea, Bollenbach!" the story would have to go. "I think you've really saved us! Now, when you're done throwing that real estate and debt overboard, why don't you toss yourself over the side as well! Pip, pip. Use that wobbly lifeboat if you want. Cheerio!"

It could have happened that way. More likely, I thought, Host might not be a hopeless basket case and Bollenbach was going to be well incentivized to make the new company work. I vowed to check up on his compensation package when the SEC documents were filed. The more stock incentive, the better. Additionally, the Marriott family was still going to own 25 percent of Host after the spinoff. Although the chief reason for the deal was to free up Marriott International from its debt and real estate burden, after the spinoff was completed it would still be to the family's benefit to have the stock of Host Marriott thrive.

3) A previously hidden investment opportunity is created or revealed.

This could mean that a great business or a statistically cheap stock is uncovered as a result of the spinoff In the case of Host, though, I noticed a different kind of opportunity: tremendous leverage.

If the analysts quoted in the original press reports turned out to be correct, Host stock could trade at $3-5 per share but the new company would also have somewhere between $20-25 per share in debt. For purposes of our example, let's assume the equity in Host would have a market value of $5 per share and the debt per Host share would be $25. That would make the approximate value of all the assets in Host $30. Thus a 15 percent move up in the value of Host's assets could practically double the stock (.15 X $30 = $4.50). Great work if you can get it. What about a 15-percent move down in value? Don't ask.

I doubted, however, that Host Marriott would be structured to sink into oblivion—at least not immediately. I knew that all the new Host shareholders had good reason to dump their toxic waste on the market as soon as possible. With the prospect of liability and lawsuits from creditors, employees, and shareholders, though, I suspected that a quick demise of Host Marriott, the corporation, was not part of the plan. Add to this the facts that Marriott International, the "good" company, would be on the hook to lend Host up to $600 million, the Marriott family would still own 25 percent of Host, and Bollenbach would be heading up the new company—it seemed in everyone's best interest for Host Marriott to survive and hopefully thrive. At the very least, after I did some more work, it seemed likely that with such a leveraged payoff it had the makings of an exciting bet.

Believe it or not, far from being a one-time insight, tremendous leverage is an attribute found in many spinoff situations. Remember, one of the primary reasons a corporation may choose to spin off a particular business is its desire to receive value for a business it deems undesirable and troublesome to sell. What better way to extract value from a spinoff than to palm off some of the parent company's debt onto the spinoffs balance sheet? Every dollar of debt transferred to the new spinoff company adds a dollar of value to the parent

The result of this process is the creation of a large number of inordinately leveraged spinoffs. Though the market may value the equity in one of these spinoffs at $1 per every $5, $6, or even $10 of corporate debt in the newly created spinoff, $1 is also the amount of your maximum loss. Individual investors are not responsible for the debts of a corporation. Say what you will about the risks of investing in such companies, the rewards of sound reasoning and good research are vastly multiplied when applied in these leveraged circumstances.

In case you haven't been paying attention, we've just managed to build a very viable investment thesis or rationale for investing in Host Marriott stock. To review, Host could turn out to be a good pick because:

• Most sane institutional investors were going to sell their Host Marriott stock before looking at it, which would, hopefully, create a bargain price.

• Key insiders, subject to more research, appeared to have a vested interest in Host's success, and

• Tremendous leverage would magnify our returns if Host turned out, for some reason, to be more attractive than its initial appearances indicated.

If events went our way, with any luck these attributes would help us do even better than the average spinoff.

So, how did things work out? As expected (and hoped), many institutions managed to sell their Host stock at a low price. Insiders, according to the SEC filings, certainly ended up with a big vested interest, as nearly 20 percent of the new company's stock was made available for management and employee incentives. Finally, Host's debt situation, a turn-off for most people—though a potential opportunity for us—turned out to be structured much more attractively than it appeared from just reading the initial newspaper accounts.

