We Study Billionaires - The Investor’s Podcast Network - TIP136: Joel Greenblatt - You Can Be A Stock Market Genius (Business Podcast)

Starting point is 00:00:00 You're listening to TIP. All right. How's everybody doing out there? So today we've got a really exciting episode for you. We're going to be talking about a gentleman named Joel Greenblatt. And for anybody who's not familiar with Jewel Greenblatt, he is a professor up at Columbia Business School, but he's not only a professor. He's actually a master at value investing.

Starting point is 00:00:26 And when I say a master, what I mean is he's. has had huge returns whenever he had his fund actively run. And so his fund, the fund that he ran back in the 80s and 90s was called Gotham Capital. And he started this fund in 1985. And in his first year, he had a 70.4% return. And I know that sounds absolutely insane. And it is. But he ran his fund for another nine years after the first year. He had it open for a total of 10 years. And here's some of his returns. He had 53%, 29%, 64%, 31%, 31%, and it goes on, he even had 115% in 1993. And his average for that 10 years that he kept Gotham Capital open was 50%. So, Joel Greenblatt is a studier of Warren Buffett, Benjamin Graham. In fact, he teaches the course security analysis and

Starting point is 00:01:26 the intelligent investor and all that stuff up at Columbia Business School. So that's who we're going to be studying today. Greenblatt is probably best known for his magic formula. And the magic formula is where you buy cheap stocks with high earnings yield and a high return of capital. And he outlined that in another book. It's a book called The Little Book that Beats the Market, where he talks about how this formula can beat the market 96% of the time. Now, what we're going to talk about in this episode is more related to the returns

Starting point is 00:01:56 that Preston's talking about before, because he's talking about how, the investor can make individual stock picks in many different areas of investing, including spin-offs, risk arbitrage, merger securities, bankruptcy, restructuring, and much, much more. So what we're going to talk about in this episode is we're going to simplify the concepts even more, and we're also going to teach you how you can profit from them too. All right, guys. So if you're ready, we're ready. We're going to be talking about Jewel Greenblatt, his book, You Can Be a Stock Market Genius.

Starting point is 00:02:28 So hold on to your hats because here we go. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. All right, guys. So great to have you guys back with us. And I just got to start off by saying, Stig, his writing style was so much fun. Is that not? I was loving this.

Starting point is 00:03:06 Yeah, it was a lot of fun. He has a lot of great metaphors and he actually managed to make very complicated concepts, very simple, which is really, really hard, especially in finance. So I thoroughly enjoyed that. Yeah, I thought the book was fantastic. I was very impressed with his writing style. He seems like a very intelligent person just by the way his writing style kind of came through. For anybody that's picking this book up and that's going to try to go through this

Starting point is 00:03:29 and you don't have some background in accounting, I think you're going to still struggle reading this book. I'm kind of curious to hear what Stig's thoughts are, but some of these concepts and some of the terminology is going to be very difficult for a person that doesn't have a firm understanding of how accounting works to kind of plow through this book and really understand everything.

Starting point is 00:03:49 Yeah, I definitely don't think that this is the first book you should dig into if you're into stock investing, but if you do have some experience in accounting and in stock investing, I think that might be one of those books that would take you to the next level. So we'll try to make it a promise here between Stig and I that as we talk about this book, during this episode, we're trying to try our best to make sure that we don't go deep diving into things and we'll try to make it understandable with some of the terminology. So that's our promise for you. So we'll start off with chapter one.

Starting point is 00:04:19 And the title of this chapter is follow the yellow brick road and then hang a right. He goes through this chapter just kind of outline and some real basics for the person before. he starts getting into some of the heavy hitting ideas. For example, one of the first things that he tries to discuss is this idea of diversification. And in the first chapter, he says that really you only need about eight stocks that are in different industries. And I think that's important to highlight. He's not saying that you get eight stocks all in the banking sector. They have to be diversified across, you know, different sectors.

Starting point is 00:04:55 But if you have eight stocks, he has mathematically proven. talks a little bit about this in the book, that you have really minimized your exposure to the different risk levels and downside risk that could basically hit your portfolio by that much diversification. He says, once you start getting beyond eight, his opinion is it starts getting difficult to keep track of the direction that a company can go and that you're basically setting yourself up for diversification is what a lot of people like to call it. Or basically, you're giving yourself just what kind of

Starting point is 00:05:29 return you could expect to get from the S&P 500. And so I don't know that he's trying to promote somebody to not use an ETF or go after an S&P 500. But I think what he's trying to say is that if you are really trying to beat the market, you're going to have to kind of keep it very scoped and you're going to have to watch that basket of eggs very closely opposed to having too many in the basket. Yeah, I think that the reason why he's only talking about eight, and he might even say like six to eight, and I was pretty surprised whenever I read that the first time, because he has

Starting point is 00:06:05 a background in academics and academia, you would typically say that you would have around 20 stocks before what we call the market risk is more or less gone. And when we're talking about something like market risk or systemic risk, we're primarily talking about volatility. And what he's saying is that you probably don't necessarily need more than eight because additionally, the more stocks you include, there's actually not that much of a difference. I think that's one side of it. The other side of it is that he's not talking about normal stock picks, at least that's not

Starting point is 00:06:37 what he's talking about the rest of the book. He's talking about different types of what we'll call special situations. So if you would buy into a spinoff or a partial spin-off or arbitrage, you probably need to watch the basket pretty closely. So there's no reason to confuse yourself with 20 different picks like a lot of people would say, but eight picks should be enough. Also because you probably have a watch list of other picks that you could look at. So at least that's my take why he was talking about numbers that were so low.

