We Study Billionaires - The Investor’s Podcast Network - TIP677: You Can Be a Stock Market Genius w/ Roger Fan

Starting point is 00:00:00 You're listening to TIP. On today's episode, I'm joined by my friend Roger Fan to discuss Joel Greenblatt's book, You Can Be a Stock Market Genius. Joel Greenblatt is one of the greatest hedge fund managers of all time, as he famously averaged 40% a year over 20 years. At that rate, $1 million grows into $836 million. Greenblatt is also the author of best-selling classics like The Little Book that Meets the Market and was a key character in William Green's book, Richer, Wiser, Happier.

Starting point is 00:00:32 Now, my guest today is Roger Fan, who's the chief investment officer at RF Capital Management, and he likes to invest in these types of businesses that are discussed in Greenblatt's book, You Can Be a Stock Market Genius, which is special situations. Rogers' returns at RF Capital since inception in 2017 are 14% versus 12% for the S&P 500, and over the past five years, he's had returns of 19.3% per year, generating six percentage points in alpha over that time period. During this conversation, Roger and I give an overview of Joel Greenblatt's background as an investor, author, teacher, and philanthropist, why Greenblatt focused much of his attention on special situations to beat the market,

Starting point is 00:01:13 what a spinoff is and why they are ripe hunting grounds for mispricings, one of Greenblatt's favorite case studies for spinoffs, the three key characteristics to look for in a spinoff transaction for investors, how Joel Greenblatt views investing in bankruptcy deals and risk arbitrage situations, which situations Roger prefers to invest in, and whether he's adopted Greenblatt's highly concentrated investing approach and much more. This was a great chat with a sharp investor, so I hope you enjoy today's discussion with Roger Fan. Celebrating 10 years and more than 150 million downloads. You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that

Starting point is 00:01:55 influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Clay Fink. All right, welcome to the Investors Podcast. I'm your host, Clay Fink, and today I'm happy to welcome my friend, Roger, fan to the show. Roger, thanks so much for joining me today. It's great to be here. Thank you for having me on. So on today's episode, we'll be covering Joel Greenblatt in his book, You Can Be a Stock Market Genius, which covers special situations in detail. So special situations isn't a topic We've covered too much on the show in detail. And as I've gotten to know Roger here, I found that he knows and understands special

Starting point is 00:02:44 situations much better than I do, admittedly. So I decided it'd just be a good opportunity to bring Roger onto the show to discuss this book and Joel Greenblatt and his approach to investing. So we've actually featured Joel Greenblatt on the show multiple times in the past. And he's also just a great person overall. So how about you paint some color around just how good of an investor Greenblatt was? and why you admire him personally as a fund manager? Yeah, absolutely.

Starting point is 00:03:11 You know, I admire Greenblatt for a few reasons. First and foremost, I mean, he's got a phenomenal track record. I mean, the first decade at Gotham, he did 50% returns, and the second decade, he did 30%. And so over two decades, that comes out to 40%. And so even if you take the standard two-and-twenty fee, that's a 30% net return. And so some people might say, oh, 30% net, that's, you know, it's okay.

Starting point is 00:03:35 Well, keep in mind, He didn't employ leverage. He wasn't leveraged 4 to 1 or 20 to 1. And so it was basically a pure vanilla 30% net return, which is phenomenal. And if you take that relative to the S&P 500, for example, I mean, he just destroyed the market. He's got just a wonderful track record. And one of the best long investors that I know. And second, you know, he's just a phenomenal writer.

Starting point is 00:04:00 You talked about the book, You Can Be a Stock Market Genius. In my opinion, that's his best book. It's just wonderfully written, easy to understand. Anybody can really just grasp the concepts from that book and really apply it to their investing. He's also written other books. Another one that comes to mind is the little book that beats the market. That one is also a great book, really easy to understand. He's got a great sense of humor when you write.

Starting point is 00:04:23 And that book really details his current strategy now, which is buying companies that are cheap and good. So taking the Buffet approach. He did an extensive backtesting of the strategy. been shown to beat the SEP of 500 quite handily as well. And he's also a phenomenal teacher. If you look at his old Columbia lecture videos, they're really good. I mean, he just explains things so simply that you can just understand what he's saying, even though the subject matter, is actually quite complex.

Starting point is 00:04:52 Like, you know, if you watch the video on options, for example, I mean, you've really got to stop and think sometimes, but he really explains it very well. He's a great communicator, and he just breaks things down really simply. And another thing I really like about Joel Greenblatt is he's actually really good at backing investment managers. And so obviously he's a fun manager himself, but he's also, it seems like obviously we're not privy to the overall returns of all the horses that he's backed. But he's backed from famous managers. Michael Burry is one that comes to mind of the Big Short. Michael Burry just had a phenomenal record at Zion.

Starting point is 00:05:27 And I think he's still doing pretty well now. But Michael Burry is up there in terms of fame and one of the best. managers that he's ever backed. There's also a guy named Norbert Liu, a punch card capital. Norbert Lou is not as famous, but I think diehard value investors all know Norbert Liu, and he really takes the punch card approach that Buffett advocates to heart. I mean, Norbert Liu, if you just pull his 13F, or if you just look at the filings, he has really just a handful of positions, and so he really takes even Joel Greenblatt's concentration to heart. And last, you mentioned he was a good person, just a great human. He's done a lot of work in philanthropy, right?

Starting point is 00:06:03 A lot of work in education. And so I know he's on stuff with charter schools and whatnot. And so all these things added together, and he's got the record. He's a great writer, teacher, professor, great at backing managers, and also the philanthropy. I think he's just got the overall package. And so I really admire him as a fund manager. And he's up there in terms of the Mount Rushmore of great investors. Man, I'm not sure if I could have put it any better myself.

Starting point is 00:06:28 So thank you for that great introduction to Greenblatt. I think he's probably most well-known for the magic formula, but today, again, we're going to be discussing special situations, and he's also just a well-known value investor as well. So it's amazing how he can sort of apply these different flavors to the game of investing. For those in the audience who might not be familiar, special situation includes an unusual or a unique event that can potentially affect a company's value. This could be a spinoff, a merger, a bankruptcy, a restructuring. And sometimes this means a company is sort of going through a transformation period or sort of reinventing itself to some extent.

Starting point is 00:07:07 And investing can just be so interesting because there's a lot of second order thinking that needs to be applied to be a good investor. So when someone hears the term spinoff or bankruptcy or special situation, I think most people's initial gut reaction is that's going to be too complicated or that's just not a good investment and coincidentally, that in itself can make it interesting for somebody like Greenblatt or a savvy investor like yourself because the market might be overlooking the value that's there. So, Roger, how about you share, why does Greenblatt find special situations to be right, hunting grounds, maybe expand a little bit more on that? And to what extent he actually

Starting point is 00:07:48 utilize them in his investment approach? Yeah, you're absolutely right. So it's that ick factor, right? You just hear bankruptcy or you hear about a distressed company and you just say, oh, it's too complicated. It's not the situation I want to be. And you just shy away from that. And so I think just the key word is mispricings. Special situations, it's right punting grounds because it just naturally leads to mispricings. And that's the name of the game when you're a fund manager or a private investor.

