You Can Be a Stock Market Genius - Joel Greenblatt
Note: While reading a book whenever I come across something interesting, I highlight it on my Kindle. Later I turn those highlights into a blogpost. It is not a complete summary of the book. These are my notes which I intend to go back to later. Let’s start!
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After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small
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Overall market risk will not be eliminated merely by adding more stocks to your portfolio.
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In the academic world, risk is measured by a stock’s “beta”—the price volatility of a particular stock relative to the market as a whole. Usually the calculation of “beta” is based on an extrapolation of a stock’s past price volatility
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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 spinoff’s stock can perform at its best
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Joel thought Host could turn out to be a good stock 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
On Spinoffs
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Spinoffs, in general, beat the market.
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Picking your spots, within the spinoff universe, can result in even better results than the average spinoff.
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Certain characteristics point to an exceptional spinoff opportunity:
a. Institutions don’t want the spinoff (and not because of the investment merits).
b. Insiders want the spinoff.
c. A previously hidden investment opportunity is uncovered by the spinoff transaction (e.g., a cheap stock, a great business, a leveraged risk/reward situation).
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You can locate and analyze new spinoff prospects by reading the business press and following up with SEC filings.
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Paying attention to “parents” can pay off handsomely.
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Partial spinoffs and rights offerings create unique investment opportunities.
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Oh, yes. Keep an eye on the insiders. (Did I already mention that?)
Case Study
In April 1985, Harcourt Brace Jovanovich (HBJ), the book publisher and owner of Sea World, announced that an acquisition agreement had been reached with Florida Cypress Gardens. Under the terms of the merger agreement, each share of Florida Cypress Gardens would be exchanged for .16 of a share of Harcourt Brace. Since the chairman of Cypress Gardens owned 44 percent of the stock outstanding, I didn’t think shareholder approval was much of a risk. On the HBJ side, the value of the deal was so small relative to the size of Harcourt Brace that no shareholder vote was even required.Before the deal was announced, the stock traded at only $4.50 per share. As Harcourt Brace stock was trading at $51.875, a purchase price for Cypress Gardens of .16 of a share of HBJ translated to a buyout value of $8.30 per share (.16 multiplied by $51.875).
After the announcement, shares of Cypress Gardens rose $3 per share to a price of $7.50. This meant that, even after a dramatic 66-percent rise in value ($3 gain on original price of $4.50), there was still a sizable profit left to be made by arbitrageurs. An arbitrageur could purchase stock in Cypress Gardens at $7.50 and, if the deal closed, make eighty cents per share (the spread). After about three months, each share purchased at $7.50 would be exchanged for $8.30 worth of HBJ stock. An eighty-cent profit on an investment of $7.50 equaled a return of 10.67 percent in about three months, or on a compounded basis—nearly 50 percent annualized (1.1067 × 1.1067 × 1.1067 × 1.1067-you do the math– compound interest is great, isn’t it?). The only flaw in the equation was that the $8.30 acquisition price was payable in stock, not cash. If HBJ stock declined even 5 or 10 percent during the three months prior to the closing of the deal, the expected eighty-cent profit could be greatly reduced or erased entirely. To eliminate this risk, an arbitrageur would generally sell the shares of HBJ short at the same time he purchased shares in Florida Cypress Gardens. Selling HBJ stock short involved borrowing HBJ shares from a broker and selling them on the open market. An investor who sells stock short has an obligation to replace the borrowed stock at a later date
An arbitrageur will generally sell short .16 of a share of HBJ (receiving $8.30) for every share of Florida Cypress Gardens he purchases at $7.50 (e.g., a sale of 800 HBJ shares for each 5000 shares of Florida Cypress Gardens purchased). If and when the merger closed, shareholders of Cypress Gardens would receive .16 of a share of HBJ stock in exchange for each of their Cypress Gardens shares: an owner of 5000 Cypress Garden shares would receive 800 shares of HBJ. The arbitrageur would then replace the borrowed HBJ stock with the HBJ shares he received in the merger. (See, he has to return the borrowed shares but, if the deal closes, he doesn’t have to buy them back.) After the merger is successfully concluded, the arbitrageur has no stock position and a profit of eighty cents (a 50-percent annualized return!) for each share he purchased of Florida Cypress Gardens.
When I first purchased my clever arbitrage position (buying Cypress Gardens stock, shorting stock in HBJ) and the big sinkhole fiasco, Harcourt Brace’s stock had climbed to $60.75. If the deal was eventually called off, since I wouldn’t be getting the HBJ stock I had expected in exchange for my Cypress Gardens shares, I would be forced to buy back the stock I had shorted in HBJ—or go to prison, remember? The added problem was, the stock I had sold for proceeds of $8.30 (.16 of a share of HBJ at 51.875) was now going to cost me $9.72 to buy back (.16 multiplied by $60.75). So, in addition to my $3 per share loss on my stock in Florida Cypress Gardens, I was going to lose an additional $1.42 (a $9.72 purchase less an $8.30 sale). That’s a $4.42 loss on a $7.50 stock. But wait; if Cypress Gardens’ facilities were damaged enough for the deal to be called off, maybe the stock could fall to $3.50 or even $2.50 per share. With Florida Cypress Gardens trading at $2.50, my loss would be $6.42 on a $7.50 stock. All this risk for that juicy eighty-cent profit. Somehow my warm and fuzzy feeling, my childhood memories, and my money had all fallen down the same sinkhole. The risk/reward issue—the ratio of how much you can lose in a situation to how much you can make—is a much more important factor in determining long-term profitability.
Risk arbitrage—NO
Merger securities—YES!
The reason why major corporate restructurings may be a fruitful place to seek out investment opportunities is that often times the division being sold or liquidated has actually served to hide the value inherent in the company’s other businesses. A simple example might be a conglomerate that earns $2 per share and whose stock trades at thirteen times earnings, or $26. In reality, that $2 in earnings may really be made up of the earnings of two business lines and the losses of another. If the two profitable divisions are actually earning $3 per share while the other division contributes a $1 loss, therein lies an opportunity. If the money-losing division could simply be sold or liquidated with no net liability, the conglomerate would immediately increase its earnings to $3 per share. At a price of $26, this would lower the stock’s earnings multiple from thirteen to less than nine. In many cases, the sale or liquidation of a loss-ridden business can result in positive net proceeds. Of course, this would make the investment opportunity more compelling
On Bankruptcies
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Bankruptcies can create unique investment opportunities—but be choosy.
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As a general rule, don’t buy the common stock of a bankrupt company.
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The bonds, bank debt, and trade claims of bankrupt companies can make attractive investments—but first—quit your day job.
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Searching among the newly issued stocks of companies emerging from bankruptcy can be worthwhile; just like spinoffs and merger securities, bargains are often created by anxious sellers who never wanted the stuff in the first place.
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Unless the price is irresistible, invest in companies with attractive businesses—or as Damon Runyon put it, “It may be that the race is not always to the swift nor the battle to the strong—but that is the way to bet.”
On selling
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Trade the bad ones; invest in the good ones.
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Remember that hypotenuse thing from the last chapter—it won’t tell you when to sell, but at least I’m sure it’s right.
On Restructuring
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Tremendous values can be uncovered through corporate restructurings.
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Look for situations that have limited downside, an attractive business to restructure around, and a well-incentivized management team.
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In potential restructuring situations, also look for a catalyst to set things in motion.
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Make sure the magnitude of the restructuring is significant relative to the size of the total company.