Starting point is 00:07:08 And just one final highlight. He basically says, if you are trying to measure how good you are at doing this stuff, you absolutely have to compare yourself to the S&P 500 returns. He says, that's the yardstick. For you to go out and say, well, I got 12% this year. And for some people, be like, oh, that's a really good return. But if the market, if the S&P 500 did 14%, you just lost. That's a theme we've talked about on our show in the past.

Starting point is 00:07:32 But he reemphasizes that here in the first chapter. So let's go on to the second chapter. And the name of this chapter is some basics. Don't leave home without them. And the first thing that he highlights is you have to do your homework. And I'll tell you, after reading through his book, you can see this guy does his homework because every single topic that he brings up in this book, he has probably three case examples of how that's played out on the good side and on the bad side of exercising the

Starting point is 00:08:03 strategy. And so he's not just telling you do this. He's actually showing you with real companies how things have played out and why they've played out. And his analysis before he made a decision and how it actually came to fruition because he had these opinions up front. So he is a reader. He is a person who enjoys going into a 10K or a 10Q and reading all the details of what a company is filing with the SEC. And if that's not something that you enjoy doing, this is probably not an approach that's going to fit real well for you,

Starting point is 00:08:36 because this is a lot of homework and a lot of reading. I love what you said about why you should do your own homework. The first argument you says is you don't have any other choice. This This is something you really can't outsource. And the second thing is that you shouldn't be paid to take big risk. You should be paid to do your homework. And I really love that analogy in terms of how do you measure how much time you're spending and what you are basically investing in? Because whenever he is making 50%, and he did that with a small amount of capital.

Starting point is 00:09:07 That's something we addressed a few times. It's easier to do, say, 50% if you have a million dollars than if you have 10 billion dollars. But he actually made those whenever he was running Gotham Capital. At the very beginning, he had some great returns. And reading this book, I'm sure, is not because he took big risk in any way. It's because he was really, really paid to do his homework. The next thing that he talks about in the second chapter is pick your spots. And I really like this because there's this thought that I think a lot of people have,

Starting point is 00:09:38 that they have to be making moves, they have to be doing things in the market. He references a really famous quote by Warren Buffett, or a couple famous quotes by Warren Buffett, The first one that he says is swing at only one of the 20 pitches. Here's another quote that Buffett says, there are no called strikes on Wall Street. Or in other words, wait for your pitch. And that's what he's getting at.

Starting point is 00:09:59 He's saying there's so many different opportunities that are constantly presenting themselves. So if you're not comfortable, 100% comfortable, going forward with the selection of whatever security it is you plan on buying, don't do it. This should be easy, breezy whenever you make the decision. It should be very obvious to you.

Starting point is 00:10:16 And I think that's the point that he's trying to make here. Yeah. And in continuing that, Preston, he's saying that you should look down, not up whenever you're looking at stock picks. And what he means by that is that don't think too much about the upside. There might be a huge upside. We don't know, but we know that there is a downside. If you monitor the downside really, really well, in other words, buy the margin of safety, which means buy significant below the intrinsic value.

Starting point is 00:10:41 Don't worry, the upside will take care of itself. So for me, on that point, look down not up. I think you find a lot of people that when they're looking for a stock pick, they look at companies that are at their 52 week high instead of finding companies that are at their 52 week low. And I forget what it was. It was some interview with Monish Pobri. And they were asking Monish, you know, where do you go to find new stock ideas?

Starting point is 00:11:08 And he says, one of the my favorite places to look is the 52 week lows. and I always remembered that because that is such a great tip for a lot of people because so often people read the headline and they hear Apple is at a new market cap high. It's the highest it's ever traded, you know, as far as market capitalization. And so people read that and they're like, wow, Apple's doing really good. And so then they go and buy it. But what I think they're failing to realize is this whole idea of mean reversion. And so when you're buying a company that it's at a 52 week high, the mean reversion is. that it's probably going to underperform the market in the next year.

Starting point is 00:11:45 That's just a fact. If you're buying something that it's at a 52-week low, the mean reversion as a collective group, if you're going to take 500 companies that are a 52-week low, most likely they're going to outperform the S&P 500 because they're going to mean revert back into a spot that gives them their normal pricing. So when Greenblatt talks about this idea, look down, not up. I really see that is what he's talking about here. And I really love that you addressed the conversation we have with Monash because one of the things that both Monish and Joe Greenblatt is talking about in this book is that you can't trust analysts.

