[00:02:52] Clay Finck: 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?

[00:03:07] Roger Fan: Yeah, absolutely. You know, I admire Greenblatt for a few reasons.

[00:03:10] Roger Fan: First and foremost, I mean, he’s got a phenomenal track record. I mean, the first decade at Gotham, he did 50 percent 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 2 in 20 fee, that’s a 30 percent net return. And so some people might say, oh, 30 percent net, that’s, you know, it’s okay.

[00:03:32] Roger Fan: 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 percent 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.

[00:03:55] Roger Fan: And second, you know, he’s just a phenomenal writer. 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.

[00:04:11] Roger Fan: 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. You know, he’s got a great sense of humor when he writes. And that book really details his current strategy now, which is buying companies that are cheap and good. So taking the Buffett approach, he did an extensive backtesting of the strategy, and it’s been shown to be the S&P 500 quite handily as well.

[00:04:36] Roger Fan: 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. Like, you know, if you watch the video on options, for example, I mean, you really gotta stop and think sometimes, but he really explains it very well.

[00:04:56] Roger Fan: 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 fund manager himself, but he’s also, it seems like, obviously we’re not privy to the overall returns of all the, you know, horses that he’s backed, but he’s backed some famous managers.

[00:05:18] Roger Fan: You know, Michael Burry is one that comes to mind of the big short. Michael Burry just had a phenomenal record at Scion. 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 Lou of Punch Card Capital.

[00:05:35] Roger Fan: Norbert Lou is not as famous, but I think diehard value investors all know Norbert Lou and he really takes the punch card approach that Buffett advocates to heart. I mean, Norbert Lou, 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. He’s a great human. He’s done a lot of work in philanthropy, right? A lot of work in education. And so I know he’s done stuff with charter schools and whatnot. And so all these things added together, you know, he’s got the record.

[00:06:08] Roger Fan: 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.

[00:06:22] Clay Finck: Man, I’m not sure if I could have put it any better myself.

[00:06:25] Clay Finck: So thank you for that great introduction to Greenblatt. And 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 spin off a merger a bankruptcy restructuring and sometimes this means a company is sort of going through a transformation period or sort of reinventing itself to some extent. 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.

[00:07:13] Clay Finck: 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.

[00:07:35] Clay Finck: So Roger, how about you share, why does Greenblatt find special situations to be right? Pounding grounds, maybe expand a little bit more on that and to what extent he actually utilized them in his investment approach.

[00:07:48] Roger Fan: 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.

[00:07:58] Roger Fan: It’s not the situation I want to be in. You just shy away from that. And so I think just the key word is mispricings. Special situations, it’s right putting 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, you’re looking for mispricings.

[00:08:14] Roger Fan: Right? And I don’t know if you believe in EMT, the Efficient Markets 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 the 52 week low.

[00:08:34] Roger Fan: There’s no way that a business’s valuation fluctuates as much as, you know, 50 percent or 100 percent in one year. It just doesn’t happen. And so the markets in general are efficient, but they’re not always properly valued and priced. And so the special situations is a great place to look for mispricings.

[00:08:51] Roger Fan: And a lot of it is you have what’s called force 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 CA 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.

[00:09:14] Roger Fan: And also, if you focus on the smaller situations, like the micro cap type situations that fall under the special situations umbrella of investments, you can really, really do well, because I’m sure we’ll get into some case studies. If you just look at the bulk of Greenblatt’s case studies, all of them are small situations.

[00:09:34] Roger Fan: They’re all 500 million or billion dollars or less. We are not talking about $10 billion situations or $30 billion 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.

[00:09:55] Roger Fan: And so, 80 percent of his portfolio would be in special situations. And he would say that of that 80 percent or more, I mean, it was just concentrated in 5, 6, or 8 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 20%, or less, those are probably in risk ARB situations, in leaps, in options, in warrants and preferreds, and also just small cap value.

[00:10:27] Roger Fan: He’s got the magic formula now. And so I don’t know if he had large positions or a small cap value, but I would imagine he had small cap value names as well, but the bulk of his portfolio was special situations. And he’s known as a special situations investor. As it pertains to the first two decades of Gotham Capital.

[00:10:47] Clay Finck: Yeah, that’s simply amazing given how rare some of these great opportunities can be within the special situations space. So let’s dive into chapter 3 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.

