The Spinoff Bible (Podcast Transcript)

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About: Invesco Exchange-Traded Fund Trust - Invesco S&P Spin-Off ETF (CSD)
by: Behind The Idea
Summary

We continue our series on Joel Greenblatt's "You Can Be A Stock Market Genius" with a look at chapters 3 and 4.

These are the chapters everyone remembers, especially the discussion on spinoffs. But does Greenblatt's pitch still hold?

And what to make of his aversion to risk arbitrage, another popular special situation category? Popularity may be the thing.

Editors' Note: This article is a transcript of our podcast discussion from last week about Chapters 3-4 of Joel Greenblatt's You Can Be A Stock Market Genius. We hope you enjoy it. Watch for the remaining two episodes this and next week.

Introduction

On this week’s Behind The Idea, we talk about Chapters 3 and 4 of Joel Greenblatt’s “You Can Be a Stock Market Genius.” These are the chapters you remember if you’ve read this book. Risk arbitrage, merger securities, rights offerings, but most of all spin-offs. We breakdown our favorite case study from the book, assess whether spin-offs and these other strategies still make sense 22 years later and of course we share our favorite lines and jokes. Have a listen on this week’s Behind The Idea.

Podcast

Daniel Shvartsman: Welcome to Behind the Idea. I’m Daniel Shvartsman.

Mike Taylor: And I’m Mike Taylor.

DS: This is Part 2 of our special series breaking down one of our favorite books, Joel Greenblatt’s “You Can Be a Stock Market Genius.” Last time we talked about the first two chapters, which lay out the blueprint for Greenblatt’s investing mindset. The advantage individual investors have and the need to look in hidden places of the market for ideas.

This time we’re getting to chapters 3 and 4 where Greenblatt gives examples of the hidden places he likes to look, spin-offs, right offerings, merger arb. This is what people will remember when they talk about this book. The big question is, are these places still hidden or has the territory been picked over by all the stock market geniuses out there. We’ll discuss that, as well as our favorite quotes in Greenblattism’s on this week’s Behind The Idea.

Before we begin, Behind The Idea is a podcast that breaks sound, what makes great investment analysis work using articles and ideas from the Seeking Alpha Ecosystem and books by Joel Greenblatt. Nothing on this podcast should be taken as investment advice. We might discuss stocks in this episode and if we do discuss any stocks, we own positions in, we will disclose them at the end of the podcast. Today’s episode is brought to you by Seeking Alpha PRO Plus, try PRO Plus for 30 days free at seekingalpha.com/proplus.

MT: And real quick listeners listen up, I have to tell you, I have to discuss this, I have to bring up the topic of podcast ratings. My request is simple. Please rate us. We know you are out there and we know that you are growing in number, a teaming horde of Behind The Idea listeners, eager for investment analysis and ideas and the breakdowns thereof. Please support our efforts and help us get better with the rating on Apple Podcast, and if you are truly inspired, please put finger to keyboard or a phone touch screen or tablet I guess, tablet heads out there shout out and leave us a review. We appreciate you all from the bottom of our hearts. Thank you for joining us along this investment analysis path and thank you so much for your support.

Okay, Daniel, Chapters 3 and 4, the special situations Bible, what are we doing here?

DS: Well let’s start with chapter 3. Chapter 3 is primarily about spin-offs. He also covers partial spin-offs and rights offerings as part of this spin-off. We’re not going to go too in-depth into the rights offerings. We are going to pick our favorite example to discuss. It’s one of the cleaner examples in here, but also, let’s get into some of the high-level stuff. As I said on the top, I think when people think of Joel Greenblatt they think of spin-offs, they think basically of this chapter, and I think it’s interesting to first look at what the case is and I think then zooming out, does this still apply to the markets today, because I think this is a strategy that appeals to both of us, but it’s a strategy that appeals to lot of people to the point where it may not appeal as much anymore.

So, Greenblatt addressed this, by the way, upfront, arguing that this will still outperform even when people know about this strategy and he is just quite confident about that. And his argument is basically that there are a bunch of dynamics related to spin-offs that just fundamentally lead to mis-pricings that shouldn’t happen. There is the fact that when a company is spun off, which means that a unit of a business is spun to public investors without going through an IPO process, without going through any other sales process.

It means that the investors who finally receive them invested in a bigger company X and now we’re getting this random segment Y, which they owned as part of X, but it’s usually not core to what X does and so it’s not really of interest to those investors. They are not the right audience for that. They sign up for the dividend yield from X and now you’ve got Y, which is a growth company or they signed up for the exciting as one example is, the exciting hotel management business and don’t actually want to own the hotels. In that case it was the reverse, I think they spun off the hotel management business.

