Updated: Mar 17, 2020
In his book "You Can Be a Stock Market Genius," hedge fund manager Joel Greenblatt shares ways for smaller investors to profit from the structural constraints that most institutional money managers face. These big funds often adhere to requirements forcing them to trade popular, large-cap companies that occupy a major index like the S&P 500. When a company experiences a special situation, the company’s shareholders often automatically receive new financial instruments that don’t satisfy institutions’ strict criteria. The company’s institutional investors predictably sell these financial instruments regardless of their merit.
Greenblatt’s research shows that after falling severely, those instruments’ prices almost always revert and begin a powerful uptrend. By sharing his case studies, he shows investors what specific traits they can look for to identify trades with the highest potential. His strategy focuses on spinoffs, rights offerings, merger securities, and stub stocks. These situations are simpler than they sound. And don’t fear if you have to learn about them yourself. In many cases, so did Greenblatt.
His ideal portfolio has about a dozen carefully analyzed investments in special situations. Many of these situations can outperform the market by more than 10% a year on average. Hence, this strategy can outperform even if opportunities only come around about once a month. But how much added risk do you take on by owning such a concentrated portfolio? Not much. Greenblatt’s studies found that the overall market’s expected return is 10% per year with an 18% standard deviation. Meanwhile, a portfolio of five random stocks has the same expected return, with only a slightly higher standard deviation of 20%. In his view, the added risk from concentrating your stock portfolio to a dozen investments is a small price to pay for the potential outperformance.
In Greenblatt’s view, the best way to outperform is to bet only on high-conviction opportunities that you can fully understand. Diversification has diminishing returns. The math shows that owning just eight stocks in different industries eliminates more than 90% of stock-dependent risk. And no matter how many stocks you own, you won’t reduce “general market” risk like bear markets, where almost all stocks fall by 50% or more. You can only reduce general market risk by reducing your overall investment in stocks and buying uncorrelated assets. And whatever strategy you use, Greenblatt stresses that diversification won’t save you if you invest with money you’ll need for living expenses in the next 2-3 years. That practice is a fast path to financial ruin.
Since investors must wait for the indiscriminate selling to stop before buying, they have plenty of time for research and due diligence. Plus, federal law forces companies to release disclosures that help investors determine whether the situation has potential. The approach requires elbow grease, but that’s part of its edge. Large financial institutions don’t bother to have their research teams analyze these opportunities and appreciate their merit. That’s why Greenblatt loves them, and he’s not alone. Investing legends like Graham, Buffett, and Lynch all have experience investing in these situations.
Now, let’s look at the special situations that Greenblatt prefers the most.
Often, one company operates a variety of divisions and businesses. A spinoff occurs when the company decides to free one of those divisions or businesses and turn it into a new, unrelated company. Often, the new company’s stock is automatically distributed to the original company’s investors whether they want it or not. Many of them are institutional investors who follow strict rules that only allow investments in large-cap companies. Some can only buy shares of companies that occupy a major index like the S&P 500. Yet, the spinoff business is often a tenth of the size of its former parent company. When the spinoff occurs, those institutions receive the spinoff shares even though they’re not allowed to own, so they predictably unload them as fast as they can. After falling severely, the spinoff’s price almost always reverts and begins a powerful uptrend. This is true regardless of the reason for the spinoff.
Greenblatt cites a study from Penn State that compared the stock performance of spinoff companies with other companies in its industry and with the S&P 500 index. From 1963-1988, spinoff shares beat both by an average 10% per year during their first 3-5 years of existence. Greenblatt highlights that the original company’s stock also outperforms at around 6% in that same timeframe.
The study also found that most of the spinoff stock’s gains occurred after its first year of trading. In his view, this probably occurs because the indiscriminate selling takes a year to complete, or because the spinoff company needs a year to adjust to its new structure before it can generate earnings growth and excite the market. The parent company likely performs well because investors recognize it truly is better off after parting with the spinoff business. Investors now expect the more efficient parent company to generate higher earnings and/or cash flow and are willing to put a higher valuation on it.
Why companies spinoff
Often, a growth-obsessed company gets merger-happy and acquires a business far outside of its expertise. Since the company lacks the knowledge to properly manage the acquired business, the acquired business suffers and weighs on the company’s overall profitability. Luckily, the company can undo its flawed acquisition by spinning off that struggling business and making it an independent company again. Other times, a company will spinoff one of its most successful divisions because investors are more likely to appreciate it as a standalone business then as a cog in a complex corporate structure. This is especially true if that division operates a business fairly unrelated to the parent company. In many cases, the spinoff division will have a stronger employee incentive plan, with employee stock options that motivate workers to help the business succeed.