Starting point is 00:12:22 And this is one of the basics that you really need to understand. And the reason why I bring up Moniz is that he told us the story about he had a visit from an analyst from the big investment banks. And he wanted Moniz's opinion about railroads. And Moniz said, well, you know, there are some great railroads, but they're not priced and attractive level. And then the analyst said, well, that's the only industry I'm covering. And I need to suggest to the investors which one they should invest in. And when you said, well, can you just, you know, tell them none of them because they're not priced at any good level.

Starting point is 00:12:55 And what Bernice told us was he just found it so sad because there's basically only four railroads for him to analyze. What are you going to do at the end of the day if your job is to analyze and recommend one of those four railroads? and that industry might be overvalued for five, ten years. They all suck. What are you going to do? Yeah, exactly.

Starting point is 00:13:15 And I think Monish was also talking to the person's intellectual level. You know, some of these guys are Harvard MBAs or whatever and are stepping into these roles. And then it was a really interesting conversation. But fantastic point there, Stig. So real fast to wrap up this second chapter. So Greenblatt's saying there are numerous ways to make money in the market. You don't have to just be a value investor. You can do these special type situation securities, which is what Greenblatt really talks about in this book.

Starting point is 00:13:43 There's plenty of different ways that you can make money. Look at Ed Thorpe the way he did it with options and he did it through options completely different than the way Greenblatt does it through options. And so the main thing is, is know your personality and then mesh that personality with the type of investing style that really makes sense to you the most. And so that's something that he kind of concludes the chapter with. And then he finishes the chapter. The very last thing is he says there's a lot of secret hiding places for where people can make large stock market profits. And so then the rest of the book is his outline of where he thinks those places are. So as we go through the following chapters, these are his secret hiding places where he thinks he can find value.

Starting point is 00:14:25 So we go into chapter three. The title of this chapter is spinoffs, partial spinoffs, and rights offerings. So I'm sure that that sounded like white noise as I read that. So this is where I'm telling you it's going to get a little complicated for people that don't have a lot of background in business, accounting, finance, things like that. Some of this might sound a little difficult. We're going to try to use simple language. And if you find this stuff interesting, we highly encourage you go buy this book because, man, it is a treasure trove of information. if you are interested in learning about some different approaches and places to look.

Starting point is 00:15:07 Okay, so spin-offs. Let's talk about spin-offs. This happens because unrelated businesses can grow better being separate. So let's just say company XYZ. Maybe it has two different divisions, main divisions that encompass about half of the revenues of the company. And if the leadership within the company feels that division A versus division B would be better off, if they were split and not having the same company headquarters, that would be a reason for a spinoff.

Starting point is 00:15:38 Another reason for a spinoff would be to remove the bad business so that the good one can shine. That's another reason. The third reason, sometimes a spinoff is a way to get value to shareholders for a business that they can't easily be sold. Another consideration is for tax considerations. Another one is antitrust concerns that they might want to do a spinoff. So when a company spins something off, it means that they're selling. selling it, they're getting rid of a division, they're trying to remove a portion of their

Starting point is 00:16:07 business for the betterment of one side and then, and sometimes if it's being split, sometimes it's better for both businesses to be split. So that's the idea of a spinoff. Now, the reason that there's value here, according to Greenblatt, is that newly spun off companies tend to outperform the market. And the reason is because newly issued stock in the spinoff is generally provided to the people that don't want to own it. So think of it like this. Let's say that company XYZ has two divisions. And we'll call division A, the good division, and division B, the bad division, and the smaller division.

Starting point is 00:16:50 So when these companies get split off into two, what happens is some of the stock is provided to, let's just say that division B gets spun off. and some of the stock is provided to division B, and some of the stock has provided the division A. When these get spun off, that stock being provided to the two divisions is not sometimes wanted by the people that now possess it. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo

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Starting point is 00:21:15 Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right, back to the show. And to continue this example, I would like to tell you about my own experience with a spinoff. And it was actually not a spin-off that I planned to be a part of. A few years ago, I bought stocks in a company called National Oil Lavago. And I probably owned it for like 12 months or so before they did a spin-off. and they were spinning off one of the divisions, which was actually not a bad division.

Starting point is 00:21:52 So what National Ovali was doing is that they're primarily in oil rigs, onshore and offshore. And the division they were spinning off that was in maintenance of these rigs, that was spun off. It was not necessarily a bad business. I got rid of it. I actually didn't look too much at it. And that might also show how bad an investor I am, because Joe Greenblatt was definitely right. A lot of investors doesn't look at it. because that is not why they bought it in the first place.

Starting point is 00:22:20 The reason why I bought into National Oil Vago was because the part about building the oil rigs, that was really the profitable part and the part that I really felt I understood. And what also typically happens in the spin-off is that as a shareholder, you get a smaller portion of whatever you would have in the original stock in the new company.