[00:11:06] Clay Finck: So the 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, or maybe something as simple as like a strategic or an antitrust or just a regulatory issue.

[00:11:33] Clay Finck: So it paves the way for the business’s strategy going forward. Greenblatt claims that both spinoffs and the parent company significantly outperformed 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 percent per year.

[00:11:57] Clay Finck: And the first three years of their independence. And then when he looks at the shares of the parent company, post spinoff, they outperformed by 6 percent 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 a, maybe a good pond to go fishing in if that’s something you’re interested in.

[00:12:18] Clay Finck: 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?

[00:12:33] Roger Fan: Yeah. So I think Joel Greenblatt is, I think what he wrote about is still very relevant today.

[00:12:39] Roger Fan: And I think results will continue. 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 these same dynamics that happen today that are in the markets today, it’s the same as 1985 or the early 2000s.

[00:13:06] Roger Fan: Because what a spinoff 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 spinoffs possibly a better option than an outright sale, for example.

[00:13:30] Roger Fan: 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.

[00:13:54] Roger Fan: 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, my analysts that half of the game is just investor psychology, right? It’s knowing market psychology.

[00:14:11] Roger Fan: 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 spinoffs. They’re just going to dump the shares because they were investing in the parent company.

[00:14:29] Roger Fan: They don’t necessarily want anything else, 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 dollar market cap situation.

[00:14:46] Roger Fan: 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 for selling this non economic 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.

[00:15:10] Roger Fan: 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 if you were a concentrated investor put it on in size and also on that note, you know, this has been off companies when they get spun off.

[00:15:28] Roger Fan: 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 it’s just harder to unlock value. And so at the end of the day, spinoffs is just a way for the parent company to unlock shareholder value.

[00:15:49] Roger Fan: So overall, I think spinoffs 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 gonna work.

[00:16:01] Clay Finck: 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.

[00:16:12] Clay Finck: 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 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 spinoff in the first place.

[00:16:30] Clay Finck: So, are there any resources that compile these types of events just so investors can simply identify them in the first place?

[00:16:40] Roger Fan: There’s no 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 Gotham, right?

[00:16:54] Roger Fan: Because he was in the 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 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.

[00:17:12] Roger Fan: 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.

[00:17:30] Roger Fan: 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. 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.

[00:17:54] Roger Fan: 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, cell by cell, you’re naturally, going to be quote unquote one with the numbers.

[00:18:11] Roger Fan: If you do that, if you go through 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.

[00:18:29] Roger Fan: 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? 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 gonna analyze information Just put together your own calendar or a spreadsheet of all the situations like Greenblatt talks about spin offs, merger securities Risk arbitrage, post bankruptcy exits, and all that good stuff.

[00:19:04] Clay Finck: 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. I’m like, oh, this is wonderful. Greenblatt can go and buy this good business.

[00:19:21] Clay Finck: It’s got all this toxic waste 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?

[00:19:39] Roger Fan: Absolutely. 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 Bollenbach to solve the problem and Stephen Bollenbach, 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 Marriott at the time had two businesses.

[00:20:12] Roger Fan: The first was the hotel management business which is the good business with that everybody wanted where they generated consistent earnings from fees and Basically, they managed hotel properties for others. Right, and so Marriott International was the parent company, or the good portion of the spinoff.

[00:20:28] Roger Fan: 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 Spinco. With common sense, you can just think that with the development of hotels, owning the properties, it involves a lot of debt.

[00:20:47] Roger Fan: And so Bollenbach’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.

[00:21:01] Clay Finck: Let’s see, it was Marriott International, that’s the toxic waste, and I love the point that Greenblatt made.

[00:21:08] Clay Finck: 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 desirable characteristics in a spinoff opportunity. So we can just walk through these one by one.

[00:21:25] Clay Finck: 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 or anything.

[00:21:45] Clay Finck: 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 and how it applied in this case study here.

[00:21:58] Roger Fan: Right, so we did talk about it before, but just to recap, it has to do with mandates and size constraints.

[00:22:04] Roger Fan: And also, it may not have been the business that the institution wanted to be in and oftentimes the shareholders and 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, Host Marriott, which is the spin co, was actually only going to be 10 to 15 percent of the parent.

[00:22:25] Roger Fan: And so at the time the parent was a 2 billion market cap. So if you do the math there, that means the spin co was going to be just 200 to 300 million, which makes it a micro cap. And just to recap again, Mary international was the management business, but it was debt free and 85 percent of the business valuation was for Mary internationals.