Greenblatt adds that companies also use spinoffs to avoid antitrust lawsuits, improve their tax situations, or make themselves more attractive acquisition targets. He mentions that the latter is likely if a company is spinning off a division that faces regulatory threats (e.g. banking, broadcasting, or insurance), or if they have recently pursued multiple spinoffs. Whatever its reason, when a company spins off one of its divisions, it’s admitting that its current corporate structure could be more profitable and is trying to fix it. The spinoff is a painful process that decreases the original company’s assets and power. Odds are, the company wouldn’t pursue one unless it believes the spinoff would substantially improve its businesses. In Greenblatt’s experience, this is often the case.
Spinoffs as a whole outperform the market, but Greenblatt says investors can outperform even more by focusing on the cream of the crop. In his experience, they share three main traits. Institutions are uninterested or unable to own the spinoff’s shares, the insiders/employees have a vested interest in the spinoff company’s success, and the spinoff uncovers an attractive new investment opportunity. Most spinoffs satisfy the first criteria, but fewer satisfy the second and third. Luckily, his case studies serve as illustrative examples.
In the ‘80s Marriott profited by borrowing money to build hotels, selling the hotels to others, and helping them manage the hotels in exchange for lucrative fees. The real estate sales and management fees helped Marriott pay back the creditors that loaned Marriott money. As Greenblatt explains, in the 90’s the real estate market slumped and Marriott struggled to sell its properties and repay its heavy debt load. Then CFO Stephen Bollenbach realized he could turn Marriott around by spinning off the successful hotel management division as a new company called Marriott International and by leaving the parent company, aka Host Marriott, with the real estate and heavy debt load.
This example has one quirk. Even though Marriott International was technically a spinoff company, the former parent company, Host, was only left with 10-15% of the original company’s market value. Most institutions weren’t allowed to own Host since it was so small and relied heavily on debt, forcing them to indiscriminately sell Host’s shares. In this way, Host essentially had the same qualities of a typical spinoff company. Hence, Greenblatt considered Host to be a spinoff-like investment opportunity. Meanwhile, most institutions could hold on to shares of Marriott International. Anyways, Host clearly satisfied the first requirement; institutions had no interest in owning it and simply wanted to unload it.
What about the second criteria? Company insiders definitely needed Host to succeed. Greenblatt notes that Bollenbach himself was set to be Host’s CEO and manage its comeback. Bollenbach had an excellent track record, having recently revived Donald Trump’s hotel and gambling businesses. His compensation package strongly incentivized him to save Host. And Host would allow Marriott International investors to own up to 20% of Host’s shares. Plus, Greenblatt read publicly available documents and found that a quarter of Host would be owned by the Marriott family, who committed to lending Host $600 million to help it survive. He also realized that if Host went bankrupt, insiders would have to face expensive lawsuits from its creditors. Clearly, insiders were invested in Host’s success and trying to help.
Lastly, Host’s debt reliance presented investors with a leveraged opportunity. Its debt-laden balance sheet magnified investors' potential returns. As Greenblatt describes, the initial press releases suggested that Host’s stock, aka equity, would trade around $5 per share, and it would have around $25 of debt, aka liabilities, per share. From accounting, we know that company assets = equity + liabilities. So Host had $5 (equity) + $25 (liabilities) = $30 per share of assets. Those assets were mostly hotel properties.
Rearranging, we have equity = assets - liabilities. Host’s liabilities, the interest payments it owed to its creditors, were fixed. So an increase in its assets’ value would increase its equity value. If the value of Host’s properties increased 10% to $33 per share, Host’s equity would be $33 - $25 = $8 per share, 60% higher than Host’s expected $5 share starting price.
Clearly, Host met Greenblatt’s spinoff criteria. Within four months of the spinoff, Host’s stock tripled. But beware, Greenblatt urges. Spinoff investors must be comfortable defying the crowd. When the Marriott spinoff was first reported, the media portrayed Host stock as risky, low-quality garbage. Yet, only after pouring through countless documents did Greenblatt realize that the media didn’t understand the whole situation. It was blind to the many attractive qualities that suggested the Host turnaround had a higher chance of success and a leveraged payout opportunity for investors.
Greenblatt discusses a spinoff trade that had a different appeal than Host Marriott: future earnings growth. Briggs & Stratton made small gas engines and was a member of the S&P 500. Around ‘95, it spun off its car-lock business, Strattec, which had a drastically different business model than Stratton and was about a tenth of its size, far too small to be included in the S&P. These facts alone made Greenblatt strongly believe that Strattec would see substantial indiscriminate selling from institutional investors.