So, how'd it work out? Pretty well, I think. Host Marriott stock (a.k.a. the "toxic waste") nearly tripled within four months of the spinoff. Extraordinary results from looking at a situation that practically everyone else gave up on.

Are you ready to give up? Too much thinking? Too much work? Can't be bothered with all those potential profits? Or, maybe, just maybe, you'd like to learn a little bit more.

Digging for buried treasure

So far the only work we've really discussed has been reading about a potentially interesting situation in the newspaper. Now (you knew there was a catch), it gets a bit more involved. You're about to be sent off on a mind-numbing journey into the arcane world of investment research, complete with multi-hundred-page corporate documents and mountains of Securities and Exchange Commission (SEC) filings.

Before you panic, take a deep breath. There's no need to quit your day job. Sure there will be some work to do—a little sleuthing here, some reading over there—but nothing too taxing. Just think of it as digging for buried treasure. Nobody thinks about the actual digging—insert shovel, step on shovel, fling dirt over shoulder—when a little treasure is on the line. When you're "digging" with an exciting goal in sight, the nature of the task changes completely. The same thinking applies here.

Essentially, it all boils down to a simple two-step process. 

First, identify where you think the treasure (or in our case the profit opportunity) lies. 

Second, after you've identified the spot (preferably marked by a big red X), then, and only then, start digging. No sense (and no fun) digging up the whole neighborhood.

So at last you're ready to go. You're prospecting in a lucrative area: spinoffs. You have a plausible investment thesis, one that may help you do even better than the average spinoff, Now, it's time to roll up your sleeves and do a little investigative work. Right? Well, that is right—only not so fast.

In the Marriott example, the spinoff plan was originally announced in October 1992. Although the deal garnered plenty of press coverage over the ensuing months, the relevant SEC filings were not available until June and July 1993. The actual spinoff didn't take place unit! the end of September—nearly a year after initial disclosure. While six to nine months is a more usual time frame, in some cases the process can stretch to over a year.

If you have m impatient nature and are partial to fast action, waiting around for spinoffs to play out fully may not be for you. Horse racing never succeeded in Las Vegas because most gamblers couldn't wait the two minutes it took to lose their money. The same outcome, only more immediate, was available in too many other places.

The financial markets have also been known to accommodate those who prefer instant gratification. On the other hand, having the time to think and do research at your own pace and convenience without worrying about the latest in communication technologies has obvious advantages for the average nonprofessional investor. Besides, once you've spent a year prospecting in The Wall Street journal (or in countless other business publications) for interesting spinoff opportunities, there should, at any given time, be at least one or two previously announced and now imminent spinoffs ripe for further research and possible investment.

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You Can Be a Stock Market Genius,

Joel Greenblatt

Specializing in Corporate Events: Spinoffs, Part One

Specializing in Corporate Events: Spinoffs, Part One

The Theory behind Spinoffs

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The first investment area we'll visit is surprisingly unappetizing. It's an area of discarded corporate refuse usually referred to as "spinoffs." Spinoffs can take many forms but the end result is usually the same: A corporation takes a subsidiary, division, or part of its business and separates it from the parent company by creating a new, independent, freestanding company. In most cases, shares of the new "spinoff" company are distributed or sold to the parent company's existing shareholders.

There are plenty of reasons why a company might choose to unload or otherwise separate itself from the fortunes of the business to be spun off. There is really only one reason to pay attention when they do: you can make a pile of money investing in spinoffs. The facts are overwhelming. Stocks of spinoff companies, and even shares of the parent companies that do the spinning off, significantly and consistently outperform the market averages.

One study completed at Penn State, covering a twenty-five-year period ending in 1988, found that stocks of spinoff companies outperformed their industry peers and the Standard & Poor's 500 by about 10 percent per year in their first three- years of independence. The parent companies also managed to do pretty well—outperforming the companies in their industry by more than 6 percent annually during the same three-year period. Other studies have reached similarly promising conclusions about the prospects for spinoff companies.