Starting point is 00:08:16 You're looking for mispricings. And I don't know if you believe in EMT, the efficient market's hypothesis. But I think by and large, that's true. but it's definitely inefficient at times, and there are pockets and niches such as special situations where you can find mispricings. And if we just go back to the magic formula or just companies in general, you know, you have the 52 week high and a 52 week low. There's no way that a business valuation fluctuates as much as, you know, 50% or 100% in one year. It just doesn't happen. And so the markets in general are efficient, but they're not always properly valued

Starting point is 00:08:50 and priced. And so the special situations is a great place to look for mispricings. And a lot of it is you have what's called for selling or people who sell for non-economic reasons. And that's because institutions, they have mandates and they have very specific strategies. And so when they get a security or a CIA security or a company that falls outside of the mandate or the strategy, they just sell without asking questions because it can't be in their portfolio. And also, if you focus on the smaller situations like the microcap type situations that fall under these special situations umbrella of investments, you can really, really do well because I'm sure we'll get into some case studies. But if you just look at the bulk of Greenblatt's

Starting point is 00:09:34 case studies, all of them are small situations. They're all 500 million or billion dollars or less. We're not talking about 10 billion dollar situations or 30 billion dollars situations. I mean, maybe they are the size of the parent, but not for the spinoff or for the company that's being acquired, et cetera. And so to the extent that he uses them, he basically ran a special situations fund. And so 80% of his portfolio would be in special situations. And he would say that of that 80% or more, I mean, it was just concentrated in five, six, or eight situations. And so I would say, obviously, we don't have 13Fs to verify and, you know, I don't think he's made his letters public, but I think we can gather that the rest of that portfolio, the

Starting point is 00:10:20 20% or less, those are probably in risk ARP situations, in leaps, in options, in warrants, and preferred, and also just small cap value. He's got the magic formula now, and so I don't know if he had large positions or small cap value, but I would imagine he had small cap value names as well. But the bulk of portfolio was special situations, and he's known as a special situations investor as it pertains to the first two decades of Gotham Capital. Yeah, that's simply amazing, given how rare some of these great opportunities can be within the special situation space.

Starting point is 00:10:57 So let's dive into chapter three of the book. So in this chapter, Greenblatt covers spinoffs, partial spinoffs, and rights offerings. And I think spinoffs are quite simple to understand from a high level. So a spinoff is simply when a corporation takes a part of its business and then just simply separates it from the parent company and creates a new and independent company. And this can happen for a variety of reasons. Perhaps the management team wants to separate an unrelated business. Sometimes there's a bad business that's maybe dragging down the valuation of a good business

Starting point is 00:11:30 or maybe something as simple as like a strategic or an antitrust or just a regulatory issue. So it paves away for the business's strategy going forward. Green Black claims that both spin-offs and the parent company significantly outperform the market post that transaction. So one study that he referenced in the book looked at a 25-year time period and it found that stocks of spinoffs outperformed their industry peers and the S&P 500 by around 10% per year in the first three years of their independence. And then when he looks at the shares of the parent company post-spinoff, they outperformed

Starting point is 00:12:07 by 6% annually during that same three-year period. So of course, this doesn't mean we should go out and buy a basket of spinoffs, but it instead potentially tells us that it's maybe a good pond to go fishing in if that's something you're interested in. And of course, past performance doesn't mean it's going to continue into the future. But Greenblatt, as the time of the book, was quite convinced that it was a good pond to go fishing in. So what are your thoughts on this and how it might apply to investors today? Yeah, so I think Joel Greenblatt is, I think what he wrote about is still very relevant today. And I think results will continue.

Starting point is 00:12:44 I don't know if it's going to be 10%, but if you pick your spots out of the many spinouts that take place in a year, I think you can generate similar results relative to the market. And so the first thing is that spinoffs, they're going to continue to occur regularly because the same dynamics that happen today that are in the markets today, it's the same as 1985 or the early 2000s. Because what a spin-off does is that it leads to better market perception and appreciation of the separate businesses. And better valuations are definitely going to happen for the good company, but also for the bad business as well, when you separate out when you have the parent co and the spin co. And also tax considerations make spin-offs

Starting point is 00:13:30 possibly a better option than an outright sale, for example. And so, you know, these are just strategic options that management teams have at their disposal. And I think you touched on it as well, but it's a way to solve strategic issues, antitrust issues, regulatory issues. And when you solve these kind of problems, they lead to acquisitions and other transactions, because a lot of times antitrust issues or strategic problems prevent companies from doing deals. And so if you do that spin-off, you solve that problem, then the deal that they were actually thinking about gets done. And I also think the spinoff returns will continue because I always tell people and, you know,

Starting point is 00:14:09 my analysts that half of the game is just investor psychology, right? It's knowing market psychology. Half of it is economics. Half of it is doing models and working with the numbers and doing all the good reading and stuff, but the other half is market psychology. And so just in general, shareholders, when they receive the shares of spin-offs, they're just going to dump the shares because they were investing in the parent company. They don't necessarily want anything else.

Starting point is 00:14:35 And so when they get shares in their brokerage account that is for a small company that's in a really bad business, they're just going to sell. The same thing goes with institutions. They were invested in the multi-billion dollar company, not this little $300 million market cap situation. And also, you know, when that situation comes into the portfolio, again, if it doesn't fit their mandate and or size parameters, they just have to sell no matter what. And so again, you have this force selling, this non-economic

Starting point is 00:15:03 selling. It makes no sense. But for private investors and for enterprise investors who are looking for special situations, they can really step in and take advantage of those situations. And of course, you don't want to buy them all, right? But you have to analyze each and every one of them and then pick the ones that you have the most conviction in, the ones you can value, the ones that you can understand. And if you were a concentrated investor, put it on in size. on that note, you know, this is spin-off companies when they get spun off. They can also really focus on the business and just improving the business, turning around, because when they're kind of stuck with the parent, the parent company has to allocate resources to all the divisions. And so

Starting point is 00:15:43 it's just harder to unlock value. And so at the end of the day, spin-offs is just a way for the parent company to unlock shareholder value. So overall, I think spin-offs are still a great place to look. It's more competitive these days, but it's still a great place to look. You have the same market dynamics and market participants, and so it's still going to work. Yeah, I loved your points there. I mean, the market psychology aspect certainly makes a lot of sense, especially when you have these big institutions just automatically selling post-transaction. And then I just love that it's also an example of if you just simply do the work that other people aren't willing to do, you can be rewarded handsomely for the

Starting point is 00:16:25 that. I think many individual investors in the audience might be wondering, you know, how they can even find a special situation or how they can even find a spendoff in the first place. So, are there any resources that compile these types of events just so investors can simply identify them in the first place? There's not go-to resource, but there's definitely a lot out there. I mean, whatever you're looking at, the great thing about this day and age is that we have Google. For example, Joel Greenblatt did not have access to information. like we do now when he ran in Gotham, right? Because he was in 80s and 90s, in the early 2000s. I mean, even then, he didn't have the internet that we have today. It's just not the same. And so if you're looking for

Starting point is 00:17:07 spinoffs, you can just say, hey, go to Google and type in spinoff calendar and a bunch of results will come up and they'll actually give you a calendar with all the spinoffs. Or, you know, if you're interested in risk arbitrage, you know, you can just Google that and you'll have a calendar of situations to look at. But you were talking about doing your own work. And I actually do believe in that. So my recommendation to investors is to actually do your own work, right, to make your own spreadsheet, your own calendar, because the difference is if you do your own work, you search for press releases, you know, you have keyword alerts fed to you, you're actively searching for these situations yourself, you can actually internalize everything,

Starting point is 00:17:46 and you're more connected to the corporate events and transactions, as opposed to depending on 5, 10, or 20 resources to feed information to you, then there's a disconnect there. And so it is similar to the way that I train my investment analysts, for example. I always tell them, you need to build your own model, and what that means is it starts with putting in your own numbers. Don't import the numbers. So if you put in the numbers line by line, sell by sell, you're naturally going to be, quote-unquote, one with the numbers.

