Stig Brodersen  3:49  

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 will take you to the next level.

Preston Pysh  4:03  

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 gonna 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 and the title of this chapter is “Follow the yellow brick road and then *inaudible 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. 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 different sectors. 

But if you have eight stocks, he has mathematically proven… He talks a little bit about this in the book that you have really minimize 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. 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 return you could expect to get from the S&P 500. 

So I don’t know that he’s trying to promote somebody to not use an ETF or go after 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, as opposed to having too many in the basket.

Stig Brodersen  5:57  

Yeah, I think that the reason why he’s only talking about eight and he might even say like six to eight. I was pretty surprised whenever I read that the first time because he has a background in academics and academia. You *inaudible really say that you would have around 20 stocks before, what we call the market risk is more or less gone. When we’re talking about something like market risk or systemic risk, we primarily talking about volatility. 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 not 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 spin off 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 topics that you could look at. So at least that’s my take when he was talking about numbers that were so low.

Preston Pysh  7:07  

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 will 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 thing we’ve talked about on our show in the past, but he really emphasizes that here in the first chapter. 

So let’s go on to the second chapter. 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. 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 strategy. 

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. His analysis before he made a decision and how it actually came to fruition because he had these opinions upfront. 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 because this is a lot of homework and a lot of reading.

Stig Brodersen  8:39  

I love what you said about why you should do your own homework. The first argument he says is you don’t have any other choice. This is something you really cannot outsource. The second thing is that you shouldn’t be paid to take big risk. You should be paid to do your homework. I really love that analogy in terms of how do you measure how much time you are spending and what you’re basically investing in, because when he is making 50%, and he did that with a small amount of capital, that’s something we addressed a few times, it’s easier to do, say 50% if you have, you know, a million dollars, than if you have $10 billion. But he actually made those when he was running Gotham Capital at the very beginning, he had some great returns. And reading this book, I’m sure it is not because he took big risks, and in a way, it’s because he was really, really paid to do his homework.

Preston Pysh  9:29  

The next thing that he talks about in the second chapter is pick your spots. I really liked this because there’s this spot that I think a lot of people have, 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.” There’s another quote that Buffett says, “There are no cold strikes on Wall Street,” or in other words, wait for your pitch, and that’s what he’s getting at. 

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. I think that’s the point that he’s trying to make here.

Stig Brodersen  10:18  

Yeah and continuing that, Preston, he’s saying that you should look down, not up when you’re looking at stock picks. 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 intrinsic value. Don’t worry, the upside will take care of itself.

Preston Pysh  10:44  

So for me on that point, look down, not up. I think it’s… 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. I forget what it was it was some interview with Mohnish Pabrai, and they were asking him where do you go to find new stock ideas. He says, “One of 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. 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 are like, “Wow, Apple’s doing really good.” So then they go and buy it. 

But what I think they’re failing to realize is this whole idea of mean reversion. 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. 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 at 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 of look down, not up, I really see that is what he’s talking about here.

Stig Brodersen  12:10  

I really love that you addressed the conversation we have with Mohnish because one of the things that both Mohnish and Joel Greenblatt are talking about this book is that you can’t trust analysts. And this is one of the basics that you really need to understand. The reason why I bring up Mohnish is that he told us a story about he had a visit from an analyst from the big investment banks. He wanted Mohnish’s opinion about railroads. And Mohnish said, “Well, you know, there’s some great railroads, but they’re not priced at an attractive level.” And then the analysts said, “Well, that’s the only industry I’m covering. And I need to suggest to investors which one they should invest in.” 

And when Mohnosh said, “Well, can you just tell them, none of them, because they’re not priced in the good level.” And what Mohnish told us was, he just found it so sad because there is basically the only four railroads we can analyze. What are you gonna 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 5-10 years? 

Preston Pysh  13:12  

They all suck. 

Stig Brodersen  13:13  

What are you gonna do?

Preston Pysh  13:14  

Yeah exactly. Well, and I think Mohnish was also talking to the person’s intellectual level, you know, some of these guys are Harvard MBAs or whatever. They’re stepping into these roles and then it was a really interesting conversation. But fantastic point there, Stig. 