What can these results mean for you? If you accept the assumption that over long periods of time the market averages a return of approximately 10 percent per year, then, theoretically, outperforming the market by 10 percent could have you earning 20-percent annual returns. If the past experience of these studies holds true in the future, spectacular results could be achieved merely by buying a portfolio of recently spun-off companies. Translation: 20-percent annual returns—no special talents or utensils required.

But what happens if you're willing to do a little of your own work? Picking your favorite spinoff situations—not merely buying every spinoff or a random sampling—should result in annual returns even better than 20 percent. Pretty significant, considering that Warren Buffett, everyone's favorite billionaire, has only managed to eke out 28 percent annually (albeit over forty years). Is it possible that just by picking your spots within the spinoff area, you could achieve results rivaling those of an investment great like Buffett?

Nah, you say. Something's wrong here. First of all, who's to say that spinoffs will continue to perform as well in the future as they have in the past? Second, when everyone finds out that spinoffs produce these extraordinary returns, won't the prices of spinoff shares be bid up to the point where the extra returns disappear? And finally—about these results even greater than 20 percent—why should you have an edge in figuring out which spinoffs have the greatest chance for outsize success?

O ye of little faith. Of course spinoffs will continue to outperform the market averages—and yes, even after more people find out about their sensational record. As for why you'll have a great shot at picking the really big winners—that's an easy one—you'll be able to because I'll show you how. To understand the how's and the why's, let's start with the basics. Why do companies pursue spinoff transactions in the first place? Usually the reasoning behind a spinoff is fairly straightforward:

• Unrelated businesses may be separated via a spinoff transaction so that die separate businesses can be better appreciated by the market.

For example, a conglomerate in the steel and insurance business can spin off one of the businesses and create an investment attractive to people who want to invest in either insurance or steel but not both.

Of course, before a spinoff, some insurance investors might still have an interest in buying slock in the conglomerate, but most likely only at a discount (reflecting the "forced" purchase of an unwanted steel business).

• Sometimes, the motivation for a spinoff comes from a desire to separate out a "bad" business so that an unfettered "good" business can show through to investors.

This situation (as well as the previous case of two unrelated businesses) may also prove a boon to management. The "bad" business may be an undue drain on management time and focus. As separate companies, a focused management group for each entity has a better chance of being effective.

• Sometimes a spinoff is a way to get value to shareholders for a business that can't be easily sold.

Occasionally, a business is such a dog that its parent company can't find a buyer at a reasonable price. If the spinoff is merely in an unpopular business that still earns some money, the parent may load the new spinoff with debt. In this way, debt is shifted from the parent to the new spinoff company (creating more value for the parent).

On the other hand, a really awful business may actually receive additional capital from the parent—just so the spinoff can survive on its own and the parent can be rid of it.

• Tax considerations can also influence a decision to pursue a spinoff instead of an outright sale.

If a business with a low tax basis is to be divested, a spinoff may be the most lucrative way to achieve value for shareholders. If certain IRS criteria are met, a spinoff can qualify as a tax-free transaction—neither the corporation nor the individual stockholders incur a tax liability upon distribution of the spinoff shares.

A cash sale of the same division or subsidiary with the proceeds dividended out to shareholders would, in most cases, result in both a taxable gain to the corporation and a taxable dividend to shareholders.

• A spinoff may solve a strategic, antitrust, or regulatory issue, paving the way for other transactions or objectives.

In a takeover, sometimes the acquirer doesn't want to, or can't for regulatory reasons, buy one of the target company's businesses. A spinoff of that business to the target company's shareholders prior to the merger is often a solution. 

In some cases, a bank or insurance subsidiary may subject the parent company or the subsidiary to unwanted regulations. A spinoff of the regulated entity can solve this problem.

The list could go on. It is interesting to note, however, that regardless of the initial motivation behind a spinoff transaction, newly spun-off companies tend to handily outperform the market. Why should this be? Why should it continue?