Starting point is 00:18:15 If you do that, if you go to the painstaking process of putting in all of the numbers, as opposed to importing it and having your model spit out a number at you, you're going to be able to see things in a different way because you process the numbers and information differently. It's like when you use pen and paper to take notes, as opposed to just typing it out, just the way that your brain encodes information, from the pen to paper, it's just a lot different. And so it's almost like seeing the matrix, right?

Starting point is 00:18:42 You're able to see the patterns within the patterns. And so there are a lot of resources out there, but my recommendation is if you have the time, if you are a really good investor, you're going to analyze information, just put together your own calendar or spreadsheet of all the situations like Greenblatt talks about, spin-offs, merger securities, risk arbitrage, post-bankruptcy exits, and all that good stuff. So let's talk about one of the case studies from the book. So this one is on host Marriott, and I'm reading through this case study in the book, and it's one of those examples where a bad business is essentially being separated from a good business.

Starting point is 00:19:21 I'm like, oh, this is wonderful. Green black can go and buy this good business. It's got all this toxic waste and separated from it. And it's like, oh, no, he's interested in the toxic waste, not the good business. So I just love that. The contrarian nature of looking for the bigger mispricings at play. So how about you talk through what even led this spinoff to take place for host Marriott? Absolutely.

Starting point is 00:19:43 So at the time, Marriott Corporation, they announced in October of 1992 that they were going to do a spinoff. And so at this time, what happened was there was a huge real estate downturn. So what ended up happening was there was just a bunch of hotels that they just could not sell. So they brought in a gentleman by the name of Stephen Bolandbach to solve the problem. And Stephen Bolandbach, he was an expert in the industry. I mean, he worked with the biggest companies in the space. And he worked with Holiday, Disney, Hilton, AIG. So Maria at the time had two businesses. The first was the hotel management business, which is the good business, where they generated consistent earnings from fees. And basically, they managed hotel properties

Starting point is 00:20:26 for others. Right. And so Marriott International was the parent company or the good portion of the spinoff. The other business involved, or it was the toxic waste that you mentioned. This business was the development and ownership of hotel properties. So this portion of the business would be called host Marriott or the Spino. With common sense, you can just think that with the development of hotels, owning the properties, it involves a lot of debt. And so Ballenbach's solution was to separate the two businesses so that shareholder value could be unlocked. Because with these two businesses muddled up together, the market couldn't really appreciate the valuation of one or both businesses. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:25:15 Let's see. It was Marriott International. That's the toxic waste. And I love the point that Creamblatt made. He looks at this. He's reading through these press releases and whatnot. He's just like, who in the world is going to want this thing with all this real estate that's really tough to sell, all this debt and whatnot? And then he walks through three designs.

Starting point is 00:25:34 desirable characteristics in a spinoff opportunity. So we can just walk through these one by one and as it applies to the Marriott International and host Marriott transaction here. So the first one he lists is institutions don't want it. So we've alluded to this before. Essentially they don't want it. And the reason they don't want it is for non-economic reasons. So they're just selling it just to get rid of it and not because they think it's overvalued

Starting point is 00:25:58 or anything. So they just want to sell their shares immediately and just move on with their strategy. and it might be in line with their mandate, as you mentioned. So talk more about this characteristic in how it applied in this case study here. Right. So we did talk about it before, but just to recap, it has to do with mandates and size constraints. And also, it may not have been the business that the institution wanted to begin. And oftentimes, the shareholders and the institutions just want the stock of the parent because that's what they invested in the first place. So as it applies to this case study,

Starting point is 00:26:32 host Marriott, which is the SpinCo, was actually only going to be 10 to 15% of the parent. And so at the time, the parent was a $2 billion market cap. So if you do the math there, that means the SpinCo was going to be just $200,300 million, which makes it a microcap. And just to recap again, Marriott International was the management business. It was debt-free, and 85% of the business evaluation was for Merriot International. and so institutions want that. That's the business that they want.

Starting point is 00:27:06 It's larger. It's a fantastic business. And so that's what they want. Host Marriott was the toxic waste with the unsellable hotels and the $2.5 billion in debt. Institutions, they don't want that and they don't want the unsellable properties. And the only person that wanted it at the time, it seems like, was Joel Greenblatt. That's what he wanted. And so that's where he looked.

Starting point is 00:27:27 That's a great point. I mean, most investors who are interested in the stock are going to be wanting access to the good business. And the second that toxic waste gets spun out, there'll be a lot of them are going to be interested in selling. So the second characteristic greenblatt list is that insiders won it, which is, of course, attractive because they're going to know the business better than anybody else. So he actually found this to be the most important area because it aligns the incentives

Starting point is 00:27:52 with the shareholders. So talk more about this one. Absolutely. So insider participation actually is the most important aspect. And he'll say that it's actually the first place that he looks when he dives into the public documents. So it's not, oh, you know, look at the numbers or whatever else that people like to look at. He actually goes straight to that section of the public document and he wants to know what this insider participation look like. Because the more stock extent of for new management, the better.

Starting point is 00:28:20 And so in this situation, Bolandbach was the guy that was going to run it. And this guy, you know, he's got a reputation, as we all do to maintain. So you're not going to want to be the CEO of an entity or company that's destined for failure, right? You don't want to jump on a sinking ship. And so I think if you looked at public documents, this backed it up because nearly 20% of the Spink Coast stock was going to be available for management and for employees. So the management team, the employees, they're incentivized to make this thing work. The second thing, which was the icing on the cake, was actually that.

Starting point is 00:28:54 the Marriott family, they would still own 25% of host after the spinoff. So the Marriott family was heavily invested in what was, quote, unquote, the toxic waste. So if you combine this two things together, the Marriott family's in it, this turnaround specialist or just this guy who was really good at financial engineering, whatever his skill set was that made himself successful, these two were on the same boat as shareholders. And so inside of participation, super important. All right. The third one is that a previously hidden investment opportunity is created or revealed. So this is where a lot of the work we mentioned earlier that investors need to dig a layer deeper

Starting point is 00:29:36 past some of the initial headlines and the initial filings. So Greenblatt explained that in the case of Host Marriott, there was tremendous leverage. So analysts expected that host stock was going to trade around $5 per share. We'll just use simply round numbers here. And the company would have somewhere around $25 per share in debt. So this makes the approximate value of the assets around $30 per share. If we were to just have a 15% move in the value of host assets, the stock could practically double because of that leverage that was at play there.