[00:22:47] Roger Fan: And so institutions want that. That’s the business that they want. 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 dollars in debt. Institutions, they don’t want that and they don’t want the unsellable properties.

[00:23:07] Roger Fan: 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.

[00:23:13] Clay Finck: 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.

[00:23:24] Clay Finck: So the second characteristic Greenblatt list is that insiders want 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 with the shareholders. So talk more about this one.

[00:23:42] Roger Fan: Absolutely. So insider participation actually is the most important aspect and he’ll say. That is 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 looked like.

[00:24:02] Roger Fan: Because the more stock extended for new management, the better. And so in this situation, Ballenbach 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 a entity or company that’s destined for failure, right?

[00:24:19] Roger Fan: You don’t want to jump on a sinking ship. And so, I think if you look at public documents, this backed it up because nearly 20 percent of the spinco 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 the Marriott family, they would still own 25 percent of Host after the spinoff.

[00:24:45] Roger Fan: So the Marriott family was heavily invested in what was quote unquote the toxic waste. So if you combine those two things together, the Marriott family’s in it. This turnaround specialist or just this guy who’s really good at financial engineering, whatever his skill set was that made him so successful.

[00:25:03] Roger Fan: These two were on the same boat as shareholders. And so inside of participation, super important.

[00:25:10] Clay Finck: 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 past some of the initial headlines and the initial filings.

[00:25:26] Clay Finck: 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.

[00:25:48] Clay Finck: If we were to just have a 15 percent move in the value of host assets, the stock could practically double because of that leverage that was at play there. 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.

[00:26:14] Clay Finck: And it turns out that tremendous leverage can be found in a lot of these spinoffs because it allows the good business to shut off what’s undesirable and troublesome to get rid of. So, Host Marriott had all three of these characteristics. So, most institutions were likely to sell their shares without doing any further digging.

[00:26:32] Clay Finck: 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?

[00:26:51] Roger Fan: It worked out extremely well. He triples his money within four months. So you do the annualized return on that. Well, it was a huge return for his portfolio and his firm, Gotham, because he actually put almost 40 percent 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 percent of the portfolio in this situation.

[00:27:16] Roger Fan: But the way he’ll rationalize it is that his downside was protected. Basically, he was just paying 4 dollars for the debt free assets. And he valued those assets conservatively at about 6. So 6 for, so you’re getting about, you know, like a 33 percent margin of safety. And everything else was essentially a free option.

[00:27:35] Roger Fan: 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, it’s a 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 percent because that was a situation where basically what he looks for when he puts together a 40 percent position is that he’s looking for situations where you can’t lose money.

[00:28:04] Roger Fan: 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. The problem is if you got a 40 percent 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 year.

[00:28:21] Roger Fan: 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 Host actually involved preferred shares and call options.

[00:28:43] Roger Fan: And I think he must have involved the common stock in this because, you know, if you’re putting 40 percent 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 that are available to you after you analyze the situation.

[00:28:58] Roger Fan: 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, et cetera, and you just take a big picture of you and you just think to yourself, what is the best way to play this situation?

[00:29:15] Roger Fan: And sometimes it’s just a common stock, and so it’s an easy investment, but sometimes maybe you do a Joel Greenblatt 40 percent type investment and you structure it around preferreds 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 wade through the documents and take a look.

[00:29:43] Roger Fan: Don’t let the leverage and the debt dissuade you from investing because then you’re going to miss out on a triple in four months.

[00:29:50] Clay Finck: That’s simply amazing, to say the least. So, 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.

[00:30:06] Clay Finck: So let’s transition to one of the other chapters here where Greenblatt 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.

[00:30:25] Clay Finck: So investors have the opportunity to essentially bet that the deal is going to close and they’re able to capture that spread. And of course, these types of deals are no sure thing. There’s a chance that regulators stop it, their financing issues or certain things are uncovered in the due diligence process.

[00:30:41] Clay Finck: 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 on that bet, and probably a very humbling experience for someone like him early in his career.

[00:31:00] Clay Finck: 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 our play. And at Berkshire, they took roughly a 2022.

[00:31:22] Clay Finck: That was at 79 per share. And then the deal ended up closing in the fall of 2023 and Berkshire netted a 20 percent gain in around 18 months, which, you know, when the downside is 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.

