I think Joel Greenblatt is one of the best investors of all times. I'm not alone.
He impressed the investment community with his outstanding returns, based on his magic formula, which has proved to be a valid tool to use in order to design a successful investment program.
You can check his results in his The Little Book That Still Beats the Market, along with the rationale of this (apparently) simple strategy.
Anyway, I don't want to delve into Greenblatt's most famous book, also if I urge you to read it.
Why? Because Mr. Greenblatt doesn't follow exactly the magic formula strategy. He uses (as I think most of modern Value Investors do) the list of stocks coming out of the formula just as a starting point.
Subsequently, he adds his long experience in order to pick the best of the best.
Moreover, in some cases, some special cases, he doesn't pick his stocks from that list at all.
These cases don't fall in his magic list, because they're not value stock in the classical sense. They don't show a big E/P ratio (also if adjusted and calculated the Greenblatt way), and probably don't even show a big profitability in terms of return on capital, but, for different reasons, hide undervalued assets, and/or are in the process to realize their true value, due to an imminent event that acts as a catalyst.
Such kind of circumstances are called special situations.
Some examples of special situations are: corporate spin-offs, rights offering, risk arbitrages, merger and acquisitions (M&A), restructuring, bankruptcies, etc.
Most of individual investors generally are not interested in them because of their obscure outcomes, their complicated maths, and for the high uncertainty involved in the corresponding deals (e.g. regulatory issues).
Greenblatt's first book, You Can Be a Stock Market Genius, is a book on special situations.
I love (re)reading it from time to time. There's always something that I underestimated or that simply I didn't catch. It think it is really a treasure filled with a lot of investment gems.
Mr. Greenblatt wrote this book in a very plain language, so at the beginning you have the feeling that things are really that simple, but when you start analyzing your special situations, you understand that, yes, probably you can be a stock market genius, but there's a long long way to go before you really realize it.
Instead of concentrating on the whole book (it would have necessarily been less accurate), I will try to highlight the key points of the chapter titled "Chips Off the Old Stock", most of which is dedicated to corporate spin-offs.
Practically, I decided to... spin-off Greenblatt's chapter on corporate spin-offs from Greenblatt's book.
Spin-offs: "discarded corporate refuses" or what?
Using Greenblatt's words, a spinoff is a process in which "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".
Why should we pay so much attention to something so unloved? Because, as a Penn State research demonstrates, spinoff company stocks systematically outperformed the S&P 500 (referring to a 25 year period ending in 1988) by 10% in the first 3 years of independence.
There seems to be something special in companies subject to spin-off operations. Greenblatt argues that if you don't just pick them randomly, but try to analyze them to find the best of the best, you could outperform the S&P 500 by even more, having a compound annual return similar to that of Warren Buffett!
Some questions come to the mind. What if spinoff stocks will not perform well in the future? What if everyone discovers the trick? How can the reader be able to pick the right stocks?
In order to answer to these questions, the author lists the (main) reasons that led companies to decide for a spinoff deal.
A spinoff can be necessary or desired in order to:
· Separate unrelated businesses
· Separate out a "bad" business from a good one
· Get value for a business that can't be easily sold
· Perform a tax-free transaction (as opposed to an outright sale)
· Solve a strategic, antitrust, or regulatory issue
Depending on the specific reason, good opportunities can be found in the spun-off company, in the parent one, or in both.
Ok, but why a spin-off company should perform so well? Greenblatt thinks that "these extra spinoff profits are practically built into the system".
In most of cases, shares of the spin-off company are distributed to shareholders of the parent company. If they feel that this is a business they don't want to own, either because they were mainly interested in the parent company core business or simply don't want to analyze the new company, generally they sell all the spinoff company shares they own in order to raise cash and forget about it.
In other cases, the spinoff company is simply too small to fit into large institutional portfolio rules (some funds manage several $ billions, so they're forced to hold only big cap stocks in their portfolios) so this is another reason to sell without any regard to value. Finally, also if the parent company belongs to an index, usually the spinoff company, because of its size, will probably be excluded from it: another reason for institutional investment firms to sell.
Every time people sell a stock without a "fundamental" reason, opportunities can show up. They are what Seth Klarman calls "motivated sellers".
The stock price of the spinoff company, subject to this huge selling pressure, usually goes down to the point that it can begin to be undervalued, compared to its intrinsic value.
Generally spinoff stocks perform better in the 2nd year after the spinoff, not in the 1st. Greenblatt explains this behaviour saying that it takes time for it (now with a new plan and probably a new staff) to implement the changes that can put the company on the right path.
Spinoff stocks: are they all the same?
Ok, it seems simple. So is Mr. Greenblatt saying that we should buy a spinoff stock as soon as we find one?
The answer is always the same: you have to search, think, and work hard.
Anyway he goes through a list of characteristics he looks for when he wants to find a wonderful spinoff opportunity. Let's see them:
· Institutions don't want it
· Insiders want it
· A previously hidden investment opportunity is revealed
If institutional investors are not interested in the spinoff stock, but this doesn't happen for investment reasons, the company is worth a closer look.
Likewise, if insiders are compensated almost exclusively with the spinoff stock, we should suspect that its intrinsic value isn't so low. After all, they are in the best position to understand how much the company is really worth.
Many times something that was well hidden in parent company financial sheets, shows up in a new light, so that you can clearly analyze new company key strength points and understand their real benefits.
The author dives into the intriguing spinoff world by examining some recent cases, like Host Marriott spinoff of Marriott International (MAR) and the American Express (AXP) spinoff of the sadly famous Lehman Brothers.
Some questions to be addressed: where is (most of) the debt going? Where is (most of) the cash going? What is the spinoff company shares distribution ratio?
All examples provided in the book are different from one another, with different degree of difficulty and opportunity, so I highly recommend reading everything.
Joel Greenblatt is widely known for his Magic Formula, but he's also an expert in special situations.
In his first book he tries to transfer to the reader his insights on these kind of investments.
Spinoff companies are one of the easiest ways to approach this intriguing (and potentially profitable) branch of Value Investing.