When scanning publicly available disclosure documents, Greenblatt was excited to see that Stratton’s directors said they wanted to spin off Strattec to let investors more fully appreciate it, and to give Strattec employees stronger incentives like stock options, which allow workers to profit when the company’s share price grows. The company hoped to create Strattec with a stock incentive plan that would allow employees to own 12% of its shares.
Greenblatt also looked at Strattec’s hypothetical income statements had it been its own company. Those publicly available “pro-forma” statements revealed that over the last six months, Strattec’s earnings were 10% higher than the same time during the prior year. Greenblatt also discovered that Strattec dominated the car lock market, providing almost all of Chrysler’s locks and most of General Motors’ locks, and that it expected to get Ford as a new big customer (>16% of sales). The earnings growth and new future customers presented an exciting new investment opportunity, meeting Greenblatt’s third criteria.
With this info, Greenblatt could ballpark a valuation for Strattec. He read the disclosure documents and found that Strattec fell into the auto parts original equipment industry, which had an average P/E range of 9 - 13. Its most recent annual earnings per share was $1.18, so Greenblatt multiplied the 9 - 13 range by $1.18 and estimated Strattec’s reasonable price range to be between $10.62 and $15.34. He felt this was conservative, assuming Strattec’s earnings would remain what they have been in the past, despite the fact that its earnings had recently been growing 10% YoY. Strattec stock ended up starting between $10.50 and $12, near the low end of the range. In the next eight months it rose more than 50%.
Home Shopping Network
Greenblatt’s third spinoff case study demonstrated that spinoff situations often create multiple attractive opportunities. In ‘92, he read about Home Shopping Network (HSN) and noticed that its stock had dropped so substantially, it was cheap even according to the strict valuation metrics popularized by investing legend Ben Graham. Its share price was in the single digits. In Greenblatt’s experience, institutions have little interest in stocks with such low prices and market caps, so they barely research and analyze those stocks. This presents opportunity.
HSN, which mainly sold retail products on TV, also owned broadcasting properties. Investors usually value retail stocks based on their earnings and value broadcasting companies based on their cash flows. But HSN investors assumed the whole company was in retail and exclusively focused on earnings. They were underappreciating the massive cash flow from the broadcasting properties. It produced $26 million of annual cash flow, compared to just $4 million of annual operating earnings. To make matters worse, HSN used loans to buy the broadcasting stations, and most investors likely considered the cost of the interest payments and lowered their valuations of HSN accordingly. Thus, the market’s valuation of HSN penalized HSN for the debts it acquired when buying the stations while ignoring the stations’ strong cash flows.
As a result, HSN wanted to spin off its broadcasting business, Silver King, so investors could better appreciate it as well as HSN itself. During the spin off, HSN would also transfer $140 million of its debt to Silver King. As Greenblatt points out, this meant that HSN would no longer have to pay as high interest costs, which would substantially lower HSN’s overall annual costs and boost its earnings numbers. HSN’s value could increase after the spin off. Plus, HSN had just a few weeks ago stated it would spin off its unprofitable call-processing business Precision Systems. This happened only a couple days after merger talks with competing network QVC fell through. These two events strongly suggested that HSN was trying to become a more attractive acquisition target. Also, like in the Host Marriott example, Silver King’s debt load presented a highly leveraged opportunity.
Silver King and Precision Systems made great investments. Precision Systems saw the best results despite the business initially being a money loser. Greenblatt notes that its share price rose from under $1 to $5, then $10, all over just a two year time period after its spinoff. Silver King started trading around $5 and rose between $10 and $20 within a year. Also, HSN’s stock rose around 5% on the day of the spinoff. Later, someone did try to acquire part of HSN. Just before the Silver King spinoff, Liberty Media became HSN’s major shareholder.
This flavor of spinoff presents another advantage. When a firm spins off a chunk (rather than the whole thing) of a business or division that it owns, you can use some simple math to determine the market value of the rest of the company. In Greenblatt’s experience, that market value is often far too low.
Case in point: Sears in late ‘92. Around this time, there were 340 million Sears shares in existence. Sears announced it would soon partially spinoff two of its divisions, Dean Witter and Allstate Insurance, by selling 20% of each to the public. After doing so, Sears would still own 136 million Dean Witter shares and 340 million Allstate shares. Sears also stated that in about a year it would sell the rest of its Dean Witter stake to the public, all 136 million shares.
