Book Summary of You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits

The author of The Little Book That Beats the Market, Joel Greenblatt, has written yet another very entertaining book. In You Can Be a Stock Market Genius, Joel outlines the “secret hiding places” of investing ideas. He takes the reader off main street, and discusses all kinds of so-called ‘special situations’ and how you might be able to find, analyze and profit from them, i.e. risk arbitrage, merger securities, bankruptcies, restructurings, recapitalizations, LEAPS, warrants, options and spinoffs.

The latter, spinoffs, resonates most with yours truly, so I’ll dedicate this book summary to reviewing the opportunities in this sphere alongside some “basics” – let’s start there!

Some Basics
Before Joel throws you into the deep end of the special situations pool, he puts some swimmies on you in the shape of fundamental lessons.

In the sphere of special situations, you will often find yourself off the mainroad. You’ll be looking at, well, special situations – you’ll turn stones that few others turn. Hence, you need to do your own work. You’ll find little to no research from other analysts or the media – and if you do, don’t trust them.

In life, you can’t always choose your battles or the playing field. In investing, you can. Warren Buffett likens to say: “There are no called strikes on Wall Street”, meaning you can choose which pitches to swing at. Joel shares that reasoning, as he states: “It makes sense that if you limit your investments to those situations where you are knowledgable and confident, and only those situations, your success rate will be very high.” (p. 34) Hence, pick a spot where you are “knowledgable and confident”.

Academics and most investment managers don’t understand the illusive concept of risk. It’s puzzling that some people still think a stock’s volatility – beta – is a measure of risk. As so often proclaimed here on the blog, risk is the probability of a permanent loss of capital. In length, that’s why Joel advises the reader to look down, not up. In other words: Let your assessment of the downside guide your investing decision, and let the upside take care of itself.

One last thing before we delve into spinoffs. Joel had a refreshing, substantiated opinion about an otherwise flighty question: what is the optimal number of positions in your portfolio? Warren always says he prefers a concentrated portfolio, as it doesn’t make sense to allocate capital to your twentieth favorite idea when you can pile into your absolute favourite. Obviously, some diversification is needed, but how much? Joel says that “nonmarket risk is the portion of a stock’s risk that is not related to the stock market’s overall movements.”, and that “statistics say that owning just two stocks eliminates 46% of the nonmarket risk of owning just one stock.” (p. 21) A four-stock portfolio: 72%; eight stocks, 81%; 16 stocks, 93%; 32 stocks, 99%. The conclusion? “After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small.” (p. 21)

Spinoffs Spin Off Profits
As mentioned, I’ll only go into detail with one type of special situations: spinoffs. A spinoff is simply the process of ‘spinning off’ a subsidiary or division from the parent company into a new, independent company.

According to Joel, there are five reasons why a spinoff occurs: 1) To ensure that the business unit is better appreciated by the market (‘lessening’ the conglomerate discount); 2) To separate a ‘bad business’ from the ‘good business’; 3) To offload a debt burden, i.e. by spinning off the division with a great load of the parent’s debt; 4) To benefit tax-wise; 5) To solve a strategic, antitrust or regulatory issue.

Though some of these reasons sound sketchy, it can be a very profitable area to delve into. In fact, buying a pool of spun-off companies has historically returned 20% annually. Yet, how do you spot a profitable spinoff situation from a tanker?

Joel looks for three signs: 1) Institutions don’t want it based on reasons that don’t involve the investment merits, i.e. a fund is restricted from holding positions in the spun-off entity due to its size, the index it’s listed on, the industry it’s engaged in etc.; 2) Insiders want it, i.e. if the management of the parent or ‘insider shareholders’ load-up on the stock or are greatly incentivized to make the new entity a success through i.e. a stock option programmes; 3) A previously hidden investment opportunity is uncovered, i.e. the stock is cheap due to an initial selloff, the spun-off entity is a great business, or a massively debt-burden entity could make it a leveraged risk/reward situation (leverage can multiply your returns, but not your loss).

Opportunities to profit from spinoffs arise often. One just needs to keep an eye out for them! Joel recommends scouting i.e. the Wall Street Journal or other publications, but a quick Google search reveals other sources. It looks like sites such as www.stockspinoffs.com, www.thezenofinvesting.com and www.insiderarbitrage.com could be efficient places to start your treasure hunt!

Once you find an interesting pick, you need to stay in touch with the “parent’s” (it’s still one company) announcements and its SEC Form 10 filing (the document outlining the new spinoff company). When you get there, remember to look for the three signs outlined above!

To round-up this book summary, it’s important to note that the announcements and filings related to special situations are pro-forma and often serve some purpose, i.e. spinning of a bad business simply to get rid of it, so you need to double-click and study the opportunity to closely to make sure you don’t get burned. Joel has a wonderful way of putting it: “Figures don’t lie, but liars can figure” (p. 255)