You Can Be a Stock Market Genius

Joel Greenblatt · 1997

Thesis

Individual investors can earn exceptional returns by looking where large institutions are not: in spinoffs, restructurings, mergers, bankruptcies, recapitalizations and long-dated options, where corporate events create mispricings that careful readers of public filings can find and exploit.

The main ideas

The best opportunities lie in special situations that institutions ignore, are barred from or sell without looking.
Spinoffs tend to beat the market, because the new shares are dumped by holders who never wanted them.
Follow the insiders' incentives. The best spinoffs are those institutions don't want and insiders do.
Partial spinoffs, rights offerings, merger securities and bankruptcies create similar mispricings, each with its own risks.
Recapitalizations, stub stocks and LEAPS offer built-in leverage on a good idea.
Concentrate in six to eight well-researched positions. Beyond that, diversification adds little.

Where the bargains hide

Joel Greenblatt, who founded Gotham Capital, argues that the stock market is not as efficient as academics claim in the places where few professionals look. His book is a tour of special situations: corporate events such as spinoffs, mergers, bankruptcies and recapitalizations, which create securities that institutions sell or ignore for reasons unrelated to their value. The book's appendix reports that Gotham Capital compounded at about 50 percent a year from 1985 to 1994, before the general partner's share of profits.

The research method is reading: following corporate news in the Wall Street Journal and other publications, then studying the documents companies are required to file. The edge comes not from secret information but from doing work that most investors and institutions do not do.

The mechanism is that institutions face constraints that individuals do not: size limits, mandates restricting what they may own, and too little time to study small or unusual situations. Where they are forced or inclined to sell, prices can fall below value.

Implication: look for situations where the sellers are selling for reasons that have nothing to do with value, and read the filings that explain them.

Spinoffs

A spinoff is a company that a parent separates and distributes to its own shareholders. Greenblatt's central claim is that spinoffs are systematically cheap at first, because the shareholders who receive them never chose them. Institutions holding the parent often sell the new shares without even looking, because the spinoff is too small, in the wrong industry or outside their mandate.

He cites a Penn State study covering 25 years to 1988, which found that spinoffs beat their industry peers and the S&P 500 by about 10 percent a year in their first three years, with the largest gains in the second year rather than the first. Parent companies that made spinoffs also outperformed their peers.

His main example is Marriott's 1993 split into Marriott International, which kept the hotel management business, and Host Marriott, which took the hotel properties and most of the debt. Host Marriott looked unwanted, but Marriott's finance chief, who designed the plan, went with it, and about 20 percent of its stock was set aside for management and employee incentives. Host Marriott roughly tripled in the four months after the spinoff.

Implication: watch for announced spinoffs and study them after they begin trading, especially in the months when institutional selling depresses the price.

Follow the insiders

Greenblatt's most important test for a spinoff is incentives. He tells readers to study the Form 10 or the information statement that describes the new company, and to check how insiders are paid and how much stock they will own. Since management's stock options are often priced from early trading, insiders may benefit from a low initial price.

The best situations, he argues, combine three features: institutions do not want the spinoff, insiders do, and something valuable about the business has been obscured, for example by debt or by an unglamorous industry.

The same logic runs through the book. Corporate events are designed by people with incentives, and reading those incentives in the filings shows whether the event is likely to favor shareholders.

Implication: before investing in any corporate event, find out who designed it, what they stand to gain and whether their gain depends on yours.

Partial spinoffs, rights and mergers

Related events create related opportunities. In 1993, Sears spun off its brokerage, Dean Witter, and 20 percent of its insurer, Allstate. By Greenblatt's arithmetic, those holdings were worth about $15 and $29 for each Sears share, leaving Sears's retail business priced at about $5 a share, against $79 a share in annual sales. Sears rose about 50 percent within months. A rights offering, in which existing shareholders get the right to buy new shares, can be similarly mispriced: buyers in the Liberty Media rights offering of 1990 and 1991 made about ten times their money in under two years.

Risk arbitrage, betting on announced mergers, is less attractive for individuals. Greenblatt compares it to running around the house with scissors: the gains are small and the occasional failed deal produces large losses. Bankruptcies and restructurings can produce bargains in the new securities issued afterward, such as Charter Medical, which traded at just over $7 a few months after emerging from bankruptcy while comparable companies suggested a value of about $15.

Implication: in each corporate event, work out what the pieces are worth separately, and be wary of strategies where a single failure erases many small gains.

Leverage built in

Some special situations offer leverage without borrowing. In a recapitalization, a company pays shareholders a large sum in cash and leaves them with a heavily indebted "stub" stock. Greenblatt's example is FMC in 1986, which offered shareholders $80 in cash plus one new share, while management received 5.66 new shares each instead of the cash. A stub can rise many times over if the business performs.

LEAPS, long-term listed options, offer similar leverage on a single idea. Greenblatt describes buying LEAPS on Wells Fargo in 1992 and 1993, with the stock near $77, when he estimated normalized earnings of about $18 a share and a fair value of $160 to $180. He used LEAPS because he knew little about the California real estate on which the bank's loans depended, and wanted limited downside.

Implication: where you have a strong view on a single situation, consider instruments that magnify the result while capping the loss, and keep them a small part of the portfolio.

Concentration

Greenblatt rejects wide diversification. Owning six or eight stocks in different industries, he argues, removes most of the risk specific to individual companies. His figures: two stocks eliminate about 46 percent of that risk, four about 72 percent, eight about 81 percent, sixteen about 93 percent and 32 about 96 percent. Market risk remains however many stocks are owned.

The mechanism is diminishing returns. Each additional stock removes less risk than the last, while diluting the investor's best ideas and their capacity to research each holding.

Implication: hold enough positions in different industries to protect against a single disaster, then concentrate your money in the ideas you understand best.

Limits

The book helped crowd the trade. The investment firm GreenWood Investors argued that interest in special situations peaked around 2004 and that by 2014 and 2015 spinoffs no longer sold off in the way the book describes, so their returns were no longer categorically great. Academic studies disagree: John McConnell and colleagues found that spinoffs from 2001 to 2013 still beat their benchmarks.
The title promises more than the method allows. Reviewers have called it poorly named. The strategy depends on reading filings closely, judging management incentives and accepting concentrated positions, which demands far more work and tolerance for risk than the title suggests.

The Intelligent Investor — the value principles behind Greenblatt's special situations.
LEAPS — the long-term options Greenblatt uses for leverage, explained in detail.
One Up on Wall Street — another case that individual investors can beat institutions where institutions don't look.