So real fast, to wrap up the 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 that which is what Greenblatt really talks about in this book. There’s plenty of different ways that you can make money. Look at Ed Thorp, 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 know your personality, and then match that personality with the type of investing style that really makes sense to you the most. So that’s something that he kind of concludes the chapter with. Then he finishes the chapter. The very last thing 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. 

So going into chapter three, the title of this chapter is “Spin offs, partial spin offs, 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 it  is a treasure trove of information, if you are interested in learning about some different approaches and places to look. 

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 a 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 spin off. 

Another reason for a spin off would be to remove the bad business so that the good one can shine. That’s another reason. 

The third reason, sometimes a spin off 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 spin off. 

So when a company spin something off, it means that they’re selling it, they’re getting rid of a division, they’re trying to remove a portion of their business for the betterment of one side. Then sometimes if it’s being split, sometimes it’s better for both businesses to be split. So that’s the idea of a spin off. 

Now, the reason that there’s value here, according to Greenblatt is that newly spun off companies tend to outperform the market. The reason is because newly issued stock and the spin off 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. 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 is provided 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.

Stig Brodersen  17:16 

To continue this example, I would like to tell you about my own experience with a spin off. 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 *inaudible. And I probably owned it for like 12 months or so before they did a spin off. Yhey were spinning off one of the divisions, which was actually not a bad division. So what National Oil *inaudible was doing is that they’re primarily in oil rigs, onshore and offshore. And the division that 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 did much also show like how bad an investor I am because Joe Greenblatt was definitely right. A lot of investors don’t look at it, because that is not why they bought in the first place. 

The reason why I bought into Ntional Oil *inaudible was because the part about building the oil rigs that was really the profitable part, and the part that I really understood. But also typically, what happens in 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. 

So just to 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 position. 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 go back and track what happened the past 10 years for instance.

Preston Pysh  18:53  

I think there’s a psychological point to this too. So using the example that you just described, which is perfect for this scenario. I think the person who receives that one share of the new stock immediately kind of has this opinion, like, “I just got screwed.” 

I think at the end of the day, you don’t necessarily know that the division that just got spun off, like you knew the whole company, or at least you don’t think that you do. 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 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. Goodbye.

Stig Brodersen  19:40  

Yeah and one thing might be the mental thing that you’re talking about, Preston. The other thing is that it’s not only small time investors like me that are receiving stocks and spin offs. It’s also big institutions. And a lot of these institutions, they’re actually not allowed to have small positions. And *inaudible is really not impacting them anyway, even if they could. So they’re basically just selling them off. 

Now, this is not the same as saying that they’re owning something that they didn’t own before, because they actually 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 10 different stocks, approximately 10% each in your portfolio. Then something’s 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 was a massive selling, which means that the spin off *inaudible after it’s being traded. Most often you will see the new stock being knocked down by the market. 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 whenever the market realizes the value and when you have different investors starting to find interest in the stock. If you look at spin offs or trends to five period, it actually outperformed the industry peers by 10% per year. And I think the timeframe he’s using is two to three years after the spin off.

Preston Pysh  21:09  

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 spin off. 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 spin off. And there was a gentleman named Stephen Bollenbach and Stephen Bollenbach was in charge of Marriott. He was in charge of conducting the spin off and then after the spin off emerged, and there was like, 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 Bollenbach was in charge of the entire company, the transitions through this spin off and then after the spin off, he goes with the quote-unquote bad Marriott. 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. 

Stig Brodersen  22:18  

I think the leverage ratio was around five or something like that. But you 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 will lose all your money. But then he actually said what you mentioned, Preston. And since you have the right guy, it’s probably not going to crash. So he was like, “If I’m going to lose this small position, I’m going to lose it. But the upside is just enormous.” And that is what happened well. 

Preston Pysh  22:45  

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 and even get some… You can see why it 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. We’re talking about sound 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 might not know what it even means, 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 a 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.

