BOOK SUMMARY: YOU CAN BE A STOCK MARKET GENIUS: UNCOVER THE SECRET HIDING PLACES OF STOCK MARKET PROFITS

Book title: You can be a stock market genius: uncover the secret hiding places of stock market profits

Author: Joel Greenblatt

Publisher: Simon & Schuster, A FIRESIDE BOOK.

Publishing date: 1999

Genre: Nonfiction, Stock market

Number of pages: 178

Book price: Rs. 1014/-

Joel Greenblatt’s book mainly focuses on event driven investing strategies, and provides insights for the investor on recognizing these very opportunities, so that a small investor can profit from them.

Inspiring message

Greenblatt starts the book ‘You can be a stock market genius’ by posing the reader a question ‘do you have a chance for success in the stock market when you are up against an army of billion dollar portfolio managers or a horde of freshly trained MBAs?’ His short answer is ‘yes.’ According to the author in fact it is these very million dollar portfolio managers and a horde of freshly trained MBAs that do not have any chance against you; the reader, and this book. All that is required is ‘that you need to invest a reasonable amount of time and effort, and as result stock market profits can be yours.’  Greenblatt states two reason why not to accept the basic teachings of these financial professors: first, there are some fundamental flaws in the assumption and methodology used by them and second, even if they are correct in their assumptions then studies and conclusion do not apply to you. The big message for the investor is that ‘a small investor has advantage over prominent professionals because a small investor can concentrate in a handful of small positions, can take career risk of dramatically underperforming the benchmark, and won’t invest the time and resources necessary to investigate weird and tiny situations that they can’t allocate a significant portion of their capital to.’

Preparation before the actual beginning

Before embarking on the hunt for hidden investment jewels Greenblatt mentions some basics that should help the reader, and they are: do your own work, don’t trust anyone; be it over or below thirty years, invest in only few favorite situations, don’t dilute a perfectly good stock market strategy by diversifying your way into mediocre returns, and limit downside by investing in situations that have a large margin of safety. Greenblatt says it is perfectly fine to be scared of the variability of the financial market, but stresses that understanding different scenarios and by being able to keep up to date with a situation, a small investor can not only gain an edge over the big professions but can also make impressive gains. The author through this book takes the reader through various ‘special scenarios.’ These scenarios are: spinoff, merger/risk arbitrage and merger securities, bankruptcies and restructuring, recapitalization, LEAPs and warrants. Let’s take one at a time.      

Spinoff

According to the author spinoff occurs when ‘a corporate takes a subsidiary, division or part of its business and separates it from the parent company by creating a new, independent, free standing company.’ Greenblatt shares a number of reasons why a company might choose to unload or otherwise separate itself from the fortune of the business to spinoff. The following are some of the major reasons: unrelated business may be separated via a spinoff transaction so that the separate business can be better appreciated by the market, sometime it is to separate out a bad business so that an unfettered good business can show through to investors, sometime to get value to shareholder for a business that can’t be easily sold, and a spinoff may solve a strategic or regulatory issue; paving the way for other transaction or objective. Greenblatt further answers the question why ‘newly spun off companies tend to outperform the market?’ The reason is that the spinoff process is a fundamentally inefficient method of distributing stocks to the wrong people. The new spin off stock isn’t sold, but is given to shareholders who were already investing in the parent company’s business, therefore once the spinoff shares are distributed among the parent company’s shareholders they are sold immediately without regard for price or fundamental value. Another reason of spinoff companies outperforming the market is that when a business and its management are freed from a large corporate parent, pent-up entrepreneurial forces are unleashed. The bottom line is that ‘only logic, common sense and experience’ is all that is required in finding the next spinoff winner. Another term to remember is partial spinoff transaction, meaning a company decides to spinoff or sell only a portion of one of its division. For example – if XYZ Corporation distributes a 20% interest in its Widget division to its shareholders, 20% of Widget’s outstanding shares will trade publicly while 80% will still be owned by XYZ Corporation. Finally Greenblatt says spinoffs are beneficial for small investor because institutions don’t want them and insiders want them.