Luckily for you, the answer is that these extra spinoff profits are practically built into the system. The spinoff process itself is a fundamentally inefficient method of distributing stock to the wrong people. Generally, the new spinoff stock isn't sold, it's given to shareholders who, for the most part, were investing in the parent company's business. Therefore, once the spinoffs shares are distributed to the parent company's shareholders, they are typically sold immediately without regard to price or fundamental value.

The initial excess supply has a predictable effect on the spinoff stock's price: it is usually depressed. Supposedly shrewd institutional investors also join in the selling. Most of the time spinoff companies are much smaller than the parent company. A spinoff may be only 10 or 20 percent the size of the parent. Even if a pension or mutual fund took the time to analyze the spinoffs business, often the size of these companies is too small for an institutional portfolio, which only contains companies with much larger market capitalizations.

Many funds can only own shares of companies that are included in the Standard & Poor's 500 index, an index that includes only the country's largest companies. If an S&P 500 company spins off a division, you can be pretty sure that right out of the box that division will be the subject of a huge amount of indiscriminate selling. Does this practice seem foolish? Yes. Understandable? Sort of. Is it an opportunity for you to pick up some low-priced shares? Definitely.

Another reason spinoffs do so well is that capitalism, with all its drawbacks, actually works. When a business and its management are freed from a large corporate parent, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility, and more direct incentives take their natural course. After a spinoff, stock options, whether issued by the spinoff company or the parent, can more directly compensate the managements of each business. Both the spinoff and the parent company benefit from this reward system.

In the Penn State study, the largest stock gains for spinoff companies took place not in the first year after the spinoff but in the second. It may be that it takes a full year for the initial selling pressure to wear off before a spinoffs stock can perform at its best. More likely, though, it's not until the year after a spinoff that many of the entrepreneurial changes and initiatives can kick in and begin to be recognized by the marketplace. Whatever the reason for this exceptional second-year performance, the results do seem to indicate that when it comes to spinoffs, there is more than enough time to do research and make profitable investments.

One last thought on why the spinoff process seems to yield such successful results for shareholders of the spinoff company and the parent: in most cases, if you examine the motivation behind a decision to pursue a spinoff, it boils down to a desire on the part of management and a company's board of directors to increase shareholder value. Of course, since this is their job and primary responsibility, theoretically all management and board decisions should be based on this principle. Although that's the way it should be, it doesn't always work that way.

It may be human nature or the American way or the natural order of things, but most managers and boards have traditionally sought to expand their empire, domain, or sphere of influence, not contract it. Perhaps that's why there are so many mergers and acquisitions and why so many, especially those outside of a company's core competence, fail. Maybe that's why many businesses (airlines and retailers come to mind) continually expand, even when it might be better to return excess cash to shareholders. The motives for the acquisition or expansion may be confused in the first place. However, this is rarely the case with a spinoff. Assets are being shed and influence lost, all with the hope that shareholders will be better off after the separation.

It is ironic that the architects of a failed acquisition may well end up using the spinoff technique to bail themselves out. Hopefully, the choice of a spinoff is an indication that a degree of discipline and shareholder orientation has returned. In any case, a strategy of investing in the shares of a spinoff or parent company should ordinarily result in a pre-selected portfolio of strongly shareholder-focused companies.

Choosing The Best Of The Best

Once you're convinced that spinoff stocks are an attractive hunting ground for stock-market profits, the next thing you'll want to know is, how can you tilt the odds even more in your favor? What are the attributes and circumstances that suggest one spinoff may outperform another? What do you look for and how hard is it to figure out?

You don't need special formulas or mathematical models to help you choose the really big winners. Logic, commonsense, and a little experience are all that's required. That may sound trite but it is nevertheless true. Most professional investors don't even think about individual spinoff situations. Either they have too many companies to follow, or they can only invest in companies of a certain type or size, or they just can't go to the trouble of analyzing extraordinary corporate events. As a consequence, just doing a little of your own thinking about each spinoff opportunity can give you a very large edge.

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You Can Be a Stock Market Genius,

Joel Greenblatt