[00:31:43] Clay Finck: 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?

[00:31:54] Roger Fan: 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 M&A activity going on.

[00:32:07] Roger Fan: And that’s because risk arbitrage, you know, M&A, 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 an M&A deal. And then the company and the industry gets overheated, everything’s great, and then you have a bankruptcy.

[00:32:29] Roger Fan: 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? Cycle’s great, maybe it’s in a commodity business, it gets to the peak, you got a bunch of debt going on, bankruptcy, exits bankruptcy, becomes a cheap stock again.

[00:32:49] Roger Fan: And so it’s this virtuous cycle that keeps going, and M&A 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 arb.

[00:33:08] Roger Fan: Spreads have come down as well. You know, it’s not the heyday of the 70s and 80s where you could just make a killing in 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.

[00:33:27] Roger Fan: And just in recent years, for example, the government has gotten very involved in some very high profile situations involving antitrust issues. And so, if that deal falls through and you size the two big, you’re going to lose a lot of money, and you alluded to the situation with Joel Greenblatt, I mean, that property literally fell into a sinkhole.

[00:33:47] Roger Fan: And so, how could you possibly anticipate something falling through a sinkhole when you’re doing your risk r calculation on the spread, and you know, you’re reading all these public filings and court documents and 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.

[00:34:04] Roger Fan: 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 risk arb. And so what merger securities are, it’s forms of payment that get in on deals. And so typically deals are done, right?

[00:34:23] Roger Fan: The acquirer is, you know, making a deal for the target and the payment is typically cash and or stock. It’s typically not preferreds or warrants or bonds, right? It’s typically just cash and or stock. So it goes back to the whole dynamics of the spin offs and all the other types of special situations.

[00:34:43] Roger Fan: When people get securities that they weren’t anticipating or they don’t want or that 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.

[00:35:00] Roger Fan: You don’t even know what preferreds 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 your times, whatever is your publication of choice, they’re not going to feature merger securities because it’s so boring.

[00:35:20] Roger Fan: 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 they’ll disclose like hey, you know We’re adding this in or we’re throwing this into the deal structure

[00:35:34] Roger Fan: So it’s interesting that you mentioned that Greenblatt was more interested in the merger arbitrage than the risk arbitrage I mentioned.

[00:35:41] Roger Fan: And he actually mentioned in his first job out of college, he worked in risk arbitrage and he figured out that he didn’t really like the risk reward. So you might make say 5 percent or 10 percent 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.

[00:36:03] Roger Fan: But if you’re entering this arena, you want to be pretty sure that it goes 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.

[00:36:24] Roger Fan: And if something offers a 5 percent 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 L’Occitane, and this was a Hong Kong listed luxury company, and it was taken private by a French billionaire.

[00:36:46] Roger Fan: So the stock was trading at around 32 Hong Kong dollars a few months before it was taken private. 34 Hong Kong dollars representing around a 6 percent spread. How about you talk more about this since it’s a more recent example and something that you participated in.

[00:37:02] Roger Fan: 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.

[00:37:16] Roger Fan: It could be the Financial Times, it could be the Wall Street Journal, but in this case, it was the Lex column. And for those who don’t know, um, 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 fund just based on the lexicolum alone.

[00:37:33] Roger Fan: So that gives you an idea of the quality of companies that are written about in the lexicolum. And so, just the first thing that jumped out was I was actually familiar with L’Occitane. And so they’re in LA here, and they’re in all the malls, they’re in all the outlets, and they’re just everywhere, right?

[00:37:48] Roger Fan: 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 T.

[00:38:09] Roger Fan: And it’s supposed to just work really well. But they’ve got lotions, they have creams, oils. 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.

[00:38:29] Roger Fan: And 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 percent return or something, quote unquote, paltry like that. But if you annualize it out based on when you buy it to the closing date, You’re looking at a double digit return, especially if it closes in three months or six months, right?

[00:38:56] Roger Fan: So 6 percent 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, you know, what duration you bought it for, it could be like a 5 percent yield or something.

[00:39:19] Roger Fan: 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 Reinold Geiger, he was the chairman of L’Occitane and he’s also a billionaire actually, but he owned about 73 percent of the shares. And so he was the majority owner.

[00:39:35] Roger Fan: 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.