Starting point is 00:22:41 So let me give you an example of that. I was getting one stock in the new company for every five stocks I have in the original. company. So it's a smaller precision. It's something that you typically doesn't know too much about. And another thing is that you don't have that much information available. You can't go back and track what happened the past 10 years, for instance. I think there's a psychological point to this too. So using the example that you just described, which is perfect for this scenario stick, I think the person who receives that one share of the new stock immediately kind of has this opinion like

Starting point is 00:23:17 I just got screwed. I think at the end of the day, you don't necessarily know that division that just got spun off like you knew the whole company or at least you don't think that you do. And so the immediate mindset of the typical investor is, you know, I didn't buy this for that reason. And I don't even know what this is. And I kind of feel like the corporate leadership just screwed me by, you know, giving me equity into something that I didn't plan on purchasing in the first place. And so then they just sell it. It's just, I don't know what this is. I didn't want this.

Starting point is 00:23:49 Goodbye. Yeah. And one thing might be the mental thing that you're talking about, Preston. Another thing is that it's not only small-time investors like me that are receiving stocks and spinoffs. It's also big institutions. And a lot of these institutions, they're actually not allowed to have small positions. And they feel that it's really not impacting them anyway, even if they could. So they're basically just selling them off.

Starting point is 00:24:14 Now, this is not the same as saying that they're, owning something that they didn't own before, because actually they did own it before, they just owned it in another format. But it's just very, very easy to get rid of because it just looks odd in your portfolio. Say that, for instance, you have bought, you know, 10 different stocks, approximately 10% each in a portfolio, and then something spun off and you have 2% in something you really don't know anything about. It just seems easy to sell it. So what's happening is that there is a massive selling, which means that the spin-off right after it's being traded, often you will see the new stock being knocked down by the market.

Starting point is 00:24:50 And it's actually something that's trailing in the first year. Now, in the second year, that's really when you should think about buying, because that's really when you see a huge jump in the share price, whatever the market realizes the value, and when you have different investors starting to find interest in the stock. If you look at spin-offs over 25 period, it actually upperform the industry peers by 10% per year. And I think the time frame he's using is two to three years after the spin-off.

Starting point is 00:25:19 So one of the metrics that he's saying to look for whenever you're determining whether to research and do more work to uncover the potential value of a spinoff. So one of the first things he looks at is, are there insiders that want to own the new stock? In the book, he provides this amazing example with Marriott and how Marriott did this spinoff. And there was a gentleman named Stephen Bolandbach. and Stephen Bolandbach was in charge of Marriott. He was in charge of conducting the spinoff. And then after the spinoff emerged, and there was like, in the way Greenblatt describes it in the book, he says, there was a good Marriott stock and then there was a bad Marriott stock. He said, I found it really interesting that Bolandbach was in charge of the entire company.

Starting point is 00:26:07 He transitions through this spinoff. And then after the spinoff, he goes with the quote unquote bad Marriott. He said, for me, that was like fireworks going off. Like, hey, there's something here. There's something that you need to pay attention to because this guy wouldn't go with the bad Marriott if there wasn't a lot of money to be made in that position. And it turned out there was a lot of money to be made in the position.

Starting point is 00:26:29 And I think the leverage ratio was around five or something like that. But he said that it wouldn't take more than a 50% move in value of the assets to double your initial investment. Clearly, if things go bad, you'll lose all your money. But then he actually said, but you're masked in prison, that since you have the right guy, it's probably not going to crash. So he was like, if I'm going to lose the small position, I'm going to lose it. But the upside is just enormous. And that is what happened.

Starting point is 00:26:55 Well, and what really gets interesting is when Greenblatt talks about how he goes about buying these types of things with options and whatnot, which we're going to cover later in the episode here. But when you start looking at it from buying this with an option, it even gets a, you can say, you can see why I was making 50% a year for 10 years straight. It's pretty phenomenal stuff. Okay, so let's go to chapter four. This chapter was called Don't Try This At Home. The chapter discusses risk arbitrage and merger security. So I'm sure that sounded like more white noise as we're talking about some of these ideas. But we'll try our best to explain this and make this reasonable. So risk arbitrage. I'm sure people have heard that term before, but many You might not know what it even means.

Starting point is 00:27:42 And we're going to cover that real quickly. So risk arbitrage is when an investor buy stock in a company that is subject to an announced merger or takeover. How many times are you looking at Bloomberg or the Wall Street Journal or even any kind of newspaper and they say something like Yahoo is about to be acquired by, you name it company or Google just acquired or is going to try to acquire whatever company? So risk arbitrage is when you're trying to buy that new company that's being acquired and trying to profit by that deal kind of closing because you know the company's going to pay a premium to acquire them. And just to give you like a really simple numerical example of risk arbitrage, imagine a stock that's trading at $25 and then it's announced that another company would buy that stock at $40.

Starting point is 00:28:33 Then what you would typically see is that it would immediately start to trade very close to $40, but not at $40. So let's say, for instance, starts trading at $38. So basically the question is, should you try to do risk arbitrar's and get those $2 difference per share? And what Greenblatt is saying is basically that you have two types of risk if you're doing that. The first one is that the deal might simply not go through. It might be because of regulatory risk. reasons, financing problems, changes in due diligence process, it will simply not happen.