Suppose you buy Sears after it already finished the first wave of spinoffs, and that you hold it until Sears finishes spinning off the rest of Dean Witter. Sears would distribute the 136 million Dean Witter shares among Sears’ 340 million shareholders. So for every one share of Sears you own, you would receive 136/340, or .4, shares of Dean witter. And during this time, Sears still owned 340 million shares of Allstate. So for every one share of Sears you own, you would indirectly own 340/340, or 1, share of Allstate. During this time, Sears’ stock was around $54, Dean Witter’s around $37, and Allstate’s around $29.
Time for the simple math. Greenblatt was happy to see a well-known fund manager, Michael Price, had already discussed the opportunity and crunched the numbers in an interview. Price calculated the market value of Sears U.S. Retail business, first looking at Sears’ overall market value and subtracting the market values of all the other businesses Sears shareholders would own or receive.
As Price explains, for every $54 Sears share you own, you indirectly own one $29 share of allstate. This means the market value of Sears without its stake in Allstate is worth $54 - $29, or $25, per share. You’d also receive 0.4 shares of Dean Witter stock, which was around $37 per share, for free. Price subtracted that as well, leaving $25 - (0.4)($37), or $10.2 for the market value of the rest Sears. Shareholders also had stakes in Sears Mexico, Sears Canada, and Coldwell Banker; a Sears shareholder would own around $5 of those businesses for every Sears share they owned.
This left a market value of about $5 per share for Sears’ U.S. retail businesses. Yet, that business generated $79 per share in sales and had little debt reliance. In Price’s view, Sears’ shockingly low 0.06 price-to-sales ratio made it a compelling buy, and Greenblatt strongly agreed. He used other valuation metrics, and all of them indicated that Sears was drastically undervalued. Greenblatt notes that you could invest specifically in Sears’ U.S. retail business by simultaneously buying Sears and shorting Allstate. But Sears looked so cheap, simply buying Sears stock would be good enough. Shorting Allstate wasn’t worth the effort and added risk.
After it spun off the rest of Dean Witter, Sears traded for $39 per share and subsequently rose 50% in just a couple months. To quote Greenblatt, “Great work if you can get it.”
Sometimes, companies execute a spinoff using a rights offering. This approach helps the spinoff company raise more capital while allowing company insiders to increase their investment in the spinoff at an attractive price. According to Greenblatt, this rare situation has an even higher potential profit than regular spinoffs and is always worth an initial look.
During a rights offering, the parent company gives shareholders contracts, aka rights, that let them buy shares in the spinoff business at an attractive price if they want to. Sometimes, these contracts also allow shareholders to trade some of their shares of the parent company for shares of the spinoff. Shareholders receive these contracts free of charge and can sell them to outside investors if they don’t want to use them. If they don’t use or sell them, the contracts eventually expire worthless.
Greenblatt is especially interested in rights offerings that include something called oversubscription privileges, which give shareholders rights to buy more spinoff shares if a substantial number of the rights contracts expired unused. He notes that company insiders use this to increase their investment in the spinoff at an attractive price. To do so, they’ll execute a rights offering and include oversubscription privileges. During the process, they’ll try to generate as little publicity and shareholder interest in the event as possible. When a large number of contracts expire unused, the shareholders swoop in grab even more spinoff shares.
Take TeleCommunications (TCI) in early ‘90. It announced that it would spin off its programming businesses like QVC into a new company, Liberty Media. It hoped this effort would calm the anti-monopolistic sentiment among D.C lawmakers and make TCI easier for investors to understand and properly value. As time went on, TCI drastically revised their plan. Greenblatt learned from the Wall Street Journal that Liberty Media would execute the spinoff with a rights offering for tax benefits. The rights would allow investors to swap their TCI shares for some Liberty Media shares.
But under the new plan, Liberty looked atrocious. TCI would only issue a maximum of $2.1 million shares of Liberty priced at $256 per share (based on the exchange rate between TCI and Liberty shares). Greenblatt says that’s an uncomfortably high share price for individual and institutional investors. Liberty would be half as big as TCI initially expected, just 4% of the size of TCI. Liberty was far too small and illiquid for institutions to own. And based on Liberty’s pro-forma income statements, it appeared to have lost $9.77 per share for the first nine months in 1990.
Another oddity: TCI would determine how many Liberty shares to issue based on how many rights contracts were used; 2.1 million shares was merely the max. As Greenblatt explains, if half the contracts expired unused, TCI would only issue 1.05 million shares even though Liberty would own the same amount of assets regardless. If the number of Liberty shares was too low to fully pay for Liberty’s assets, Liberty would pay for the rest by issuing shares of preferred stock to TCI shareholders.