Starting point is 00:30:13 If the value of the assets were down 15%, then that would be absolutely detrimental to shareholders because of that leverage. So essentially, if the market was even slightly off the mark in the value of what the assets were worth, then this could lead to asymmetric upside for investors. And it turns out that tremendous leverage can be found in a lot of these spinoffs because it allows the good business to shed off what's undesirable and troublesome to get rid of. So host Marriott had all three of these characteristics.

Starting point is 00:30:41 So most institutions were likely to sell their shares without doing any further digging. Second, insiders had a vested interest in the company, and then the Marriott family also had a vested interest as well. And then tremendous leverage would magnify the returns if the assets turned out to be more attractive than what was initially anticipated. So in light of this, how did this all pan out for Greenblatt and for host Marriott? It worked out extremely well. He tripled his money within four months.

Starting point is 00:31:10 So you do the annualized return on that. Well, it was a huge return for his portfolio in his firm, Gotham, because he actually put almost 40% of the fund assets into host. So just imagine, you know, a private investor's $1 million portfolio, or if you were managing $30 billion, I mean 40% of the portfolio in this situation. But the way he'll rationalize it is that his downside was protected. Basically, he was just paying $4 for the debt-free assets. And he valued those assets conservatively at about $6.

Starting point is 00:31:42 So $6, $4. so you're getting about, you know, like a 33% margin of safety. And everything else was essentially a free option. So the subsidiary that was doing terribly, if that worked out, free option. If the unsellable hotels, they could be sold or monetized in some way, the free option. So basically, what he saw was it was a situation where he couldn't really lose money. And so he sized it up to 40% because that was a situation where basically what he looks for when he puts together a 40% position is that he's looking for situations where you can't lose money.

Starting point is 00:32:19 I think most investors get it wrong and they flip it the other way. They're looking for situations where they can make a lot of money. Well, the problem is, if you've got a 40% position and the situation doesn't work out because you improperly evaluated the downside and all the risks, you're actually going to have a very bad ear. And so long story short, the investment worked out very well. But I will note that he made it sound a lot simpler than it actually was. And so the execution of the trade was actually quite complicated. And so the way he structured the investment in a host actually involved preferred shares

Starting point is 00:32:57 and call options. And I think he must have involved in Common Stock and this because, you know, if you're putting 40% of your fund in something, it's not going to be all in options, right? And so the other thing I take away from this is that that's why you analyze all the securities are available to you after you analyze the situation. So when you've done your work on the situation, you don't just look at the common. You look at all the bonds that are trading. You look at all the prefers that are available. If they're available, you know, all the warrants, call options, etc. And you just take a big picture of you and you just think to yourself, what is the best way to

Starting point is 00:33:30 play this situation? And sometimes it's just a common stock. And so it's an easy investment. But sometimes maybe you do a Joel Greenblatt 40% type investment and you structure it around preferred and call options and the common. So this case study is just one of my favorites and it's fascinating because admittedly, if I see a lot of debt on the balance sheet like that, I also have an aversion to that, but it's a great reminder to myself to weigh through the documents and take a look. Don't look at leverage and the debt dissuade you from investing because then you're going to miss out on a triple in four months.

Starting point is 00:34:06 That's simply amazing to say the least. And it's also just impressive to see, you know, if you're implementing options and these are one year, two year options, or however long dated they are, you really need to do your homework because, you know, your downside is quite high if you end up being wrong. So let's transition to one of the other chapters here where green black covers risk arbitrage. So from a high level, this is also fairly simple to understand, I would say. So in its simplest form, this is when a company is set to get bought out at a predetermined price. and the stock might trade at a slight discount to the buyout price. So investors have the opportunity to essentially bet that the deal is going to close and they're able to capture that spread.

Starting point is 00:34:47 And of course, these types of deals are no sure thing. There's a chance that regulators stop it. Their financing issues are certain things are uncovered in the due diligence process. Greenblatt often references the Florida Cypress Gardens risk arbitrage trade. He bet on early on in his career. He's betting that the deal was going to go through. He's going to make a quick buck. But Cypress Gardens ended up falling into a sinkhole and ended up losing a lot of money

Starting point is 00:35:11 on that bet and probably a very humbling experience for someone like him early in his career. Warren Buffett's also someone that's ventured into risk arbitrage opportunities as well. So when he feels that the downside is just eliminated, that's when he gets certainly interested. So back in early 2022, Buffett participated in Microsoft and Activision Risk Arb play. And at Berkshire, they took roughly a $1 billion stake in Activision in early 2022. That was at $79 per share. And then the deal ended up closing in the fall of 2023. And Berkshire netted a 20% gain in around 18 months, which, you know, when the downside's

Starting point is 00:35:49 eliminated, that's something that's pretty attractive to Buffett. This certainly can feel like a low-hanging fruit, but there's always that uncertainty of what's going to happen before the deal closes. So to what extent do you see these types of opportunities and what makes these, attractive to give you or to give Greenblatt the certainty that they think it's going to close. Yeah, so just as an opportunity set, there will always be investment opportunities in this area. And, you know, if you just follow the papers, the Wall Street Journal, the Financial Times, whatever it may be, there's always MNA activity going on. And that's because risk arbitrage,

Starting point is 00:36:25 you know, MNA, it's really what keeps the grease going. You know, it keeps the entire cycle going. And what I mean by cycle is it's just on a big picture level, you know, you have a cheap company. That cheap company gets acquired in the M&A deal. And then the company and where industry gets overheated, everything's great, and then you have a bankruptcy. So after the bankruptcy gets done, there's a cheap company again. And that cheap company gets bought in an M&A deal. And then it repeats itself again, right? Cycles great.

Starting point is 00:36:56 Maybe it's in a commodity business. It gets to the peak. You got a bunch of debt going. on bankruptcy. Exist bankruptcy becomes a cheap stock again. And so it's this virtuous cycle that keeps going and MNA is at the center of it all. And so it's like the Lion King, the circle of life. That's just how the markets and companies operate. However, I will say that it's gotten very difficult over the years because of increased competition. There are a lot of funds doing risk arm. Spreads have come down as well. You know, it's not the heyday of the 70s and 80s where you

Starting point is 00:37:29 could just make a killing and risk arbitrage. It's different now. And there are risks, as you mentioned. And the risks, as you touched upon, include antitrust risk, financing risk, and you've also got the whole position sizing on the portfolio management side of things. And just in recent years, for example, the government has gotten very involved in some very high profiled situations involving antitrust issues. And so if that deal falls through and you size the too big, you're going to lose a lot of money. And you alluded to the situation with Joel Greenblatt, I mean, that probably literally fell into a sinkhole. And so how could you possibly anticipate something falling through a sinkhole when you're

Starting point is 00:38:07 doing your risk arm calculation on the spread and, you know, you're reading all these public filings and court dock and so whatnot? You're not going to think about a sinkhole. It's just, you know, way out in the left field, but you have to account for that. And so for that reason, that's why Joel Greenblatt actually recommends merger securities over risk arbitrage. And merger securities are, well, first. it's just a safer way to make money than RiskGARB.