Starting point is 00:29:09 And if that doesn't happen, perhaps the stock would trade at $25 again and you will have lost your investment. The other risk is opportunity costs. I said another way, you might need to wait, say, six months for this to happen. So you tied up all your money and need to wait six months before it can cash in your additionally $2. So Greenblatt's advice on this is don't ever do it, which I found kind of interesting. I know there's a lot of people that will read things in the newspaper and be like, oh, they're going to get acquired.

Starting point is 00:29:39 There's going to be a higher premium paid to buy them out. Grayblatt saying, stay away from this. This is a sucker's game that he hasn't figured out a way to win at. So the other thing that he was talking about in this chapter was merger securities. And I think this one is also a really difficult one to pull off, but he's much more optimistic about merger securities. So whenever a company is,

Starting point is 00:30:01 trying to acquire another company. A lot of the times the company that's buying doesn't have enough cash in order to complete the transaction. If it's a multi-billion dollar deal, they might do half of the deal in cash. They might do the other half in common stock. They might do a mix of common stock, preferred stock with bonds and all sorts of ways to basically complete that transaction. And what Greenblatt says is those securities that are being issued during that transaction are

Starting point is 00:30:31 sometimes very lucrative for a person because the way he describes it is they're sweeteners for the deal to go through. So the company that's being acquired, if it's not a cash deal, then they want something more. They want something because it's not cash. They want maybe a bond that's paying 10% with a coupon that's convertible at a certain strike price. And this is where you get into a lot of security analysis stuff. So if that didn't make any sense, don't worry. And without all the fancy terminology, what it really is is it's a way to sweeten the deal for the people that could actually acquire some of these securities. Where I think that this gets difficult for the common investor is gaining access to those sweetener kind of securities that are making the deal so

Starting point is 00:31:18 sweet. Unless you work for the company that's being acquired, a lot of the times you don't have access to some of these securities unless they're immediately sold on the market after the deal goes through, and that's when you might have the opportunity to buy them. But this is kind of a unique situation. This definitely involves a lot of work and a lot of studying and a lot of understanding of how these things are structured, what the actual value of the underlying business would be, if they are convertible into common stock, because that's usually where the value lies, because you're able to get a strike price in a year from now at a really cheap price if you expect it to grow. It requires a lot of work.

Starting point is 00:31:58 way that it's explained is that you just need to read the proxy, basically. You need to read the information about these securities, then you can take an informed decision. I don't think it's that easy. I do want to say that. If you actually do read some of those proxies, it's not that simple as you probably outlines them to be. And some of those sweeteners, the way they're structured, and the reason why they're giving in the first place is very often for tax reasons. It's basically because it's very expensive to acquire another company with stock, but if it's issued in different securities, there are some tax reasons to do that. But it's also, it's hard to value because, for instance, something like a bond, and especially something like a convertible bond, that you can

Starting point is 00:32:35 turn into something else. It can be hard, especially because it is perhaps in a company that you don't know the form of yet. So it's also hard for you to determine how likely are you that it won't default. So there are so many different layers in evaluating these type of securities that It's really, really hard. Because let's just take the convertible bond for an example, or you could do the preferred stock. If you're doing a convertible bond, first of all, you have to know whether the bond is priced at an appropriate yield for the coupon on it. Then you've got to understand when it's convertible. It might not be convertible for a certain amount of time.

Starting point is 00:33:15 So then you have to go in and you have to make an assessment of what you think the common stock is. And where you think that common stock could appreciate to and value versus what you might be able to exercise. it at. So all those things, it's like trying to hit a pool ball, you know, when you play pool, when you try to hit one of your own balls into another one of your own balls to hit it into the pocket, that's difficult. It's so much harder than just hitting one ball. This is like trying to hit three balls and then getting it into the pocket where you're doing so many different things. It can be done and there's very intelligent people that are experts at this stuff, but a very fancy thing that he's talking about here in the book and it's merger securities

Starting point is 00:33:49 if you guys want to read up on it more. Yeah. And I think one of the interesting points is that the reason why you can make a great profit with emergency curses, the same reason that you can make a profit in spin-offs, people usually don't want them. And even if they do, they might not know what it's worth. So your benefits comes from knowing more than other people. And I think that's the challenge. You really need to know more than other people to make a profit here. All right. So chapter five, this one is called Blood in the Streets, Bankruptcy and Restructuring. I think when anybody hears that, they know that this is not.

Starting point is 00:34:24 going to be an easy kind of thing. Whenever I read bankruptcy and restructuring, I think, where's all the lawyers at and how are they going to take all of my money? So this is a very complex chapter as well. To start off, he says that, and I think this is really important, he says that it's rarely a good idea to buy common stock for a company that has recently filed for bankruptcy. That is really, really important for somebody listening to this show. and I'm just going to read it one more time. It's rarely a good idea to buy common stock for a company that has recently filed for bankruptcy. So the reason why is because whenever you're buying common stock in a company, you're at the bottom of the totem pole as far as getting your money back.

