Have you heard the story about the plumber? He arrives at a customer's house and bangs on the pipes, and tells the customer that "That will be $100". The customer responds "$100! All you did was bang on the pipes..." the plumber replies that "oh no, the banging on the pipes is $5, but knowing where to bang is another 95". This is where the following takeaways take root... Where to bang. As with all investing strategies, you need to create your edge over the market. According to Joel Greenblatt, the founder of Gotham Asset Management, a lucrative place to start digging is with special corporate situations. From 1985 to 1994, Joel Greenblatt achieved an annualized return of 50% per year, that's a good return. Sorry, I think I mispronounced that - that is a tremendous return! This investment record is largely boosted by investing in these special corporate situations that you soon will learn about.
This is a Top 5 Takeaway
Summary of: You Can Be a Stock Market Genius, written by Joel Greenblatt, and this is The Swedish Investor bringing you the best tips and tools to reach financial freedom through stock market investing.
Takeaway 1: Spin-offs
The first investment area of special corporate events and perhaps the most lucrative one is spinoffs. A spinoff is when a company takes a subdivision and separates it from the parent company, making it an independent entity. A study that went on for 25 years and finished in 1988 found that spinoffs had on average beaten the S&P 500 by 10% per year during the first three years as standalone companies. Also, the parent company managed to beat the market average by about 6% per year. Other studies have found similar results. So, on average, with a basket of spinoffs, one would have achieved returns of about 20% annually without any talent or comprehensive research. Imagine picking your spots within this area and increasing those returns even further.
Even though that period ended 30 years ago, the same mechanics that enabled those returns to spinoffs back then are at play today. Institutions don't want them. A spin-off company can be too small for institutions to own and they're often not the reason that they bought the stock in the first place. This creates initial selling pressure on the stock that hasn't got anything to do with the business itself. The spun-off company lacks existing analyst coverage. This makes private investors hesitant and increases the initial dumping of stocks even further. Operators of the spin-off suddenly have increased incentives. Now, this standalone entity isn't hidden away in some subdivision of its parent any longer. Combine this with higher freedom to operate and it makes an acceleration in the business of the spun-off company more likely. There are additional mechanisms that make the spin-offs a lucrative area, but these are the major ones. Greenblatt dedicates most of the book to spin-offs and states that one doesn't really have to go beyond this to become a successful investor. But hey, the more possibilities, the better.
Must Read: The Intelligent Investor’s Road to $1,000,000
Takeaway 2: Merger Securities
Another sort of special corporate event is one of mergers and acquisitions, and here you want to be on the lookout for the special type of merger securities that are sometimes used during these transactions. Normally, when a company buys another company, the majority is paid in cash and stocks. However, in order to further sweeten the deal or when the acquirer doesn't want to issue more stocks or raise more cash, the decision can be made to use other merger securities. The opportunity for you arises because as a general rule, no one really wants these other securities.
 |
| Image by Gerd Altmann from Pixabay |
A company named Mr. Mash is producing and sells canned mashed potatoes. The stock is trading at $31 per share. When another company, Franky's Fries announces a takeover bid for Mr. Mash for $39 per share in cash and another $4 in face value of Frankie Fries's 7% bond due in 2032. Pretty good for the shareholders, their portfolio is made a huge return just overnight. But, what do people typically do with the proceeds? Well, the cash part is easy, they reinvest. And what about the bond? A 7% return per year in coupons and $4 of face value received in 2032, might actually be a good deal in terms of risk-reward, but who cares? A bond? Nah... People own the stock because they want to own their favorite brand of mashed potatoes, not some boring bond of whatever. So, they sell the merged securities and don't think twice about it.
What is face value anyways? But what about sophisticated institutions? Surely, they will make some advanced calculations in Excel; benchmarking the yield to maturity, analyzing the synergies between the two companies, and so on. Nah... Institutions who own stocks in Mr. Mash also wanted stocks in that company, not some bond of a new conglomerate. And this is where you enter the picture. Similar to the dynamics of spin-off situations, merger situations can make you a lot of money, dealt with correctly. Since individuals and institutions both get out quickly, the selling pressure makes the security trade far below its actual value, and this is where you can pick it up.