[00:39:52] Roger Fan: The CFI, they raised 2 billion euro 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 Blackstone and Goldman Sachs, they’ve got the financing done.

[00:40:11] Roger Fan: 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 or deal. And so they just made a bad decision with an acquisition and they overpaid and, you know, didn’t get the financing right. They took on too much debt, but that doesn’t mean they’re a bad business.

[00:40:28] Roger Fan: They just made a bad strategic move. And so that could be one reason. And they actually cited that the Hong Sek index was down like 45 percent over the past 5 years. And also down 46 percent 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.

[00:40:48] Roger Fan: 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 arb situation where you have potentially an antitrust issue or a regulatory issue, etc. So in my mind, the worst case scenario was that I will be stuck with an average to above average business.

[00:41:12] Roger Fan: But a business with a recognizable brand that was trading for about 15 times EV EBITDA and about 70 times EV EBIT. And so while I would like to play lower multiples in the M&A world, just multiples in general, encompassing all types of businesses across all industries. Those multiples are fine, right?

[00:41:31] Roger Fan: And the business was also generating free cash flow, and the revenue K for the last three years was 18%. So, you know, that’s pretty decent. And the return on the capital was over 15%. So, you know, you have the good and cheap aspects of Joe Greenblatt’s magic formula here. And so, you know, basically, my thinking was there are worse businesses to be stuck with if the tender offer doesn’t go through.

[00:41:54] Roger Fan: So, how did it work out? Pretty well. It took only 5 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 if, assume 32, your annualized return would have been about 15. 7%. So 15.7 % to put in a deal just in 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.

[00:42:27] Clay Finck: And how would you explain why the spread existed? Why did the opportunity exist?

[00:42:33] Roger Fan: 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.

[00:42:42] Roger Fan: 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 yet there was a threshold.

[00:43:01] Roger Fan: I believe the threshold was something like 90 percent 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 what Joel Greenblatt says in general. He doesn’t know why businesses are undervalued. He doesn’t know why he sees situations like Host, these situations in general, why they exist.

[00:43:19] Roger Fan: 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 trade in size, you’re going to do very well.

[00:43:30] Clay Finck: Yeah, I think there’s certainly something to be said around just that. I mean, you think something might happen, but you never know for sure.

[00:43:37] Clay Finck: So that certainly seems like a logical reason to me, especially with how many of these couldn’t happen in theory within a year. So let’s transition here to the chapter 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.

[00:44:01] Clay Finck: I think most investors would, of course, just steer clear. Anyways, I don’t think they need to be here for me to tell them. And I think that would certainly be a wise 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.

[00:44:17] Clay Finck: 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 you know what makes for the rare case in that investors might be interested in something like this?

[00:44:33] Roger Fan: You’re absolutely right. So private investors and small funds in general should steer clear of companies in bankruptcy or those that are about to file for bankruptcy.

[00:44:42] Roger Fan: Because, first of all, when a company is in those stages, vulture investors and distressed funds They’re going to have an advantage over you due to their sheer size as well as their legal expertise. So you’re already at a disadvantage from the get go, right? 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 been dealt with, right? And you’ve got a disclosure statement.

[00:45:16] Roger Fan: And once they exit bankruptcy, you’re 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 vulture investor to do well with post bankruptcy exits.

[00:45:34] Roger Fan: 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 follow bankruptcy for a reason, right? There’s a reason why they got there in the first place. So one way to approach post bankruptcy exits is to just invest in the good businesses.

[00:45:52] Roger Fan: And so you might be wondering, like, how is a good business even possible, you know, if they’re a post bankruptcy exit? Well, there are a few things that could have happened, actually. The first is they may have been over leveraged 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.

[00:46:14] Roger Fan: 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.

[00:46:30] Roger Fan: 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. 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.

[00:46:54] Roger Fan: 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. But you’re really just making money.

[00:47:08] Roger Fan: 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 and the too hard pile, but talking about host, maybe you gotta look sometimes.

[00:47:27] Clay Finck: Yeah, I’m reminded. I recently interviewed an investor named Derek Pilecki, and during the great financial crisis, he bought into General Growth Properties, which was being walked through their bankruptcy process by Bill Ackman. Pilecki made it a 1 percent position in his portfolio, and it ended up being a 20 bagger for him.

[00:47:44] Clay Finck: So, 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, it still might be just severely undervalued when you look at the assets and whatnot.