Stig Brodersen  24:11  

Just to give you like a really simple numerical example of risk arbitrage, imagine the stock that’s trading at $25. And then it’s announced that another company would buy that stock at $40. Then what you would typically see is that immediate stocks 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 arbitrage 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 reasons, financing problems, changes in due diligence process, it will simply not happen. If that doesn’t happen, perhaps the stock would trade at $25 again, and you have lost your investment. The other risk is opportunity costs are set another way, you might need to wait, say six months for this to happen. So you’re tied up all your money and need to wait six months before it can cash in your additional $2.

Preston Pysh  25:17  

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, there’s going to be a higher premium paid by them out.” Greenblatt is saying stay away from this. This is a sucker’s game, that he hasn’t figured out a way to win out. 

So the other thing that he was talking about in this chapter was merger securities. I think this one is also a really difficult one to pull off, but he’s much more optimistic about merger securities. So when a company is 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 some 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. 

What Greenblatt says is those securities that are being issued during that transaction are sometimes very lucrative for a person because the way he describes it is there are 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, 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 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. That requires a lot of work. 

Stig Brodersen  27:48  

The way that it’s explained this, 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 he probably outlines them to be. 

And some of those sweeteners, the way they’re structured, and the reason why they’re giving it in the first place is very often for tax reasons, especially because it’s very expensive to acquire another company with its stock. But if it’s issued in different securities, there’s some tax reasons to do that. But it’s hard to value because for instance, something like a bond and especially something like a convertible bond, that you can 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 types of securities that it’s really, really hard.

Preston Pysh  28:45  

Because let’s just take the convertible bond or 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 got to understand when it’s convertible, it might not be convertible for a certain amount of time. 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 in 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 and you try to hit one of your own balls into another one of your own balls, they 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 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 very fancy thing that he’s talking about here in the book, and it’s merger securities, if you guys want to read up on it more.

Stig Brodersen  29:41  

Yeah, and I think one of the interesting points is that the reason why you can make a great profit with mergering securities is the same reason that you can make a profit on 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. I think that’s the challenge, you really need to know more than other people to make a profit here.

Preston Pysh  30:04  

Alright, 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 going to be an easy kind of thing. You know, whenever I read bankruptcy and restructuring, I think, where’s all the lawyers at? And how are they going to take off 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. 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. 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, or 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 anew and the company issues new stock.” To start over again, 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 thing 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. 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 listening as liabilities, what is their competitive advantage? What kind of cash flow do we expect 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. 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. 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. That’s your opportunity right at that single point in time.

Stig Brodersen  33:03  

And you can think about it like this. Remember what Preston said before in terms of what’s called the seniority. 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 investments won’t hold equity for a bunch of different reasons, some for distribution purposes, and some simply because they don’t understand it, or it’s simply something that don’t want to hold. 

So again, you have this massive selling where the price will just be knocked down when there were stocks trading. Actually, from 1980 to 1993, which is the period that Greenblatt was looking at, he saw that the newly distributed bankruptcy stocks outperform with 20% annually over the first 200 days. One thing he really talks about in terms of when should you go into this new business is also to understand why is it that the company was bankrupt in the first place and how much is carrying over in the new company. 

He says it’s not just because we’re talking about a lousy business per se, that can be a ton of reasons for that. It could be or expansion, it could be a problem with regulation, 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 are at whenever the new distributed bankruptcy starts 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? How much money are they making now on a normalized basis?

Preston Pysh  34:38  

Alright, so the second part in this chapter is called “Corporate restructurings,” and what he’s saying here is if a company is going through a major and he emphasizes the word ‘major restructuring,’ there might be opportunity there. Oftentimes the division being sold or liquidated, or completely revamped has actually serve 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. This is a major restructuring that’s occurring. 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 is, making $2 per share. The next division is making another $2 per share. 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, as the company would move past that restructuring. 

But the hard part is knowing what the profit margins of those divisions are, what the cashflow those divisions are. But if you do your due diligence, you dig into all the 10Ks and 10Qs, 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.