Greenblatt did some sleuthing and it paid off. After reading publicly available documents, he learned that the preferred stocks were designed to have a fixed redemption price, which meant the preferred stock price couldn’t increase. Thus, if investors increase their valuation of Liberty, all of the upside would occur in its regular shares, not the preferred shares. The smaller the number of Liberty’s regular shares, the more each share would rise when the market increases its perceived value of Liberty. This essentially provided leveraged upside. Liberty shareholders profit the most when there are very few regular Liberty shares. This occurs when few shareholders exercise their rights contracts. Thus, Liberty investors had a vested interest in investors disliking Liberty and letting their rights contracts expire.
Greenblatt discovered another detail suggesting that Liberty was intentionally set up to deter investors. TCI CEO John Malone would assist Liberty, and his compensation included the right to buy $25 million of Liberty stock at its initial price of $256. That’s a lot of stock, half as much as he owned in his own company TCI. Malone could profit heavily if Liberty’s stock price rises. As previously explained, that stock is more likely to rise substantially when fewer people own it. At this point, Greenblatt was convinced that Malone designed the spinoff for his own gain and was making efforts to deter most investors from biting. In interviews, Malone and Bob Magness, another big TCI executive, said they’d probably use half of their rights contracts, suggesting a neutral disposition. But Greenblatt also discovered that Liberty would have the same managers as TCI did; yet another indicator that top executives wanted Liberty to do well.
In the end, Malone and Magness exercised all of their rights contracts. As they likely expected, the majority (64%) of the rights contracts expired unused, resulting in the creation of only 700,000 Liberty shares. In two years, those rose from $256 to $3700 per share. Malone multiplied his initial investment more than ten times, and since the gains came from stock swaps, he didn’t even have to pay capital gains taxes. The media and professional analysts fell right into his pessimistic narrative. If only they’d read the publicly available documents as Greenblatt had. Funny enough, Liberty improved its capital structure and split its shares to rectify its appeal to institutional investors. Malone certainly knew how to game the system.
When one company acquires another, the acquirer usually pays the target company’s shareholders with cash or stocks, but sometimes it pays with other instruments like bonds and warrants. The target company’s institutional shareholders usually aren’t allowed to own these instruments and have no choice but to sell them indiscriminately. In Greenblatt’s experience, these instruments can make attractive investments. Some of them are complicated but can lead to exceptionally high payoffs.
Take Super Rite, the publicly traded grocery chain, in ‘89. A group of investors wanted to take it private by buying all of its shares. They planned to convert Super Rite into a private company using a leveraged buyout, meaning they’d pay for most of the shares with borrowed money and the rest with cash. “Going private” transactions signal that the acquiring group has strong convictions about the target company’s future. Super Rite received multiple other offers, so its board put it up for auction. On a per share basis, the final bid offered $25.25 of cash, a warrant to buy a tenth of the newly private company at no cost, and a preferred stock with a $2 face value that paid 15% annually.
Greenblatt noted that the $2 face value preferred stock seems puny compared to the $25.25 per share of cash that each shareholder would receive. The warrants looked even more insignificant. Each shareholder would receive 4.1% of a warrant. At the time, investment bankers estimated that chunk was worth about 25 cents per share, a true joke compared to the $25.25 of cash that shareholders receive per share. Shareholders could sell their chunk of the warrant to the public if they don’t want it. Most shareholders would likely see both the preferred stock and warrant as worthless and dispose of them regardless of their values. That indiscriminate selling could make them bargains. The bankers’ estimates were pretty close. The warrants traded for $6 each, around 28 cents per share, just a couple months after the deal completed.
The warrant especially caught Greenblatt’s eye. Compared to the preferred stock, its future value was far more uncertain. Luckily, public documents shed light on Super Rite’s future. Management expected that one of Super Rite’s newest customers would contribute $80 million to sales in the next three years, and overall Super Right would be steadily earning a fat $5 per share of post-tax free cash flow.
If that happened, Greenblatt anticipated the stock could trade around $50, assuming the market would value the company with a reasonable price to free cash flow multiple of 10. The reality could be even higher. In that case, since you’d buy the warrant for $6, exercise it to get a free stock, and sell that stock at its current $50 market price, you’d make $44, a 730% profit. Generally, Greenblatt dismisses forecasts, but he gave it more weight since it came from management who had convictions strong enough to put money on the line to snatch up all of the shares. He felt the warrant was an attractive play.