Starting point is 00:38:32 And so what Merger Securities are, it's forms of payment that get in on deals. And so typically deals are done, right? The acquirer is making a deal for the target. And the payment is typically cash and or stock. It's typically not preferred or warrants or bonds, right? It's typically just cash and or stock. So it goes back to the whole dynamics of the spinoffs and all the other types of special situations, when people get securities that they weren't anticipating or they don't want or that

Starting point is 00:39:02 doesn't fall within their mandate, they're just going to sell it. So imagine you own the stock in the acquiring company. All of a sudden, the deal closes and you've got, say, preferreds. Maybe you're an unsophisticated investor. You don't even know what prefers are. Right? It's just automatic. And so just going back to the overall opportunity, it's definitely there, but you have to look. and especially with merger securities because the Wall Street Journal, the Financial Times, and New York Times, whatever is your publication of choice, they're not going to feature merger securities because it's so boring, nobody's going to talk about those things. And so you have to follow the deals and stay on top of the information because eventually

Starting point is 00:39:43 they'll disclose like, hey, you know, we're adding this in or we're throwing this into the deal structure. So it's interesting that you mentioned that Greenblatt was more interested. in the merger arbitrage than the risk arbitrage I mentioned. And he actually mentioned in his first job out of college, he worked in risks arbitrage and he figured out that he didn't really like the risk reward. So you might make, say, 5% or 10% in three months. But if you happen to be wrong, you might lose 20, 30, 40%. At times, it can be just not an attractive risk reward where you're really completely eliminating the downside. But if you're entering this arena, you want to be pretty sure that it goes

Starting point is 00:40:22 through. And another thought that kind of comes to mind is that someone like Greenblatt, his time and his energy and his attention, it's very scarce. So to be able to go through all the filings on a merger arbitrage or risk arbitrage, you need to be sure you're spending your time in the right place. And if something offers a 5% jump in three months, you know, is it really worth the time? This is a question I would sort of be asking if I was in his shoes. So you actually highlighted to me another recent risk arbitrage play that you participated in, I believe, is called Loxetan. And this was a Hong Kong listed luxury company. It was taken private by a French billionaire.

Starting point is 00:41:02 So the stock was trading at around 32 Hong Kong dollars a few months before it was taken private at 34 Hong Kong dollars representing around a 6% spread. How about you talk more about this, since it's a more recent example and something that you participated in? So I first read about this in the Financial Times, and more specifically, it was the Lex column. And I know people don't really read newspapers these days, but I still find reading newspapers to be a great way of generating ideas. It could be the Financial Times, it could be the Wall Street Journal.

Starting point is 00:41:34 But in this case, it was the Lex column. And for those who don't know, the Lex column is just a column in the back of the paper that has little stock pitches. And, you know, Michael Price once quipped that he could run a fun. just based on the Lex column alone. So that gives you an idea of the quality of companies that are written about in the Lex column. And so just the first thing that jumped out was I was actually familiar with Loxetan. And so they're in L.A. here and they're in all the malls.

Starting point is 00:42:01 They're in all the outlets. And they're just everywhere, right? The company operates in 90 countries worldwide. And they have more than 3,000 retail outlets and over 1,300 stores, I believe. And also, if you have a friend, a colleague, a girlfriend, or a wife, you've probably bought something from there as a gift. And so I think one of their most popular products is like a hand cream and they've got it, you know, just formulated down to the tea and it's supposed to just work really well. But you've got lotions, you have creams, oils,

Starting point is 00:42:30 all kinds of beauty and cosmetic products. So the article went on to say how they were going to take the company private and they wanted to conduct a tender offer to buy back all the outstanding shares. And so the offer was for $34 per share, Hong Kong. And so, So let's just use 32 as the example, because you can actually buy for a little bit below 32 and also obviously a bit above 32 at the time that this occurred. And so you're saying, okay, a $2 spread, it's not a lot, right? It's like a 6.25% return or something quote-unquote poultry like that. But if you annualize it out based on when you buy it to the closing date, you're looking at

Starting point is 00:43:08 a double-digit return, especially if it closes in three months or six months, right? So 6% becomes a double-digit return. And so depending on your analysis, if it's relatively safe and you don't think the deal is going to fall through, it gives your portfolio something to do rather than have it sit in cash. Which, as you know, cash does nothing and it's a better alternative to treasuries. Because treasuries, depending on what duration you bought it for, it could be like a 5% yield or something. So if you're getting a double-digit return, you know, the opportunity cost is obviously better if you invest in this situation. Right, so, Renal Gaggart, he was the chairman of Lausaton, and he's also a billionaire, actually, but he owned about 73% of the shares, and so he was the majority owner.

Starting point is 00:43:51 And so it's safe to say, and just with common sense, if you're the majority owner and you're pushing for this, it's likely that the deal is going through, right, unless you just have second thoughts and you just back out of the deal. So that part of the equation was pretty much solved. And in terms of financing, no issues there. the CFI, they raised $2 billion to buy out the minority shareholders via this deal. And so, 1.6 billion came from Blackstone and Goldman Sachs, and the other 400 million came from the CACIB. In my mind, the financing aspect is also pretty secure. I mean, if it's coming from

Starting point is 00:44:23 Blackstone and Goldman Sachs, they've got the financing done. And so why did he want to get this deal done? And the motivation for getting deals done is actually very important, both in this situation and also for any risk our deal. And so they just made a bad decision with an acquisition, and they overpaid and, you know, they didn't get the financing right. They took on too much debt. But that doesn't mean they're a bad business. They just made a bad strategic move. And so that could be one reason.

Starting point is 00:44:48 And they actually cited that the Hongse Index was down like 45% over the past five years and also down 46% from its peak in 2021. And it makes sense given all that's going on in the Chinese and Hong Kong market. Anyway, for all intents and purposes, it looked like a slam dunk. Everything was in place. And so the downside is, of course, the deal not going through. But of course, tender offers tend to go through more often than not. It's not a sure thing, but it's definitely not a risk-arps situation

Starting point is 00:45:17 where you have potentially an antitrust issue or a regulatory issue, etc. So in my mind, the worst-case scenario was that I would be stuck with an average to above-average business, but a business with a recognizable brand that was trading for about 15 times EV-E beda and about 70 times EVEBEDA. EBIT. And so while I would like to pay lower multiples in the M&A world, just multiples in general encompassing all types of businesses across all industries, those multiples are fine. And the business was also generating free cash flow. And the revenue cater for the last three years was 18%. So, you know, that's pretty decent. And the return on the asset capital was over 15%. So, you know,

Starting point is 00:45:58 you have the good and cheap aspects of Joe Greenblatt's magic formula here. And so basically, my thinking was there are worst businesses to be stuck with if the tender offer doesn't go through. So how did it work out? Pretty well. It took only five months from the initial buy to the close. They actually completed the delisting on October 15th. And so assuming you bought in May, you know, for $32, and you could have gotten it for less than $32. But assume $32, your annualized return would have been about 15.7%.