Must Read: Trading for a Living: Psychology, Trading Tactics, Money Management by Dr Alexander Elder
Takeaway 3: Risk Arbitrage
As many great individuals and investors advocate, start with what not to do. This is a takeaway of a special company situation which to stay away from, the one of risk arbitrage or sometimes referred to as Merger Arbitrage. Let's get back to Mr. Mash and Frankie Fries. Let's say that the shareholders of Mr. Mashdeclined the takeover bid of $39 plus bonds. Now Frankie decides to up the bed a little and pays in cash. It is now offering $60 in cash only. The stock was previously trading at $31 per share but in anticipation that this bid will go through, the stock market pushes the stock to $58. A risk arbitrageur is a person that will buy Mr. Mash at $58 hoping the deal will go through as soon as possible in order to cash out the$2 per share indifference. There are many great ways to make money in the stock market but according to Joel Greenblatt, this is generally a bad one.
 |
| Image by Gino Crescoli from Pixabay |
The risks undertaken by attempting this are mainly two; there's always a possibility that the acquisition doesn't go through due to a number of reasons including financial problems, extraordinary events after the announcement, discoveries during the due diligence process, etc. In the case this happens, the downside is huge and it's not uncommon to see stocks fall back to the trading price before the acquisition announcement. So, given the example above, the upside is $2, and the potential downside is perhaps 25 to 30 dollars. The second risk is time. An acquisition can take a much longer time to go through than first intended. If you have to wait, let's say 12 months for the deal to go through, you've made an annualized return of about 3.4 percent, which considering that the stock market is full of other opportunities is a terrible use of your money. Again, there's a vast number of ways to make money in the stock market, please don't choose risk arbitrage.
Must Read: How Warren Buffett Made His First $1,000,000 at age 31
Takeaway 4: Restructuring
Back to the kind of special corporate situations that you should try to understand and be involved in, restructurings. When we talk about restructurings, I don't mean minor tweaks, I mean when companies decide to sell off or shut down a whole division. This actually happens on a regular basis, and if you are on the lookout, you may spot some real opportunities here. Usually, the reason for selling or shutting down a whole division is simply that its business isn't doing that well. Let's say a company has three divisions and makes earnings per share of $4 in total, but if you look under the hood, (which I hope you will do in these events from now on) you discover that division A contributes with earnings of $2 per share, division B with $5 per share and the third, division C actually drags down the result with $3 per share. All in all, the company makes $4 per share. But once division C is gone, the earnings per share will take a leap to $7 and this will most likely lead to an increase in the price of the stock.
Also, another contributing factor that makes this area potentially a lucrative one is that management can now focus more of its time and effort on developing the part of the business that is the most profitable, which is likely to lead to better results in the future. It is often a difficult decision for management to decide to shut down a large part of its operations, as it means that from now on they will lead a smaller organization. This is bad for people with large egos. Management teams that decide to shut down a whole division, therefore, show that they put shareholder's interest first and these are the leaders you want to invest in.
Must Read: Big Mistakes: The Best Investors and Their Worst Investments (BY MICHAEL BATNICK)
Takeaway 5: How to act in all special situations.
This last takeaway is a mash-up of things to keep in mind when going for these special situations. hey, repetition is the mother of all learning. Don't trust anyone under 30, and don't trust anyone that is above 30 for that matter. Actually, don't trust anyone at 30 either, do your own homework. If you ought to look at special corporate situations because so few others do, you simply have no choice but to do your own digging. You can beat the rest of the market with these methods because you'll stand out of the herd and understand something that other people don't.
 |
| Image by Lorenzo Cafaro from Pixabay |
1. Invest with the operators: As in all investments, you want to be on the same side as the insiders; make sure that the management has skin in the game. Taking spin-offs as an example, the new standalone entity will open the possibility for the new CEO to buy shares in the company, but if he or she doesn't bother, you shouldn't either.
2. Pick your spots and concentrate: While you can reach extraordinary results by investing in special events, it is a minefield. So, make sure you pick your spots carefully. But once you've found one of these gems, make it count by investing big. After having distributed your money in around 6 to 8 of these situations, the benefit of adding additional investments in order to decrease the risk is small though. Once you have a basket of eggs, just make sure to watch that basket carefully. If you are not willing to put in the effort required to learn about and identify these types of special situations, that's completely Ok.
Then you may want to check out a more passive investment approach, like the one from Joel Greenblatt's other book: The Little Book That Still Beats The Market. This book reveals how to spend a minimal amount of time and still be able to reap a great deal of the rewards that the stock market has to offer. Cheers guys!
Nice 👌
ReplyDelete