Starting point is 00:35:11 When a company does go through bankruptcy, the first people to be paid are the employees. They're getting their wages. The next people to get paid are the ones who issued loans to the company. The next people after that are the bondholders. The next people after that are the preferred shareholders. And then the last person, after all those people were paid, if any of those people are paid with the money that remains in the business after it's completely liquidated are the common shareholders. Now, this is where Greenblatt has an awesome pivot in the book because he says, but there's a certain point at time where all the legal paperwork and all this disaster that's taking place with the company ends. and the company starts a new, and the company issues new stock to start over again.

Starting point is 00:35:58 That is a critical point when there might be huge opportunity for an investor. So the key point in time to understand when this happens is when you see something called a private document service or the registration statement. When that comes out, that means basically all the legal disaster that happened beforehand is now over and the company is issuing new stock. And that's where a person who understands how to value a business needs to go in and look at that registration statement to see what are they listing as assets, what are they listing as liabilities, what is their competitive advantage, what kind of cash flow do we expect

Starting point is 00:36:40 them to potentially be able to make and what would be the value of that. And you're basically going through your typical value investing stuff right there. And the reason he says there's a big opportunity is because there's this stigmatism with that brand that people don't want to own this. And a lot of the people that were paid off from the previous deal that lost tons of money are paid in this new stock. And once again, they want to sell that new stock because they just want to get their hands clean and get rid of this thing and move on with their life. And that's your opportunity right at that single point in time. And you can think about it like this. Remember what Preston said before in terms of what's called the seniority.

Starting point is 00:37:20 So basically, who gets money first? It's the bondholders. So we're talking about bond investors here, and they're getting common stock. Now, a lot of bond investors won't hold equity for a bunch of different reasons, some for the isolation purposes and some simply because they don't understand it, or it's simply something they don't want to hold. So again, you have this massive selling where the price will just be knocked down whenever it starts training. Actually, from 1980 to 1993, which is the period that Greenberg was looking at,

Starting point is 00:37:52 he saw that the newly distributed bankruptcy stocks outperformed with 20% annually all the first 200 days. And one thing he really talks about in terms of when should you go into this new business. It's also to understand why is it that the company was bankrupt in the first place and how much is carried over in the new company. He says it's not just because we're talking about a lousy business per se. There can be a ton of reasons for that. It could be over-expansion. It could be a problem with regulation.

Starting point is 00:38:22 It could be product liability, something that is no longer an issue in the new company. So basically what he's saying is identify what happened before the bankruptcy and where you're at whenever the newly distributed bankruptcy stocks comes out. What happened in there in between? Not thinking too much about all the legal stuff, but thinking about what is the fundamentals, How much money were they making before?

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Starting point is 00:42:27 Oftentimes, the division being sold or liquidated or completely revamped has actually served to hide value inherent in the company's other businesses. So let's say that the company is getting rid of one of its divisions, and this is a major restructuring that's occurring. And the way that I think I remember him describing it in the book, he'd say, let's say a company has three divisions. The first division's making $2 per share. The next division's making another $2 per share.

Starting point is 00:42:56 And the third division is losing $2 per share. What you're actually seeing as a collective company is you're seeing $2 of profit for the entire company. If you can get rid of that third division, now all of a sudden you've got $4 of profit being shown up on the income statement instead of just $2. And that is going to unlock value. That's going to give you a much larger multiple

Starting point is 00:43:20 as the company would move past that restructuring. But the hard part is knowing what the profit margins of those divisions are, what the cash flow of those divisions are. But if you do your due diligence and you dig in, to all the 10Ks and 10 Qs and read all this stuff, you might find a very big opportunity if the company is able to basically offload some of the areas that have been an anchor to their progress. This could really be a challenge because whenever you have something called a corporate

Starting point is 00:43:50 restructuring, everything seems to be somewhat blurry one way or the other. There are a few reasons for that. One of the reasons is that a lot of people use the cover of a corporate restructuring to add a lot of bad expenses they have over the years into one restructuring. Because the reason why they do that is that they can do it as a one time write-off. So it just looks like it's just been a bad year and not like the business is consistently bad. And also the way that it's characterized in the income statement is it's a one-time thing and it's not a part of the normal operations. So it can be beneficial for managers sometimes to basically somewhat hide it from

Starting point is 00:44:27 the investors. But if you do go into the 10-Ks, you could typically see the different segments of the business and see how profitable they are. And if you read that they will one way the other get rid of one segment because of a restructuring, for instance, think about that the way the market typically values a business is as a multiple of the earnings. So for instance, in the example before, if you were talking about going from $3 in earnings to $2 in earnings, and after restructuring, it's valued at the same multiple, you're actually talking about a 50% gain. that you will achieve as a stock investor. All right, guys.

Starting point is 00:45:04 So let's go on to chapter six and the title of this one, which I guess maybe I'm just a little dense. I didn't really get the title here. Maybe you did stick. The title of chapter six is baby needs new shoes meets other people's money. Go ahead. What am I missing?