Stig Brodersen  36:12  

This can really be a challenge, because whenever you have something called a corporate 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 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 the investors. But if you do go into the 10Ks, you could typically see the different segments of the business and see how profitable they are. If you read that they will one way or 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’re talking about going from $3 in earnings, to $2 in earnings, and after restructuring, it’s valued at the same multiple and you’re actually talking about a 50% gain that you will achieve as a stock investor.

Preston Pysh  37:30  

Alright, guys, so let’s go on to chapter six. 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, Stig. The title of chapter six is “Baby needs new shoes, meets other people’s money.” Go ahead. What am I missing?

Stig Brodersen  37:47  

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. Oh, I was completely blank when I read that.

Preston Pysh  37:57  

No, I read this chapter. I’m like I’m sure there’s people listening to this are like, “You don’t get that?” But I really don’t. 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. 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 Icahn 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.” 

Think of stub stocks as basically an option to buy, but it wasn’t bound by time, 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 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 markets going to go in then next month or next six months is next 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 and that’s why he’s recommending that you go with the option route in order to capture the fastest kind of return that 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 in the puts. Puts are whenever you buy and the stock goes down, you make money. He doesn’t even talk about that in the book at all. 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 spin offs, and you can buy a call option on this. And let’s say that the company is trading for $25, and you can buy a call option at $25. And it doesn’t expire for two and a half years. 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. 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 the breadth of different securities that you have done the analysis on, that you know are good companies that you would actually ultimately like to own. 

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 timeframe. And the upside is enormous. And then if you do this across the breadth of them, you’re distributing your risk with a very lopsided upside versus downside.

Stig Brodersen  42:46  

I thoroughly enjoyed this discussion about warrants and options. Warrants 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 a section. But I would definitely encourage you to go back and listen to Episode 128 of The Investor’s Podcast. And the reason for that is we had Ed Thorp on and he was actually the guy who invented how to value warrants and options.

Preston Pysh  43:16  

So just to kind of piggyback off of Stig’s comment, 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 sticks referencing is Ed Thorp was actually I think, two or three years ahead of the Black Scholes model with valuing options in the marketplace. He had actually uncovered this role before them, 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. There’s proof. There’s written proof, that documents all of this. So Ed Thorp, 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 Greenblatt’s using them, to combine it with this value investing approach, it’s much more for short term valuations based on the volatility. Ed Thorp literally invented that.

Stig Brodersen  4:20  

And especially if you look in the long term, even the formula like the Black Scholes, it is not a good indicator of how to value options. So just to refer back to what Preston said before, when you’re 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 also looking at how volatile has it been? Because obviously if you have an option where the underlying security is a stock That fluctuates a lot. 

So say that if Coca Cola is trading at 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  Thorp actually did back then, and how we actually also did money *inaudible, he is much better at projecting than the Black Scholes 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.

Preston Pysh  45:32  

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 help people learn how to use discount cash flows in order to do these analysis.

One of the things that we’re going to add into this course and just so you know, the course is not out yet, we’re working hard to finish it, but it’s not done yet. 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 and I just want people to know that. 

All right, so chapter seven, “Seeing the trees through the forest.”

Stig Brodersen  46:25  

This was a really short chapter. And what Greenblatt is talking about is that you should know what you’re doing. He’s outlining a lot of different concepts. He’s talking a lot about how you can outperform the market influence, implement the strategies. But if you don’t have a good understanding of what you’re doing, you shouldn’t do it. It’s like running through a dynamite factory with a lead 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 know to stidy 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.  I think that’s great advice to pass on to the audience as well.

Preston Pysh  47:12 

All right, so chapter eight, this one is called “All the funds and getting there”  This is a chapter, I’m so glad he ended this 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 to 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 possess. 

You look at Joel Greenblatt. A lot of people might look at his returns: 50% 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’s 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. 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. 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 Joel Greenblatt, and you have access to Joel 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. 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. But 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.

Stig Brodersen  49:24  

Okay, guys, that was all the Preston and I had for this week’s episode of The Investor’s Podcast. We will see each other again next week. 

Outro  49:30  

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