Merger/risk arbitrage and merger securities

The author discourages small investor for investing in Risk arbitrage; is the business of buying stock in a company that is subjected to an announced merger or a takeover, and portrays why that investment will be bad for a small investor. Suppose Company A announces that it has agreed to acquire all of company B’s stock for $40 per share. Prior to announcement, Company B traded at $25 per share, after the announcement, Company B’s share trade at $38, not at the proposed price of $40 per share. A risk arbitrageur or person investing attempts to profit from this discrepancy, but according to Greenblatt this is a bad deal for the risk arbitrageur as in the first place deal may not go through, in this scenario company B’s share may fall back to the pre deal price of $25, resulting in a big loss. However, the author encourages the small inventor for merger securities; sometime companies may utilize mergers securities to pay for the acquisition. This usually presents opportunities that should be viewed favorably mainly because these securities trend to be undervalued. The discriminate selling of these securities often effectively drive down the price, regardless of the true underlying quality. Therefore with careful research, small investor can seek out much overlooked opportunities that can lead to positive results.            

Bankruptcies and restructuring

According to the author it is rarely a good idea to purchase the common stock of a company that has recently filed for bankruptcy, the reason is investors who own stocks in bankrupt company are at the bottom of the totem pole: employees, banks, bondholders, trade creditors etc are all ahead in line when it comes to dividing up the asserts of the bankrupt company. Greenblatt does believe that the debt of bankrupt company is often mispriced and offer incredible mispricing. But unfortunately, distressed debt investing is a serious challenge to research for small investor. However, according to the author there is a time for investing in it, when a company emerges from bankruptcy. Before the stock begins trading, all the information about the bankruptcy proceeding, the company’s past performance and the new capital structure all readily available in a disclosed statement. Since the new stock is initially issued to banks, former bond holders and trade creditors, there is enough reason to believe that the new holders of the common stock are not interested in being long term shareholders. Due to an unfortunate set of circumstances, these former creditors got stuck with an unwanted investment and make for willing sellers. But still, unlike spinoff, it is doubtful that the random purchase of stocks that have recently emerged from bankruptcy will result in a super investment.  At this section of the book Greenblatt discusses the age old question ‘when to hold and when to sell.’ According to the author selling is actually makes buying easier, because it is preferable to buy when it is relatively cheap, buy when insiders are incentivized, buy when it is undiscovered, buy when you have an edge etc. Greenblatt tries to answer the ‘selling part’ by saying – ‘at some point after special event has transpired, the market will recognize the value that was unmasked by the extraordinary change and once the market has reacted and/or the attributes that originally attracted you to the situation become well known, your edge is lessened.’ Author adds that the trigger to sell may be a substantial increase in the stock price or a change in the company’s fundamentals. Author talks about corporate restructuring i.e. big change happening, as another area for investing opportunities. Normally restructuring is happening most of the time, Greenblatt is taking about situations where companies sell or close major division to pay off debt or focus on more promising lines of business. Author mention two ways by which a small investor can take advantage of a corporate restructuring: invest in a situation after a major restructuring has already been announced and invest when a company is ripe for restructuring.            

