Joel Greenblatt’s hedge fund was open to the public for 10 years. Its average annual return was over 50%. In his brilliant book, You Can Be A Stock Market Genius, he reveals where he found and how he selected the stocks that allowed him to be so consistently successful.
Two of his strategies are particularly interesting and super easy to understand and implement. I can’t wait for you to get started…
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In his book, Greenblatt explores mergers, rights offerings, restructurings, and several other very specific occurrences in the world of business and stocks that create amazing opportunities for the disciplined, research-focused investor. And if that sounds like something you are interested in—and since you are here, reading this post, I can only assume it is—then you should probably get yourself a copy.
Cause these opportunities aren’t going away any time soon; you’ll see what I mean as we dive in.
My two favorites from the book are spin-offs and bankruptcies.
Sometimes a business grows large and diversified enough that it makes sense to split up. This could be because the business made some bad investments and wants a way to offload them, or it could be because part of the company is so different from the principle line of business that both parts would be better off on their own.
Examples include when Phillip Morris spun off of Altria in 2008; Chipotle from McDonalds in 2013, and PayPal from Ebay in 2015. What started as a small part of a much larger company had grown to the point that it couldn’t fully thrive unless it was allowed to go off on its own.
What creates the opportunity?
When something like this happens, there is some inevitable (and understandable) confusion in the investment world. If the spun-off entity is small enough, there is often indiscriminate selling from large holders of the stock.
Indiscriminate selling is when investors sell their shares of a company for reasons other than those based on some sort of research or analysis.
This can cause the price per share to plummet, which causes other investors who were on the fence about the newly formed entity to also jump ship, perpetuating the problem.
Why would investors sell indiscriminately?
There are several reasons this happens, and those reasons aren’t going away. Think about this from the perspective of the manager of a large mutual or pension fund.
- You and your team invested in the original company after much research and due diligence. You have specific, calculated reasons for investing in the larger company. But the new spin-off was just a small part of that original company. It may not have even come up in your research. As a disciplined fund manager, this doesn’t fit into your calculated approach. So you just sell.
- Or what if your fund specializes in a specific industry, and the newly formed entity is actually in a very different industry—like if a car company spins off its credit arm into a new independent financial firm. It doesn’t make sense at all for you to hold on. So you just sell.
- Or what if your fund has rules—as many large funds do—about the size of the companies in which you can invest. By your own rules, you may not be allowed to continue to hold the smaller spun-off company. So you just sell.
Regardless of the fundamentals, you don’t care. It doesn’t matter. You. Just. Sell.
If many big funds with their large share count exit, this drives prices down, creating opportunities for you and me.
How well have spin-offs performed in the past?
Greenblatt sites a relatively old statistic which is still interesting to consider. He says, “One study completed at Penn State, covering a 25 year period ending in 1988, found that stocks of spin-off companies outperformed their industry peers and the Standard & Poor’s 500 by about 10% per year in their first three years of independence.”
Now, of course, this is just what happened in history, and doesn’t predict what will happen in the future. But it gives you some useful perspective on the potential found within this relatively small pool of stocks.
To be clear, I definitely don’t recommend you just buy up every single spin-off company without further consideration. As always, due diligence and analytical research are still recommended, and probably required, for long-term success.
But understanding spin-offs and how they work in the market provides a compelling starting point for your undervalued-stock discovery process.
Now let’s talk about bankruptcies.
Imagine you’re researching a company that appears cheap. You’re trying to figure out why, and then you find it: it went through bankruptcy. How does that make you feel?
For most, that’s the end of their research. They have no interest in dealing with a company with a checkered past.
But this is a perfect example of the type of opportunity Warren Buffett was referring to when he said, "Be fearful when others are greedy and greedy when others are fearful."
Again, I’m not suggesting you buy up every company with a past bankruptcy. But if your detailed analysis suggests that the company is undervalued (based on its merits and prospects today), it may be other people’s fear suppressing the price.
Others’ fear can be our opportunity.
What creates the opportunity?
Greenblatt mentions four reasons a restructured yet solid company might see depressed valuations.
- Again, indiscriminate selling, this time from banks, bondholders, and previous creditors. He says, "…there is ample 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. Consequently, it makes sense that they would be anxious and willing sellers."
- Next, you have what are called vulture investors. They will occasionally invest in a bankrupt company. They’re looking for a surge in share price after the restructuring is complete, which often happens. Then they leave, pushing the price down.
- Then, think about Wall Street. Analysts there don’t get paid to sell post-bankruptcy stocks like they do with IPOs. Greenblatt says, "Between the ephemeral shareholder base and the lack of Wall Street attention, it may take quite a while for the price of a stock issued through the bankruptcy process to accurately reflect a company's prospects."
- Finally, a low-market-value stock may take time to attract the attention of big market players, as they likely could not take a big enough position to justify the research time and expense. In this video, we discuss the opportunity this fact alone creates for you and me across all low-market-value stocks. Greenblatt reiterates, "These situations are truly orphaned and may trade cheaply for some time before they are discovered."
My personal experience
I chronicled my first experience with a the stock of a previously-bankrupt company in an article I wrote for Seeking Alpha, published August 10th, 2016. With shares trading around $4.30, I presented this very case. I was able to identify the indiscriminate selling that was taking place by the six banks who were left holding roughly 7% of the shares outstanding. They hadn’t been allowed to sell their shares until earlier that year (several years after the company emerged from bankruptcy). Obviously, they didn’t really want to be there. Think about the downward pressure with that massive sell-off looming.
The company’s fundamentals were still sound, despite its low share price. So my thesis was that one of the main reasons for this suppressed price was the banks. I suspected that through abnormally large trading volume, you’d be able to see when they were exiting their positions, thus removing that pressure.
And that’s exactly what happened. Today, as of this recording, a year and a half later, it trades around $15.
How You Can Use This
When you understand what’s going on behind the scenes—specifically the psychology driving other market players—you’ll begin to see these opportunities. I’m not saying they’re common, and I’m not saying you (or I) will be right every time. I’m saying they exist and will continue to exist.
The first step in being able to identify them is an intimate understanding of those occurrences, so you know what to watch for.
A great way for you to do that—and where I first began developing my understanding of special situations like these—is through Greenblatt’s book directly. If these strategies interest you, I’d highly recommend it.
The other way to learn more about these strategies is for me to continue making videos and writing posts about them. What do you think? Would you like to dive deeper into either of these strategies? Would you like to be introduced to more? I want this blog to be as helpful for you as possible, so be sure to let me know in the comments.
If you get to where you’re successfully implementing these strategies, that’s one of the ways you can build your rapidly-growing, highly-diversified net worth. So if you’d like to continue on that path, stay tuned!