[00:48:06] Clay Finck: I was curious to get your take as a long term value investor. How do you think about mispricings 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?

[00:48:33] Roger Fan: 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 a secular decline, but valuation makes sense and it’s at a low multiple.

[00:48:44] Roger Fan: And so, I would take the Greenblatt approach, and these types of businesses, you have to take more of a trading mentality. Then 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 go south, I’m out.

[00:49:02] Roger Fan: 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.

[00:49:19] Roger Fan: 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 companies.

[00:49:41] Roger Fan: 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.

[00:49:59] Roger Fan: So ideally you have a lot of cash and you have minimal to no debt. Why? Because if you have a strong balance sheet, you also become a prime takeover candidate. Right? 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?

[00:50:18] Roger Fan: There just needs to be something that’s going to happen over the next two 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 nets. 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.

[00:50:41] Roger Fan: 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.

[00:50:50] Clay Finck: So the last case study I wanted to touch on today was Kmart, which is quite an interesting special situation. So they filed for bankruptcy in 2002, and then they went through some corporate restructuring, performed a spinoff.

[00:51:02] Clay Finck: It seems like they just went through this whole playbook of the book. So prior to the interview, you had told me that Eddie Lampert, he put 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.

[00:51:19] Clay Finck: So I wanted to give you the chance just to talk through this one and share some of your learnings from it.

[00:51:24] Roger Fan: 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.

[00:51:33] Roger Fan: And that makes sense. I mean, you know, investors, 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 stress debt investing, given my interest. But I also really liked Eddie Lampert’s story.

[00:51:50] Roger Fan: 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 actually on the Kmart case when she was a partner at SCAD and ARPS.

[00:52:09] Roger Fan: 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 size store.

[00:52:27] Roger Fan: 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 McCrory, they formed a partnership in 1897 to open five and dime stores.

[00:52:52] Roger Fan: So discount stores. But this partnership dissolved in 1912 and the SS Kresge Company was formed, right? And so the first Kmart opened in 1962. And because 95 percent of sales came from Kmart 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.

[00:53:16] Roger Fan: They got into Walden Book Company, Home Centers of America, Sports Authority, OfficeMax, and Boyers. So basically, stuff that’s not their core competence. 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.

[00:53:37] Roger Fan: 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, Kmart declared bankruptcy in 2002, and a lot of that was because they faced stiff competition from Walmart and Target, and Amazon at the time was on the rise in e-commerce.

[00:53:58] Roger Fan: 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 Warren Buffet. And I swear, this is like a Warren Buffett curse. You never want to be touted as an ex Warren Buffett. But, you know, here’s this guy, you know, he’s got a pristine resume, right?

[00:54:15] Roger Fan: Yale graduate, summa cum laude. He goes on to work at the Ritz Carlton desk at Goldman Sachs. So he worked for Robert Rubin. And the who’s who of the finance world went through the Ritz Carlton desk. And they all went on to start famous hedge funds, right. And so when he was relatively young, like I think in his early 20s or late 20s, 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.

[00:54:40] Roger Fan: 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 his roster of investors, you know, he invests for David Geffen, Michael Dell, George Soros, the Ziff brothers, the Tisch family, I mean, you name it, you know, just all star roster.

[00:54:58] Roger Fan: And his AUM got to as high as 16 billion or something like that in 2006. And his returns up until around 2004 were really good. Joel Greenblatt type numbers, 29 percent annualized. So going back to the Kmart situation, so leading up to it, Q4 of 2001, right, disappointing 4th quarter sales and earnings, having some trouble.

[00:55:17] Roger Fan: In November of 2001, Standard Poor’s 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.

[00:55:39] Roger Fan: 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 with money for surety bonds, you know, things start to go sideways, they’re 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.

[00:55:57] Roger Fan: Right, 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.

[00:56:16] Roger Fan: And just as an aside, it’s probably best to buy probably more than a 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. And the overall goal, like all investing, is to exit by selling these securities at a higher price.

[00:56:36] Roger Fan: But really, how you really make money is by converting the debt that you own to cash and equity. So what does Eddie Lampert do? Eddie Lampert buys a bunch of claims, right? So let’s go down the list. You know, he bought 382 million of pre petitioned lender claims. About 1. 8 billion in pre petition note claims, 61 million in trade vendor lease rejection claims, and trust deferred obligations.