Starting point is 00:46:30 So 15.7% to put in a deal just to end for you just to sit. and wait for five months, and presumably this portion of your portfolio was in cash anyway. So all in all, it worked out really well. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. Vanta automates your compliance process and brings compliance, risk, and customer trust

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Starting point is 00:50:06 And how would you explain why the spread existed? Why did the opportunity exist? That's a good question. So I think a lot of the times these spreads exist because there is the element of the deal not closing. And so in an efficient market, the shares should have traded the 34 on the day of announcement. But from the day of announcement to the close, a lot of things can happen. And so, for whatever reason, market participants as a whole thought that the tender offer might not have been completed. And, you know, there was a threshold.

Starting point is 00:50:40 I believe the threshold was something like 90% or something like that. And so there was a threshold that they had to reach for the tender offer and the whole deal to be completed. And so it's kind of like a drill green bus says in general. He doesn't know why businesses are undervalue. He doesn't know why you see situations like, these situations in general, why they exist. All he knows is that they exist. And if you do the work, you do the valuation work, and there's a gap to intrinsic value, and you put on the

Starting point is 00:51:05 trade in size, you're going to do very well. Yeah, I think there's certainly something to be said around just things simply being uncertain. I mean, you think something might happen, but you never know for sure. So that certainly seems like a logical reason to me, especially with how many of these could happen in theory within a year. So let's transition here to the chapter on on bankruptcies and reorganizations. So unlike spinoffs, bankruptcies are actually an area where investors should generally steer clear just to the base rates of success for shareholders and the amount of complexity that's involved in these.

Starting point is 00:51:40 I think most investors would, of course, just steer clear anyways. I don't think they need to hear me to tell them. And I think that would certainly be a wide decision in most cases. And many times with bankruptcies, the equity holders can, since they're at the bottom of the totem pole, they can be totally wiped out since the bondholders and other parties are above the equity holders prior to the bankruptcy and who gets paid. So why is this even a chapter in Greenblatt's book? And what makes for the rare case in that investors might be interested in something like this? You're absolutely right. So private investors and small funds in general should steer clear

Starting point is 00:52:16 of companies in bankruptcy or those that are about to file for bankruptcy. Because first of all, when a company is in those stages, vulture investors and distressed-ed funds, they're going to have an advantage over you due to the sheer size as well as their legal expertise. So you're already at a disadvantage from the get-go. You see this situation, but there are professionals out there that is their domain. And so you're already at a huge disadvantage. And so what Greenblatt recommends and what I recommend is to analyze post-bankruptcy exits instead. Post-bankruptcy exits are easy to understand because all the toxic waste has, has been dealt with, right? And you've got a disclosure statement. And once they exit bankruptcy,

Starting point is 00:52:57 you just left analyzing the common stock again. Like most special situations, you're just really looking at the common stock to start with. And so it's a much easier analysis. And you don't need to go to law school and you don't need to be a Voltra investor to do well with post-bankruptcy exits. And so with that being said, it's still a very tricky area. And so the best way is to be extremely selective because companies followed bankruptcy for a reason. There's a reason why they got there in the first place. So one way to approach post-bankruptcy exit is to just invest in the good businesses. And so you might be wondering, like, how is a good business even possible if they're a

Starting point is 00:53:35 post-bankruptcy exit? Well, there are a few things that could have happened, actually. The first is they may have been over-leverage due to a takeover that they did or via an LBO. And so they just made a bad decision with an acquisition and they overpaid and they didn't get the financing right. They took on too much debt. The second is that they had a short-term, you know, operating or performance issue. So maybe they missed a quarter or two or maybe they had a bad year or they actually had a operational issue within the business and they couldn't pay the debt. Because if you have debt, you have to service that debt. You have to make the payments.

Starting point is 00:54:09 And maybe they couldn't make the payments. And so they had to file bankruptcy to handle that issue. Another interesting reason why a good business could end up in bankruptcy is, you know, there are product liability lawsuits, for example. So maybe the product liability lawsuit was really bad and they felt that, oh, you know, we were probably going to lose this or the outcome is such that the verdict, the amount is not something that we can pay. Bankruptcy. So bankruptcy is one way to protect yourself from product liability lawsuits. And of course, you don't have to stick with good businesses if you think you're really smart. You can absolutely look at the devalue situations. You can look at the levered businesses.

Starting point is 00:54:45 But you're really just making the game more complicated than it should be. And it's just, it's a difficult judgment call to make. You're looking at bad businesses, at levered businesses. But if it's got that too hard pile, I would put post-bankruptcy exits that fall in those categories in the too hard pile. But talking about host, maybe you got to look sometimes. Yeah, I'm reminded. I recently interviewed an investor named Derek Pellecki.

Starting point is 00:55:10 And during the great financial crisis, he bought it. into general growth properties, which was being walked through their bankruptcy process by Bill Ackman. Pellecki made it a 1% position in his portfolio, and it ended up being a 20-bagger for him. So a big, big winner there. I would think with many of these bankruptcies, the post-bankruptcy company, I think over the longer term, especially when we get to this next case study, we're going to walk through. It tends to not just be a great company to own in a lot of cases, but that first year or two,

Starting point is 00:55:40 it still might be just severely undervalued when you look at the assets and whatnot. I was curious to get your take as a long-term value investor. How do you think about missed pricing's actually coming into fruition when you might be holding something that isn't all that great of a business? Is it a case where generally you're just avoiding bad companies altogether that might be melting ice cubes and have a lot of debt or whatnot? Or is this a case where the mispricing can just be so large that it's hard not to get involved with it?

Starting point is 00:56:11 So I think this is a problem that most, if not all value investors struggle with. You've got the melting ice cube. You've got a business in the secular decline, but valuation makes sense and it's at a low multiple. And so I would take the greenblower approach. And these types of businesses, you have to take more of a trading mentality than a, you know, it's going to be a five, 10 year, forever type investment, right? It's like more of a two to three year investment, but you're thinking, hey, maybe if things

Starting point is 00:56:40 go south, I'm out. So you can't get into these types of investments and say, I will hold it for a decade or it's going to be a buy and hold forever like Warren Buffett would. Keep in mind, when Buffett says buy and hold forever, that's for the highest quality businesses out there, right? If you're talking about these types of businesses, not so much. And so that's why it's actually best to identify catalysts, because catalysts will get the attention of market participants. And catalysts can come in different forms, right? It could be a new product or service. It could be a management change, you know, CEO, CFO, you replace them. Somebody really good comes in. Maybe they're doing restructuring, they're doing asset sales, maybe they're buying and acquiring

Starting point is 00:57:19 companies, maybe they've gotten new contracts, just anything that's on the horizon, you know, over the next one, two, three years. And then once you've got the press releases out, you probably have improved operating performance. That will get the attention of investors, right? And it also helps to have a strong balance sheet. So ideally, you have a lot of cash. And and you have minimal to no debt. Why? Because if you have a strong balance sheet, you also become a prime takeover candidate. If you're a buyout firm, you would rather take over companies that have a very clean balance sheet. And so these are ways that you can get around the melting ice cube issue, right? There just needs to be something that's going to happen over the next two

Starting point is 00:58:01 to three years where value can actually be realized. Because there are a lot of companies, for example, like we're not talking about devalue here, but net net net. There's a reason why net nets stay net nets. It's because they're just typically bad businesses in average to below average industries that don't do anything spectacular. And that's why they stay in net net territory. And for people who don't know what net debts are, they're basically companies trading at liquidation value or thereabouts.