He also could’ve bought the stock before the merger went through. Then he would receive the cash, the preferred stock, and the chunk of the warrant. But he felt this trade’s risks weren’t worth it. The stock’s current price was $26. On one hand, if the deal went through, Greenblatt would luck out. He’d get $25.25 in cash, so his total cost would be 75 cents. That would entitle him to the $2 face value preferred and about 28 cents of warrants that could appreciate 730%. But if the deal fell apart, he wouldn’t get any of those fancy warrands or preferred shares, and the stock price would likely revert to the $17 level where it had been before the takeover was announced. He chose to buy the $6 warrants.
In the end, the warrants rose strongly as management decided to make Super Rite publicly traded again. Shareholders who bought the warrants for $6 could sell it to the public for $40 and earn a 300% profit. The $2 face value preferred stock performed strongly too. Its initial post-buyout price was around $1.2 and ended up at $2. Plus, along the way, owners would have received 15% interest payments paid annually in preferred stocks. Greenblatt stresses that leveraged buyouts are generally too dangerous to bet on, but investors should explore them if successful investors and executives have high conviction on it.
Unlike spinoffs, bankruptcy situations are not generally attractive. As Greenblatt puts it, this type of special situation is laced with landmines. So-called “vulture investors” specialize in these situations, but he feels this investing niche is saturated and requires 24/7 dedication for success. Instead, Greenblatt focuses on companies that are turning around and resurfacing out a bankruptcy. These companies release a substantial amount of information before issuing new shares of common stock. The most helpful piece of information is the disclosure statement, which discusses the details of the bankruptcy and the management’s estimation for the businesses’ future profitability and stability.
The new common stock will likely experience indiscriminate selling. During the bankruptcy, companies that run out of cash often pay back their creditors with shares. So most shareholders are banks and bondholders who aren’t interested in holding the new stock for long. But many of these new, post-bankruptcy stocks make horrible environments despite this fact. Greenblatt explains that most companies that exit bankruptcy are weak, and their stocks have lame performance in the long run.
To reduce risk, you can focus on higher quality businesses that entered bankruptcy due to a temporary setback. As Greenblatt explains, some companies go bankrupt because they were taken private with an excessively debt-reliant leveraged buyout. In those cases, the businesses may have simply been unable to grow their earnings quite fast enough to repay creditors. Other times, companies use bankruptcy courts as a convenient place to straighten out lawsuits about a particular product or incident. After settling the dispute, the company may very well be healthy. Some companies enter due to a business slump, remove the divisions that are losing money, and refocus efforts on other promising business lines. He feels that these make good long-term plays, especially if they occupy a favorable market niche.
If he sees a severely mispriced post-bankruptcy stock, Greenblatt is interested in making a trade even if he doesn’t see the stock as a long-term hold. He doesn’t recommend this strategy for the majority of investors though.
Take Charter Medical Association in late ‘92, which traded near $7 and owned psychiatric hospitals. Greenblatt liked that it was so much cheaper than its industry peers, and that its insiders had a heavy ownership stake in it. The downside: Charter had a ton of debt, despite paying off a fair bit during its bankruptcy. It went bankrupt because its industry conditions deteriorated right around the time some investors took it private with a leveraged buyout. Even so, Greenblatt couldn’t believe how much cheaper Charter was than its peers.
Plus, he felt its recent earnings performance showed that profitability was improving, and Charter’s plan to revitalize business by limiting costs, investing in marketing, and expanding its profitable services appeared to be working. It would likely generate about $2.75 per share of free cash flow, and at $7 Greenblatt thought it a true bargain on an absolute and industry-relative basis.
This trade served Greenblatt well, and the stock eventually tripled. But watch out; after tripling, it went nowhere for the next three years. He suspects that Charter’s modest quality explained its lackluster long-term performance.
Corporate restructuring occurs when a company drastically changes its structure or operations. Greenblatt focuses on instances where a company is selling or shutting down a large division so it can repay its creditors, concentrate on its better divisions, or limit its losses.
Why invest in them? Sometimes, the unprofitable business line detracts from the success of the rest of the business, causing shareholders to ignore that success in their valuation. Once the company removes that business line, the company’s earnings look far better and the market may readjust its valuation and make the share price rise. Also, without the unprofitable division, the company can more easily focus on its successful divisions and boost their profitability.
The process is so painful, odds are the company wouldn’t restructure unless it truly felt that drastic actions must be taken for the company to substantially change. To make money, you can either invest in a company after it announces the restructuring, or invest in a company you expect to restructure soon. The latter is far tougher.