Starting point is 00:45:20 I don't know. I thought it was just me. All the Americans always saying, baby needs new shoes. Everybody's saying that over there. I don't know. I was completely blank whenever I read that. No, I read this.

Starting point is 00:45:31 I'm like, I'm sure there's people listening to this and they're like, you don't get that. But I really don't. I'm just, maybe I'm just really dense. But that's the title of the chapter. And the subtitle, which I think is his real chapter title, is recapitalizations and stub stocks, leaps, warrants, and options. So for me, this chapter alone was worth the price of the book because this is where he really gets into some really awesome ideas on how to use options. with value investing. And not just value investing, but all the stuff that he talked about earlier in the book with spin-offs,

Starting point is 00:46:10 basically how to go about buying spin-offs with options. And his logic and how he goes about this is just amazing. So he starts off talking about recapitalizations and stub stocks. And I think that this is an important idea, but I don't think that it's really too relevant for our conversation because even in his book, he says these are really hard to find anymore. This was something that was more of the 1980s, when you had a lot of Carl Icon type corporate raiders that were coming in to basically rough up the executive leadership of businesses and buy a controlling share and do these big giant buyouts. But think of stub stocks as basically an option to buy, but it wasn't bound by time.

Starting point is 00:46:51 You'd basically be able to buy the option at any point into the future. And so that's why stub stocks were so lucrative for a person who actually could get it. at a great strike price that there was a promising upside to it. So we're going to skip over that. So the next spot is Leaps, long-term equity anticipation securities. These are options. These are long-term options. So I guess a lot of the people that I've talked to, the trade options, typically do it

Starting point is 00:47:19 in much more shorter intervals. They're doing it for the next month. They're doing it for the next three months or whatever. they're not doing this over a two year, two and a half year kind of option. And that's what Greenblatt is recommending. He feels that predicting the direction that the market's going to go in the next month or next six months is next to near impossible. But he feels that over a year, two years, you're going to be able to see a company mean revert, especially one that's been spun off. you're going to see it mean revert within two years.

Starting point is 00:47:55 And that's why he's recommending that you go with the option route in order to capture the fatest kind of return it you can get. So let me talk you through what he recommends in the book. In the book, he says, don't worry about any kind of option other than a call option. And a call option is whenever the security, the stock goes up, you make money. That's what he's recommending. He doesn't even get into puts. puts are whenever you buy and the stock goes down, you make money.

Starting point is 00:48:25 He doesn't even talk about that in the book at all. And I think that's an important note. He's talking about the upside here of a good company, a company that's worth owning. So that's all we're going to be talking about on the show. So that's a call option. So what he's saying is, let's say you get one of these spinoffs and you can buy a call option on this. And let's say that the company's trading for 20. And you can buy a call option at $25.

Starting point is 00:48:56 And it doesn't expire for two and a half years. And let's say that that spun off piece of security that you just purchased starts going in a positive direction. Well, every dollar that that thing goes over, let's say it goes to $26. Well, when you buy a call, when you buy one option, one call option, you really buy the option to purchase shares of that company. oftentimes these call options that he's buying have a 500% upside and a 100% downside, meaning you could lose everything when the option expires if it didn't go up. But he's saying that that risk reward, all that upside 500% versus the downside of 100% that is so lopsided, especially if you do this across a breadth of different securities that

Starting point is 00:49:47 you have done the analysis on, that you know are good companies that you would actually ultimately like to own. And I think that is a really important part of all of this, is that you're not just going out and buying options to trade them month to month. You're going out finding good value investing picks that you think are going to mean revert, and you're buying them with a call option at a two and a half year time frame, and the upside is enormous. And then if you do this across the breadth of them, you're distributing your risk with a very lopsis. upside versus downside. I thoroughly enjoyed this discussion about warrants and options.

Starting point is 00:50:23 Warrens are basically the same thing as options. It's basically just issued by the company whereas options that's traded by third party. And I don't have too much to add to this section, but I would definitely encourage you to go back and listen to episode 128 of the MS's podcast. And the reason for that is we had it Thorpe on. And he was actually the guy who invented how to value warrants and options. So just to kind of piggyback off of Stig's comment,

Starting point is 00:50:52 people when they're valuing options and warrants, they're probably thinking, well, the Black Scholes model is what's used for valuing that. And it is, but what Stig's referencing is, Ed Thorpe was actually, I think, two or three years ahead of the Black Scholes model with valuing options in the marketplace. And he had actually uncovered this rule before them,

Starting point is 00:51:17 but he didn't take it to academia and get the prestige of having it named after him because he was too busy making money in the market for three years before it actually was named that. And there's proof, there's written proof that documents all of this. So Ed Thorpe, who we had on our show, actually literally the guy that invented this. The way that they're valued is much more off of volatility and in the short term. They're not being valued in the way Joel Greenblatch using them to combine it with this value investing approach, it's much more for short-term valuations based on the volatility.