Starting point is 00:58:29 So the last case study I wanted to touch on today was Kmart, which was quite an interesting special situation. So they filed for bankruptcy in 2002, and then they went through some corporate restructions. performing a spin-off. It seems like they just went through this whole playbook of the book here. So prior to the interview, you had told me that Eddie Lampert, he put it on a masterclass in restructuring Kmart and maximizing shareholder value with the assets they had. And I believe you studied or researched this quite intensely back when you were in school. So I wanted to give you the chance just to talk through this one and share some of your learnings from it.

Starting point is 00:59:04 Yeah, so you mentioned school. So this deal actually has a special place in my heart. So I took advanced bankruptcy in law school. And it was just one of my favorite classes during my time there. And it makes sense. I'm an investor, special situations. It all makes sense. So I actually used this case study. But at the time, not just, you know, oh, I want to get an A in the class, but it was mostly just to learn more about the stressed debt investing, given my interest. But I also really liked Eddie Lampert's story, his track record and just his concentrated investment style. And so I ended up using Kmart as the case study. And lo and behold, I actually got the top grade in the class. But it was actually kind of a shocker because, get this, my professor was

Starting point is 00:59:44 actually on the Kmart case when she was a partner at Skad and ARPS. And so for me, it was like, I was getting the stamp of approval from an expert who actually lived the situation in real time. So some background for people who don't even know what Kmart is, which is actually entirely possible because the last Kmart standing is actually in Miami, like the very last one. And it's not even a full-side store. And there are four other ones in U.S. territories, I believe, one in Guam, and three in the Virgin Islands. So the reason why people may not have heard about Kmart, it's the younger folks, Kmart at its peak, had around 2,500 stores. So Kmart, they were massive. You know, they were the retailer. So just going back, big picture, Sebastian Kresky and John McCrory,

Starting point is 01:00:28 they formed their partnership in 1897 to open five and dime stores, so discount stores. But this partnership dissolved in 1912, and the SS Creskesk Company was formed, right? And so the first Kmart opened in 1962, and because 95% of sales came from Kmart's, in 1977, they changed the name to Kmart Corporation. But going back to cycles, Kmart was doing very well, so between, you know, 1984 and 1992, they diversified. They got into Walden Book Company, Home Centers of America, Sports Authority, Office Max, and Borders. So basically, stuff that's not their core competence.

Starting point is 01:01:07 And so what ended up happening? As you can imagine, they had to start selling these non-core assets. And they had to close over 200 stores between 1994 and 1995. But even after they did all that, they still required $5 billion in refinancing. And so in today's dollars, that's $10 billion. I mean, that's a sizable chunk of change. So, you know, as you said, came with declared bankruptcy in 2002. And a lot of that was because they faced stiff competition from Walmart and Target.

Starting point is 01:01:35 And Amazon at the time was on the rise in e-commerce. Not where they are today, but they were still a player. And so in comes Eddie Lampert. So Eddie Lampert was touted as the next to Warren Buffett. And I swear, this is like the Warren Buffett curse. You never want to be touted as the next Warren Buffett. But here's this guy, you know, and he's got a pristine resume, right? Yale graduate, Summa Cum Laude.

Starting point is 01:01:57 He goes on to work at the Risk Ard Desk at Goldman Sachs. So you worked for Robert Rubin. And the who's who of the finance world went through the risk guard desk. And they all went on to start famous hedge funds. And so when he was relatively young, like I think in his early 20s or late 20s, he's not even 30, right? He was backed by Richard Rainwater, who is also a very, probably one of the best investors of all time as well, Richard Rainwater.

Starting point is 01:02:19 But he backed Eddie Lampert with $28 million. And so he started ESL investments in 1988. And so, you know, this hedge fund, you know, Eddie Lampert, my goodness, if you look at this roster of investors, you know, he invests for a lot of investors. You know, he invests for David Geffen, Michael Dell, George Soros, the Ziff brothers, the Tish family. I mean, you name it. You know, just all-star roster, right? And his AUM got to as high as $16 billion or something like that in 2006.

Starting point is 01:02:43 And his returns up until around 2004 were really good. Joe Greenblatt type numbers, 29% annualized. So going back to the Kmart situation, so leading up to it, Q4 of 2001, right? Disappointing fourth quarter sales and earnings, having some trouble. In November of 2001, Standard Impores downgrades their debt to BB. In December, Moody's also downgrades their unsecured debt to junk status, BA2. And then in January, Prudential downgrades them from hold to sell. And you know, like, when an analyst downgrades you from hold to sell, you know something's in trouble because everything's a buy or a hold in the banking world.

Starting point is 01:03:19 And so if you get downgraded to a sell, there's something seriously wrong. Right. And so in January, they're unable to come up from money for surety bonds. you know, things start to go sideways, or unable to pay, you know, Fleming, for example, which was their major food distributor and grocery wholesaler at the time, and they file for Chapter 11 bankruptcy. Right.

Starting point is 01:03:37 So let's get into what Eddie Lampert does. So what he's doing is what we would call vulture investing. And so vulture investing is actually a form of activist investing. It's where you influence management, you gain control, you strategically purchase and hold significant percentages of various classes of outstanding debt. And just as in the side, it's probably best to buy probably more than the third of the claims in the class because the class is deemed to have accepted the plan if at least the majority of the claim holders and, you know, at least two thirds vote for the plan. So you just want to buy as much as possible.

Starting point is 01:04:11 And the overall goal, like all investing, is to exit by selling these securities at a higher price. But really, how you really make money is by converting the debt that you own to cash in equity. So what does Eddie Lamper do? Eddie Lamper buys a bunch of claims, right? So let's go down the list. He bought 382 million of pre-petition lender claims, about $1.8 billion in pre-petition note claims, $16.1 million in trade vendor, least rejection claims, and trust-preferred obligations. So all in all, the total investment, which was accumulated overtime, $2.3 billion. And the Third Avenue was also involved. So Third Avenue, Marty Whitman, they're also very well regarded in the distressed debt and just value

Starting point is 01:04:51 investing space. And so Marty also bought 99 million in pre-petitioned no claims and 79 million in TradeVender lease rejection claims. And he was basically in support of what Eddie Lamper was doing. So he's got this big chunk of securities, right? What does he do? During bankruptcy proceedings, he gets appointed as chairman and director of Kmart, Eddie Lampert. And he also appoints six of the nine Kmart board members. And he also set on the FIC, which is the financial institutions committee. And so here's where it gets really interesting, right? Because it all comes down to mispricings and valuation. I have no idea how these bankers came up with these values because they were ridiculous, right? But the estimated value of Kmart. They were saying it was worth 2.2 to 3 billion,

Starting point is 01:05:36 using cop analysis and DCFs. And so basically they were saying that Kmart was worth maybe $875 a share to $17.50 to share thereabouts. But the valuation is completely wrong. I mean, And if you just use common sense, if you just actually look at the filings, they use discount rates of 20 to 25%. 20 to 25% is quite excessive. It's a bit high for my tastes, right? Especially if you're trying to pinpoint the exact valuation of a business. And they value the PPNE at just 10 million.

