by Brian Zen, Enlightened Investor Digest
An enlightened man turns on the "Light" in the dark hidden places. Joel Greenbaltt is such a man.
Discovering The Hidden Places
Nowadays, many investors are reading Warren Buffett's wise teachings about investing only in wonderful businesses managed by talented managers. Guess what? They only got the front page of the picture. The flip side of the picture is that Buffett started by flipping thousands of pages of reports on unknown tiny "not-so-wonderful" companies in neglected hiding places, places that Joel Greenblatt has been talking about.
When Buffett bought American Express, it was a credit card business near bankruptcy, with its book value depleted by a fake-warehouse-receipt scandal. Most people thought the company's reputation was forever tarnished while loosing market share to rising stars like Visa, Mastercard and Discover... At that moment, American Express was a stinky stone covered in blood in an ugly place where my daughter would run away screaming: "Oh, smells terrible!"
But Joel Greenblatt, hearing the scream of terrible smell or bloody murder, would say: "Oh, really? Let me take a look." And there he would discover his kind of hiding places for stock market treasures. Those places are usually dark, ugly, and neglected. They usually don't smell too good.
Based on our proprietary research, enlightened superinvestors in financial history are all tireless at exploring unpopular stinky places and turning over countless ugly stones in the dark corners where nobody wants to go near. Joel Greenblatt is such a tireless explorer.
On Wall Street, many would stumble and fall at street bumps and cracks. Some would later find lost dollar bills and cigar butts beneath the exactly same bumps and cracks. In his book, You can be a Stock Market Genius (Even if you're not too smart), Joel Greenblatt generously provided a list of those hiding places of stock market treasures.
- Spin-offs are the favorite hiding place for Greenblatt. When a company spins off a subsidiary into a separate company, it may be trying to unlock the hidden value in an unloved baby. Greenblatt quoted a study that found a very large number of such spin-offs outperformed their industry peers by a surprising 10% per year in the first three years after the spin-off. What is more interesting is that the parents of the spin-offs also outperformed their industry peers by 6% during the same three-year period. Why? Because the unloved subsidiary had been a drag on the parent's stock, but there were hidden values in the neglected division.
- Institutional investors are often uninterested in spin-offs, as the companies tend to be small in size. The shares of the spin-off are generally not sold in an IPO, but quietly distributed among the parent company's shareholders. The shareholders often sell them off without regard to price or fundamental value as their primary interest is in the parent company. The initial price after the spin-off, therefore, tends to be depressed, providing a bargain purchase opportunity.
- Greenblatt stresses that in every corporate change it is important to determine where the interests of the insiders and directors of the company lie. If they have a large stake in the spin-off, it means that there is a high level of commitment to making the spin-off a success. The credibility and resources of the parent company are also very important in evaluating spin-offs.
Why Spin-off Opportunities Are Exciting
- S&P 500 index funds usually sell off the spin-offs from S&P 500 companies because the spin-offs are not members of the index. On the other hand, if those index funds took a page from Greenblatt's book, sell the spin-off positions to an internal spin-off fund, would this area of hidden treasures become more difficult for bargain hunters to operate?
- If the spin-off is a 100% distribution of all the shares in a subsidiary, the "parent" company of the spin-off usually has no incentive to advertise or talk up the spin-off. The parent would not engaged investment banks to sell the IPO in the spin-off and therefore there is generally no IPO hot air what so ever.
- The subsidiary to be spun-off is generally some kind of unloved baby in the parent's family of businesses. GE would never spun-off its leading unites commanding a number one market position. The unloved and hated spin-off "bad boy" is often a drag on the parent company's valuation; in other words, the spin-off is generally not an exciting company or a good business.
- The to-be-spun-off company must file form-10 with the SEC. For the trained eyes, there is a lot of good information there to facilitate detailed research.
Merged Securities vs. Merger Arbitrages
- Greenblatt likes merged securities and has mixed feelings about risk arbitrages based on announced mergers, that is, buying stock of a company that is subject to an announced takeover. Warren Buffett also acknowledges that merger arbitrage opportunities are disappearing after the strategy was made famous by Benjamin Graham and Warren Buffett himself.
- Risk arbitrages are subject to too many uncertainties like due diligence, antitrust approvals, multiple government reviews, shareholder disapproval, and changes of market condition, etc. Sometimes, the merger may not even go through. I call this "having your fingers burned while picking the pocket of corporate acquirers". The acquirer is buying for $20 a share. You try to buy at $19.5 a share and deliver your shares to the acquirer for $20. It often works, but many things could go wrong and the engagement relation could turn sour...and you see the stock sink back to $15.
- However, in mergers, the acquirer sometimes pays for the acquisition in terms of securities other than stock. The payment could be in bonds, preferred stock, warrants or rights. Institutions typically shun these illiquid and complex securities, and individuals who receive the unfamiliar securities often dispose them in the market automatically. The prices are thus driven down, making them attractive bargains.
- What is the biggest fear on Wall Street? Bankruptcy! And that's where opportunities like American Express, and in recent years MacDonald's and perhaps Merck, are hiding.
- An unconventional and hiding opportunity that Greenblatt suggests is not the stock, but the bonds, bank debt and trade claims of companies that are broke and bankrupt.
- When a company is bankrupt, there are plenty of eager and anxious sellers and the businesses are always unpopular.
- The right time to buy is the tricky thing here. Some suggest buying during the process when the company may be emerging from bankruptcy proceedings.
- Another tricky issue is that you need to be very careful in choosing the 'right' bankrupt companies to invest in. You need to make sure that the "fried chicken" on Wall Street can one day fly again. And how do you do that? (Well, maybe you should consider research workshops like ours at zenway.com.)
- When a troubled company goes through major corporate restructuring, bargain opportunities are often created.
- People shy away from major changes and uncertainties. Wall Street analysts tend to drop coverage of companies that are undergoing major corporate changes, creating further price dips for the stock.
- You can either invest after restructuring has already been announced or when a company is getting ready for restructuring. Your job is to pick and choose to find the major corporate changes for the better instead of worse.
- Just like Buffet avoiding 7-foot-bars where you must fly over and may break your neck when falling down on your back, Greenblatt too shuns complex restructurings where you can't understand what is really going on, or you have problems measuring the height of the bar.
- Greenblatt sees recapitalization transactions as an investment opportunity, where a stock buyback is sometimes financed by additional borrowings.
- The reason that makes debt-equity-recapitalization interesting is that buyback of equity increases the leverage in the balance sheet, thus increasing the tax saving which can then be passed on to the shareholders.
- Investors are often scared of new debt, thus pushing down the stock prices to attractive levels.
- Greenblatt believes that, in regard to recapitalization, "there is almost no other area of stock market where research and careful analysis can be rewarded as quickly and generously".
Finally, The Disclaimer In Fineprints
Yes, you can become a stock market genius even if you are not too smart. But, as Joel Greenbaltt would warn you himself that there are tons of painstaking reading, learning and research involved in finding these hidden opportunities.
It's just like the conventional wisdom about free lunch, with which I had some rather personal experience. First, we've all heard that there is no free lunch. But then we would all find out that, if you search hard enough, and if you are "hungry" enough (just as I fled to America with practically nothing and was about to pass out in my advanced accounting classes), you would sometimes pick up a real free lunch here and there. And maybe, pack home some nice gift bags. For example, due to 15 years of hungry research and voracious accumulation of information and contacts, I have discovered quite a few free lunches where Warren Buffett and Joel Greenblatt would have no time to go to in places like Harvard Club... Have we met before?!