Take Greenman Brothers. In the mid ‘90s, its “Noodle Kidoodle” retail stores sold educational kids’ toys and provided a fun atmosphere for kids and parents. These stores were a recent experiment for Greenman. Their main business: distributing office supplies and toys to retailers after buying them from manufacturers. That business was decently profitable, and Greenblatt felt the Noodle Kidoodle experiment was showing potential. Greenblatt tries never to invest based on his optimism toward a new business concept.
What really attracted Greenblatt was Greenman’s 0.63 price to book (P/B) ratio, shockingly low in his view. Since Greenman’s Noodle Kidoodle business was dramatically more profitable than its distribution division, he also thought Greenman might end up restructuring. If that happened, the market would better appreciate Noodle Kidoodle, and management would fuel additional growth by channelling more resources and planning into it. Both would likely push up the share price.
What could go wrong? If the new retail concept failed, Greenman’s distribution business would likely continue its modest profitability. If not, Greenblatt realized that most of that business’ assets could be easily sold, and management would probably use the proceeds to invest more in Noodle and help it expand. By lowering Greenman’s book value, this action would make Greenman’s price to book ratio a bit higher and less attractive, but even still Greenblatt felt it would be a bargain compared to its industry’s typical valuations. Greenman already released plans to expand Noodle and said it would rapidly grow to be bigger than the distribution business, assuming Noodle continued its current success rate. If the Noodle concept was a bust, Greenblatt felt it unlikely for the price to book ratio to fall much lower than its current, dirt cheap level. In his view, Greenman’s potential upsides far outweighed its risks.
Ultimately, Greenblatt bought Greenman stock at $5, where it stayed for about a year. Then, Greenman announced it’d sell its distribution business to help Noodle expand. Four months later the stock reached $14. Greenblatt got out around $10.50. At that time, he felt Greenman was too widely followed, no longer an unknown bargain. Too bad he only made an 100% return in 16 months.
Sometimes, a company tries to increase its market value by buying back a significant chunk of their common stocks in a transaction called a recapitalization. Company insiders usually buy the stocks by paying with a mix of cash, preferred stocks, and bonds. This transaction lets the company alter the mix of funds it uses to pay for its assets. When the company buys back stock and swaps it for bonds, it is taking equity off of the market and replacing it with debt instruments. This increases the company’s debt reliance and the number of insiders who own its shares.
As a result, since interest payments are tax-deductible, the company pays a lower tax rate. This increases the company’s after-tax earnings numbers and makes investors believe the company is worth more. If this occurs, investors will likely increase their estimates for the company’s valuation and raise the amount they’ll pay for its stock. In addition, Greenblatt notes that the stock would likely rise more rapidly. A recap takes many company shares off of the market; the smaller the number of shares, the more each share must rise when investors increase their perceived value of the company. Since insiders are trying to own more of the company, recaps may indicate that company insiders have high conviction in the company’s success.
Greenblatt notes that many companies now avoid recaps, spooked by the large number of overleveraged companies that went bankrupt the ‘80s and ‘90s. However, when executed responsibly, recaps can increase companies’ market values and cause massive share price gains. In one of his examples, a recap that caused a 20% increase in after-tax earnings triggered an 80% rise in the stock.
Though recaps are now rare, Greenblatt says investors can get similar benefits by investing in attractive companies using a long-term option contract called a long-term equity anticipation security (LEAP). These contracts have long lifespans (up to 2.5 years) and often allow investors to pay the long-term tax rate on their profits, which is far lower than the short-term rate. Also, LEAPs are generally unpopular, so their initial prices tend to be quite low. Like all options, they can offer magnified potential returns and a limited downside risk. In Greenblatt’s experience, some LEAPS offer exceptional reward/risk ratios. He also suggests looking into warrants, which are similar to options but can have lifespans longer than five years. See the end of this section for a brief explanation of options.
Since LEAPs have unlimited upside potential with a capped downside risk, Greenblatt says they come in handy in situations where an undervalued company has about a 50-50 chance of seeing its stock double or tank.
Case in point: Wells Fargo in late ‘92. California’s real estate market was in a deep recession, and Wells had more commercial real estate loans in that area than most other banks did. Wells’ earnings looked bleak since it had been taking a large chunk of revenue to build cash reserves to insulate the company from future losses. Based on its cash reserves, the bank was expecting $18 per share of future losses. But by reading an interview with investment manager Bruce Berkowitz, Greenblatt gained several insights that suggested Wells had massive turn around potential.