Starting point is 00:51:52 Ed Thorpe literally invented that. And especially if you look in the long term, even a formula like the Black Shoals is not a good indicator of how to value options. So just to remember back to what Preston said before when you were talking about something in the short term, say for instance, an option will give you the right to buy Coca-Cola at $45. And right now it's trading at $42. You can actually plug into an equation saying, okay, so how far is what we call the strike price? And how far is that away from the price is currently trading at? You're also looking at, is it three months, six months or how long is it? And you're also looking at how volatile has it been?

Starting point is 00:52:30 Because obviously, if you have an option where the underlying securities is a stock, and that fluctuates a lot. So say that if Coca-Cola is trading in 42, it typically trades up to either 52 or 32. that's a lot more appealing in terms of owning an option because it's so volatile than, for instance, if it only fluctuates between 41 and 43. So what if Thorpe actually did back then and how he actually also made money sense is he is much better at projecting than the Black Shoals formula in terms of what is happening out on the curve, what's happening years and years out from where we're standing right now. So guys, one of the things, and this is just a note as to, you know, Stig and I are building these different courses. on our TIP Academy page on our website, like we did the Intelligent Investor course. One of the courses that we're working on right now is an intrinsic value course where we

Starting point is 00:53:20 help people learn how to use discount cash flows in order to do these analysis. And one of the things that we're going to add into this course, and just so you know, the course isn't out yet, we're working hard to finish it, but it's not done yet. But one of the things that we're adding is how do you combine this options approach that Joel Greenblatt outlines in this book and some of his other writings with value investing. And we're going to add that into our intrinsic value course just for anybody that's interested in potentially purchasing that course in the future when we finally finish it. That will be a part of that course.

Starting point is 00:53:53 And I just want people to know that. All right. So chapter seven, seeing the trees through the forest. This was a really short chapter. And what John Greenblatt is talking about is that you should know what you're doing. He's outlying a lot of different concepts. He's talking a lot about how you can outperform the market inflow implement the strategies, but if you don't have a good understanding on what you're doing, you shouldn't do it.

Starting point is 00:54:15 It's like running through a dynamite factory with a lit match. You may live, but you're still an idiot. What he's talking about is if you are doing some of the more advanced concepts, start with spin-offs, they're probably the easiest one to start with and to analyze. And then he goes on talking about, if you need to start this further, you should read the intelligent investor. And he's also talking about Peter Lynch's book, One Up on Wall Street, and everything about Warren Buffett. And I think that's great advice to pass on to the audience as well. All right. So chapter eight, this one is called All the Funds in Getting There. And this is a chapter,

Starting point is 00:54:52 I'm so glad he ended this book this way because he's basically saying, if you're doing this stuff, you probably need to be doing it because you're having fun and you actually enjoy the process. That's how you're going to be successful in doing all this. If you're doing it because you want make a lot of money and live in a big fancy house and have fast cars and things like that. You're doing it for all the wrong reasons. The people that are really successful at this is because they really enjoy the puzzle. They enjoy the process of trying to understand the numbers, trying to understand if there's value to be unlocked. And you know, you look at Warren Buffett living in the same house, Charlie Munger. You know, these guys live very frugally considering the amount of money that they

Starting point is 00:55:31 possess. You look at Joel Greenblatt. A lot of people might look at his returns. 50, percent annually for 10 years straight. That's insane. And you might say, well, why did he close down his fund after 10 years? Well, the guy, his net worth is $500 million. You know, he went on, and this is the thing I love about Joel Greenblatt, he went on to do this philanthropic thing with education. And if you've ever had the opportunity to read about what he has done with inner cities and these magnet schools that he's basically stood up through his philanthropy, it's amazing. downright amazing what he has done and the test scores that are coming out of these schools that he has created. Unbelievable.

Starting point is 00:56:14 So this is a phenomenal person. We've asked him to come on the show. We haven't heard anything back, unfortunately. If you know Jewel Greenblatt and you have access to Jill Greenblatt, we would love to have him on the show. We really admire him a lot. This book is phenomenal. I can't promote this book highly enough. especially for somebody who does have some type of accounting background.

Starting point is 00:56:39 Please, if you don't have a lot of experience in investing, where you don't really understand a lot of the terminology, this might be a hard book to start off with. It doesn't mean you don't go out and get it and strive to eventually read it. But if you do, this is something you've got to read. It's an amazing book. Okay, guys, that was all the Preston and I had for this week's episode of The Investors podcast.

Starting point is 00:57:01 We'll see each other again next week. Thanks for listening to TIP. To access the show notes, courses or forums, go to TheInvesterspodcast.com. To get your questions played on the show, go to Asktheinvestors.com and win a free subscription to any of our courses on TIP Academy. This show is for entertainment purposes only. Before making investment decisions, consult a professional. This show is copyrighted by the TIP network.

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We Study Billionaires - The Investor’s Podcast Network - TIP136: Joel Greenblatt - You Can Be A Stock Market Genius (Business Podcast)

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