Recapitalization LEAPs and warrants

In a recapitalization transaction, a company repurchases a large portion of its own common stock in exchange for cash, bonds or preferred stock. For example: say XYZ Corporation is trading at $36 per share and decides that a recapitalization transaction will be good for shareholders, the company decides to distribute $30 worth of newly issued bonds to its own shareholders. If XYZ stock was worth $36 before it distributed $30 of value to its shareholders, the after the distribution, the market should value the common stock at $6 per share, and if that was all that happened, recapitalization would be a no big deal. However, recapitalization tends to create a tax advantage for the small investor. For example – let’s say prior to the recapitalization XYZ earned $3 per share after taxes, for a price/earnings ratio of 12 based on its $36 stock price. The tax rate is assumed to be 40%, so pre tax earning for XYZ are actually $5 per share. Now let’s see what happens when we leverage up the balance sheet through the recapitalization. If the $30 of bond distributed to shareholders carries an interest rate of 10%, then the XYZ will owe $3 in interest on the bond each year. Since the interest in a tax deductible expenses for corporation, the new pre tax earning for XYZ Corporation will now come to $2 per share. Assuming the same 40% tax rate, then $2 in pretax earnings will net out to $1.20 per share after tax. Thus, if the common stock of XYZ after the recapitalization; called stub stock, were to trade at only $6, the price/earnings ratio would be down to 5. That is too low. The increased debt load rises the risk to investor in XYZ common stock and since the investor is taking higher risk so the stock should trade at a  lower earnings multiple, say a new price/earnings ratio of 8 or 9. This would leave the stub stock trading at around $10 resulting in total value for the recapitalization package of about $40 per share; $30 in debt plus $10 stubs, versus the original pre recapitalization price of $36. So the question arises ‘where does the $4 gain to shareholders come from?’ The answer is taxes, before the recapitalization of the $5 in pretax earnings: $3 went to the shareholder in the form of earning and $2 went to govt. in taxes. After the recapitalization, $3 goes to shareholders in the form of interest payments on the newly distributed bonds, and an additional $1.20 goes to shareholders in the form of earning on the stub stock. That is a total of $4.20 going to the shareholder versus just $3 before recapitalization.  In short, leveraging the balance sheet turns out to be a more tax effective way to distribute earnings to shareholders. Greenblatt says LEAPs; long term anticipation securities, is a way to create investors own version of stub stock, but suggests using long term options; over a year, as a way to leverage up the return on value stock. A LEAP will experience much more significant price wings than the overall stock. If a reasonably priced value stock experience a 20% gain, for instance, the underlying LEAP contract will experience much more significant increase. It is a way of leveraging up, with the caveat that if the stock fall, below the strike price, it will expire worthless, i.e. more risk, more reward. Author explains warrants as an even better than LEAPs, as warrants give the holder the right to buy at a specific price for a set period of time. However, there are two major differences between warrants and call options; LEAPs, they’re: first, warrants are issued by the underlying company so say a five year warrant to buy IBM stock at $82 per share allow the holder to purchase stock directly from IBM at any time during the next five years at a price of $82, while a listed call option; LEAPs represent contractual arrangement between investors to buy or sell a particular stock. And second, warrants usually have a longer time to expiration than typical call options.  

Correct way of looking at the stock market

Greenblatt narrates two stories representing ‘how to think about the stock market?’ The first story is about his in-laws; amateur art collectors, who when looking for an art piece do not look for the next Rembrandt or Picasso, what they were looking for was small scale mispriced work of art. They went to yard sale and flea markets looking for paintings that were cheap than their value. According to the author this is a useful way for small investors to think about the stock market, as the professional needs to find the next Rembrandt and Picasso and you; the small investor should let them fall over themselves in trying to find that out. Greenblatt’s reasoning is that – a small investor can achieve satisfactory results by merely finding things off the beaten path. The second story is when Greenblatt went to the best restaurant in New York, and asked one of the chefs ‘if an appetizer was good.’ The answer was ‘it stinks.’ The implication was ‘everything was excellent because the author was at the best restaurant in New York.’ So according to Greenblatt the best way to invest in the stock market is to ‘identify those place that are best places to invest, where no matter what you pick, the chances are that it will be good.’  

Author’s final suggestions            

Nearing the end of the book Greenblatt re-emphasizes the main idea of the book; aptly written in the title of the book – ‘You can be a stock market genius,’ but gives no guarantee of achieving that, having said that author stresses ‘like the acquisition of any new skill, becoming a good investor can take both time and practice’ which according to Greenblatt should be spend in ‘enjoying the journey.’

Closing comments

An important feature in the book is Greenblatt’s extreme use of case studies that ensures that the reader is able to fully understand and appreciate all the topics and their meanings. Adding to it the quick summary at the end of each ‘special situation’ chapter provides the reader the chance to crystalline the thoughts provided in that chapter.

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