Starting point is 01:06:06 10 million. And I'll get to why that's such an egregious mispricing. And then the liquidation analysis was for something like 4.6 million. and they were saying that the estimated recovery range was just 13 to 19%. So maybe none of that makes sense to the casual listener, but basically this was a classic misprice situation. The business and the assets were left for dead. And so here's why that valuation is completely wrong.

Starting point is 01:06:31 And it was not just wrong, but it was just way off the reservation. So if you just use 2004 as an example when they made transactions and they sold their existing stores, if you use those comps and those transactions to value Kmart's portfolio, that portfolio is actually worth something like 18 billion, 18 billion with a B versus what I just said, 10 million, 5 million. It was just one of the most mispriced situations that I've ever seen. And so I guess the lesson is take large positions in various classes of debt and use that influence and size to influence, you know, the outcome of the bankruptcy process.

Starting point is 01:07:09 So how did this work out? Kmarti emerged from bankruptcy in May of 2003, but get this. It seems like you can make a lot of money in, you know, security and unsecured and claims and bank debt and stuff like that. But the post-bankruptcy equity here, the stock went from $15 to $109, 15 to $109. That's a 7x in a matter of 18 months. So if you annualize that out, that's a 229% return. So what I got from this was even if you aren't Eddie Lampert,

Starting point is 01:07:39 and you don't have billions of assets under management and an army of lawyers at your disposal, you can still win. You could have profited very handsomely just by buying Kmart stock straight out of bankruptcy, and you would have your 230 percent return. I love that story. I love how personal it was to you back in law school in those bankruptcy classes. I wanted to jump here to chat more about a bit about your investing approach. So Greenblatt's book, it covers many different types of special situations.

Starting point is 01:08:12 We've talked about many of them here today. Based on your experience in managing money professionally, which of these types of situations are most interesting to you? And why does this type of situation seem to be most appealing? So they're actually all interesting, but it depends on the opportunity set and it depends on which looks most attractive at the time. So the easy answer is I really like spinoffs, because there's always a consistent calendar of those happening.

Starting point is 01:08:43 And I really like risk garb and tender offers. But the problem I have with those, and I think you alluded to it as well, is that you can't take large positions in the portfolio. I mean, you would be an idiot if you size your risk-arb trade at 10 or 20% of your portfolio, because that deal could very much blow up in your face.

Starting point is 01:09:01 But I always keep going back there if I have cash position. And going back to the merger securities, those aren't always available. Cash and stock are usually a typical forms of payment. But if there are merger securities out there and I like the situation, I would be happy to put on a sizable position in those as well. Post-bankruptcy equities are definitely interesting. As I just talked about Kmart, you know, you can potentially have very explosive returns. But, you know, the thing with post-bankruptcy exits is that bankruptcies in general, right,

Starting point is 01:09:30 are driven by where we are in the economic cycle, and so they may not always be available to you. However, you can find a situation like Kmart every once in a while, right? Or Toys R Us, for example. Toys R Us actually is no longer around, right? But that was also a spinoff, and it was 100X. So you just have a bunch of post-bankruptcy exits that just did phenomenally well. Obviously, for every Kmart and Toys R Us, you'll have a complete bus. But that's why you have to pick your spots and concentrate, as Joel Greenbaugh advocates.

Starting point is 01:09:57 And one thing we didn't talk about as much, but restructurings and divestrustrings, and divestitures, those are actually pretty interesting as well because they're always happening. Companies are always looking to restructure. They're always looking to sell off assets. And so when you get a situation where there are hidden assets or things are sold off and you unmask the value of the good business, those situations can also provide excellent returns. Amazing. I'm reminded of when Joel Greenblatt was on our show with William Green on the Richer Happier Podcast. One of the points that he made that I really liked was that that he doesn't know most things. He only knows a few things really well and focuses his attention

Starting point is 01:10:35 on that. So William asked him about some specific subject and he's just happy to say, I honestly don't know, but I'm happy to share my opinion in light of that. So in the way William responded to that is to simply stick to playing games that you're equipped to win. So also during that conversation, Greenblatt also stated that he doesn't think that having most of your portfolio in six to eight companies is too concentrated. As long as you know, and understand those businesses really well. So it's funny when you look at the stock market and you tell someone you own six or eight or ten companies, they say you're quite concentrated.

Starting point is 01:11:08 But if you were in, say, the town you live in and you told someone you owned eight businesses in different industries, you owned a car wash, you owned a restaurant, you know, and all these businesses, you know them well, and you think they're good companies and they seem to be pretty stable over time, then I don't think most people consider that too crazy, which is quite interesting because in some ways it's owning businesses, right? you know, that's how we think about it as value investors. So I'd be curious to get your thoughts on to what extent you like to apply Greenblatt's philosophy of concentration. Yeah, I believe every word he says about concentration. So at R of Capital, we typically have five to ten core

Starting point is 01:11:47 holdings and we size up on our positions. And so our starter position is typically a five percent minimum position and then 10 percent is baseline. And, you know, with more conviction and or favorable price action, we'll take it up to 15 or 20%. And generally, we don't really like having positions be more than 20 or 25% at cost, but I'm willing to do it if the downside is absolutely protected. I haven't done a 40% position like Joel Greenblatt did, but perhaps someday, if I see a situation. So what we do really matches up with what he says about, you know, five to eight investments making up 80% of the portfolio. Our top five or 10, definitely the first 80% of the portfolio. and the rest is cash, special situations, and maybe shorts.

Starting point is 01:12:32 And the smaller positions that we have outside of those five or ten, you know, core holdings, those are situations where we can't take a 5% plus position, right? And so because of the elevated risk. And so that would be like a leap or a call option. It could be a short. It could be a risk guard position, just situations where you can't go past 5%, especially when it comes to shorts and also options. Awesome. Well, thanks so much, Roger. I mean, you certainly did your homework in revisiting many of these case studies and revisiting just Greenblatt's book. I mean, what a fond conversation. And I can't wait for the listeners to get a hold of this one. So before I let you go, how can the audience learn more about you if they'd like and get connected?

Starting point is 01:13:14 Yeah, so my website, RFcapitalmanagement.com is the best way to get in contact. You can fill out the form submission box and we can connect that way. We also post our recent investment. letters, interviews, media appearances like this one. So everything will be linked to that website, so it's the best way. I'm also on X. I don't post that often, but I am on X. My handle is RGR, F-A-N. I'm also LinkedIn. You can just search Roger Fan.

Starting point is 01:13:39 I'm there. And I think in the coming months, I'll also be publishing on Substack. So we'll be posting research notes and also blog posts pertaining to, you know, investment approaches and philosophies, et cetera. And so I'll definitely link those blog posts through the website. side, X and LinkedIn. Wonderful. Well, I'll get that linked in the show notes as well.

Starting point is 01:13:59 So, Roger, thanks so much again. I really appreciate the opportunity. This is really fun. Same. It was fantastic chatting with you about Joel Greenblatt, special situations, and just the value investing in general. So thanks again. It was a pleasure.

Starting point is 01:14:12 Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to the investorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network.

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We Study Billionaires - The Investor’s Podcast Network - TIP677: You Can Be a Stock Market Genius w/ Roger Fan

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