[00:56:59] Roger Fan: So all in all, the total investment, which was accumulated over time, 2. 3 billion. And Third Avenue was also involved, so Third Avenue, Marty Whitman, they’re also very well regarded in the distressed debt and just value investing space. And so Marty also bought 99 million in pre petition note claims and 79 million in trade vendor lease rejection claims.

[00:57:18] Roger Fan: Lease rejection claims and he was basically in support of what Eddie Lampert 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 Lamper. And he also appoints six of the nine Kmart board members.

[00:57:35] Roger Fan: And he also sat 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, right, using COP analysis and DCFs. And so basically they were saying that Kmart was worth maybe 8. 75 a share to 17. 50 a share thereabouts. But the valuation is completely wrong. I mean, if you just use common sense, if you just actually look at the filings, they use discount rates of 20 to 25%.

[00:58:14] Roger Fan: 20 to 25 percent 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 PP&E at just 10 million. 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 percent. So maybe none of that makes sense to the casual listener, but basically this was a classic mispriced situation. The business and the assets were left for dead. And so here’s why that valuation is completely wrong.

[00:58:51] Roger Fan: 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.

[00:59:09] Roger Fan: 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.

[00:59:29] Roger Fan: So how did this work out? Kmart worked 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 seven x in a matter of 18 months.

[00:59:51] Roger Fan: 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, and you don’t have billions of assets under management and an army of lawyers at your disposal, you could 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.

[01:00:15] Clay Finck: I love that story, and 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. 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?

[01:00:44] Clay Finck: And why does this type of situation seem to be most appealing?

[01:00:49] Roger Fan: 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 spin offs, because there’s always a consistent calendar of those happening.

[01:01:03] Roger Fan: And I really like wrist 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 guard trade at 10 or 20 percent of your portfolio. Because that deal could very much blow up in your face.

[01:01:21] Roger Fan: 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 the 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.

[01:01:39] Roger Fan: 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, are driven by where we are in the economic cycle, and so they may not always be available to you.

[01:01:56] Roger Fan: 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 bust.

[01:02:12] Roger Fan: But that’s what you have to pick your spots and concentrate as Joel Greenblatt advocates. And one thing we didn’t talk about as much, but restructurings 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.

[01:02:27] Roger Fan: 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.

[01:02:39] Clay Finck: Amazing. I’m reminded of when a Joel Greenblatt was on our show with William Green on the Richer Wiser Happier podcast.

[01:02:46] Clay Finck: One of the points that he made that I really liked was that he doesn’t know most things. He only knows a few things really well and focuses his attention 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.

[01:03:03] Clay Finck: 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.

[01:03:21] Clay Finck: So, It’s funny when you look at the stock market and you tell someone you own 6 or 8 or 10 companies, they say you’re quite concentrated, but if you were in, say, the town you live in, and you told someone you owned 8 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?

[01:03:49] Clay Finck: 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.

[01:04:01] Roger Fan: Yeah, I believe every word he says about concentration. So at RF Capital, we typically have five to 10 core holdings. And we size up on our positions.

[01:04:10] Roger Fan: And so our starter position is typically a 5 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 percent. And generally, we don’t really like having positions be more than 20 or 25 percent at cost, but I’m willing to do it if the downside is absolutely protected.

[01:04:30] Roger Fan: I haven’t done a 40 percent 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 percent of the portfolio. Our top five or ten. Definitely the first 80 percent of the portfolio and the rest is cash special situations and maybe shorts 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 five percent plus position, right?

[01:05:01] Roger Fan: And so because of the elevated risk and so that’d 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.

[01:05:15] Clay Finck: 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.

[01:05:23] Clay Finck: I mean, what a fun conversation. And I can’t wait for the listeners to get ahold of this one. So before I let you go, how can the audience learn more about you if they’d like and get connected?

[01:05:34] Roger Fan: 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.

[01:05:42] Roger Fan: We also post our recent investor 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 RGRFAN. I’m also on LinkedIn. You can just search Roger Fan. I’m there. And I think in the coming months, I’ll also be publishing on Substack.

[01:06:04] Roger Fan: 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 X and LinkedIn.

[01:06:16] Clay Finck: Wonderful. Well, I’ll get that linked in the show notes as well. So Roger, thanks so much again.

[01:06:20] Clay Finck: I really appreciate the opportunity. This was really fun.

[01:06:23] Roger Fan: 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.

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