Berkowitz explained that Wells was currently putting $18 per share of its revenues into its cash reserves. During non-recession periods, this number was normally around $6. So if the recession fizzled, Wells’ would be putting $12 fewer dollars of revenue per share into its reserves. That would make its pretax earnings go from its current $18 per share to $30 per share. Assuming its PE ratio remained constant, the 66% jump in earnings would cause a 66% jump in Wells’ stock price. But Wells’ PE ratio was also historically low, around 4.3. If it survived the slumped real estate market, its valuation could revert to a more typical 9 or 10. Wells’ stock would likely double.
Berkowitz made another point. Wells’ cash reserves equaled about 5% of its entire loan portfolio. This would be almost enough to cover the loss of all of its nonperforming loans. But Berkowitz believed that loss was unlikely; Wells’ supposedly nonperforming loans were generating 6% interest on average, and half of them were receiving all required interest and principal payments. Wells seemed to have plenty of cash given the condition of its lending operations. Its ratio of capital to risk assets, aka capital ratio, exceeded Bank of America’s, even considering Wells’ higher exposure to California. Most importantly, Wells at the time was enjoying a streak of 140 years with no annual losses. Its management had a long history of surviving financial storms.
This convinced Greenblatt to look for ways to bet on Wells’ success while limiting his downside risk if the whole situation went bust. He found a particularly attractive LEAP to do just that. For a $14 per share premium it allowed him to buy 100 shares of stock for 80 at any time in the next two years. Wells stock was around $80 at this time. In his view, Wells would either survive and its stock would double, or it would go bankrupt and fall to zero. So buying the stock had a reward/risk ratio of one. What about the LEAP?
If the stock doubled and reached $160, he could use the LEAP to buy the stock at $80 and sell at its current price of $160. He’d make $80. Since Greenblatt paid $14 for it, he’d earn almost a 500% return on his investment in the LEAP. If Wells stock crashed to zero, Greenblatt would be out $14, 100% of his investment. The reward/risk ratio was 5, far better than owning stock.
Of course, since the potential downside risk of the LEAP was 100%, Greenblatt only put a very small portion of his assets into it. In general, when you buy an option, you should always scale back the amount you put into an options contract until the total risk to your portfolio is normal for you. If the contract has a higher reward/risk ratio than the stock, you’ll still make a higher return if your prediction pans out. But many investors wipe out because they take the money they were going to invest in a stock and use it to buy options instead. But most stocks are unlikely to collapse to zero, whereas most options contracts do. As mentioned, 64% of them expire worthless. Hence, long option positions should be a small fraction of your portfolio.
Back to Wells. In the end, Berkowitz called it. California’s real estate market eventually healed. Wells survived, and its stock doubled in less than two years. Greenblatt’s LEAP earned him around a 500% return. Though LEAPs can be useful, Greenblatt reminds investors to never put must of their portfolios into LEAPs.
Options in Brief
Options come in two flavors: puts and calls. A call option lets you profit from the rise of hundreds of shares even if you can’t afford to buy them. It gives you the right to buy 100 shares of a stock for a particular price (“strike price”) within a certain window of time. Calls typically cost anywhere from 30 cents per share ($30/contract) to $5 per share ($500/contract) or more, and that per-share cost is called the premium. You make money when the stock price exceeds the strike price plus the premium per share that you paid for the contract.
If GOOGL is currently $200 and you think it will be worth more in the near future, you could buy a call option contract that gives you the right to buy 100 shares of GOOGL for $200 at any point within the next three months. Let’s say the contract costs $100, or $1 per share. You make money when GOOGL trades above $200 (strike price) + $1 (premium), or $201. If GOOGL increases 10% to $220, you can buy 100 shares for $200 and sell them for the current price of $220. You’d make $20 per share x 100 shares, or $2000. You paid $100 for the contract, so your net profit would be $1900. That’s an 1800% return: you invested $100 in the contract and made $1900 with it.
But if GOOGL trades below $201, you start losing money. If GOOGL shares trade at $200.25, your contract is now only worth 25 cents per share. And if GOOGL trades below $200, your contract is worthless. You would lose money by using it, so it has a value of zero. That means you’d lose 100% of the money invested in the options. But if you think GOOGL has a good chance of hitting $220, you could make 1900%. That contract would offer an impressively high reward/risk ratio. But its potential loss (100%) is still devastating.
That’s why you should always scale back the amount you put into an options contract until the total risk to your portfolio is normal for you. If the contract has a higher reward/risk ratio than the stock, you’ll still make a higher return if your prediction pans out. But many investors wipe out because they take the money they were going to buy a stock and instead use all of it to buy options. But most stocks are unlikely to collapse to zero, whereas most options contracts do. As mentioned, 64% of them expire worthless. Hence, long option positions should be a small fraction of your portfolio.