MT: It is just like a quick hypothetical, it is like Google (GOOG) owns YouTube, those are connected companies, but they arguably could operate separately. Google could spin YouTube off to Google shareholders as a separate company trading under the hypothetical ticker symbol YTBE, all Google shareholders would have to do is sit there holding their Google stock when the spin-off consummates, they would now have GOOG or GOOGL, as well as hypothetical YTBE that would be an example of a spin-off with that sort of a company that everyone knows.

DS: Yes, I think that’s a good example and I think it illustrates the dynamics at work here and I think Google and YouTube to some degree wouldn’t quite get this, because they would still both be large caps, but if you think about the size there, I think that also gets to another key things. Google would still be and I should mention I’m along Google and I’ll mention that at the end as well, but the size dynamic here is something like you would imagine that the parent Google would still be seven times YouTube or something like that, and that happens a lot.

That’s another reason that intuitional investors, especially cannot hold positions here, because they have a mandate, they have guidelines to their fund, they might be nearing an index, if an S&P 500 spins off whatever, and so that’s a major size.

MT: Let’s go down to list. So, you have a good list here as the reasons that spin-offs work. So, one example is, spin-offs are spun to investors who don’t want shares. This is not usually true for Google, right, like Google shareholders often view YouTube as attractive, but say YouTube was a struggling video business that wasn’t the most dominant video platform in one of the biggest search engines in its own right on the Internet.

Say, it was not something that people viewed as really the same as Google than if they spun-off YouTube, investors wouldn’t want their shares. Daniel mentioned the size mismatch, say Google was smaller and YouTube was only a $15 million company instead of however many billions that actually is. Some mutual fund holders wouldn’t be able to hold the company, because they have certain size mandates that restrict them against holding micro-cap stocks. What else Daniel?

DS: The business quality was – Greenblatt broke this out clearly in his first example, which we wouldn’t go into depth, which I alluded to which was Marriott and host hotels, I think. They signed up for a nice business and then they get stuck with the business that’s because they were the bad business which happens a lot. I think that’s another reason that spin-offs. These sort of fall in a couple of areas. They fall into companies, trade off when they shouldn’t and then there is actually fundamental good things here.

So far, we’ve mentioned the bad things. The good things I think are that he points out that the research at that time showed that the second year is when a spin-off really tends outperform, which I think is interesting as we sort of spot check how this works now, but also the idea is, you spin-off a company and all of a sudden if they are a small unit in a big company, for example, and their stock options are tied to the performance of the big company, they are small unit, doesn’t really move the needle that much and it’s not – it’s just – you don’t get as creative, you don’t get as risk taking, you don’t get as enterprising and how you run the business, whereas if you spin-off, if the insider incentives are aligned and he sites examples of if, for example the CEO moves to the spin-off or stays with the worst company that is an important indicator of what’s going on.

If stock options are allocated to the new management team, other ways to align with shareholder value, I think that’s as he puts it, capitalism for all its flaws or all its challenges does work was his argument and that’s where you sort of align those incentives. And then the last thing that I think is really interesting, and I find myself falling into spin-offs that hopefully will exemplify this even though I don’t like leverage is that he points out that leverage really can play out nicely for you where if a company has – is often loaded up with a lot of debt and we might go into examples, but without alluding to the spun names Honeywell is well known for or to us well known for spinning off a company.

Making the company pay them a dividend, which forces that company to put debt on their balance sheet and they increasingly spin-off liabilities too. And in theory that loads that with something of a toxic balance sheet, but if all the other stuff works out, then all of a sudden, the leverage, you don’t need a lot to go right for that to really take off. So, I think that’s essentially the playbook for why this all works and lastly, I guess that companies don’t – that investors often don’t go deep into this, they think this looks bad and they stay away or whatever else, so that’s the last thing.

MT: Honeywell (HON), guys come on with the legal liabilities and the debt for dividend, it’s just gratuities at this point. When you spin something off just give it a nice clean balance sheet for me and Daniel, that’s all we ask. Honeywell come on.

DS: It’s true, it’s true.

MT: You sympathize with that Daniel.

DS: Empathize, sympathize, lots of pathos around that.

MT: So, that’s the affirmative case and the contra-case I think is something, in a recent article by Seeking Alpha author and frequent PRO Plus author, Ian Bezek talks about how spin-offs are the – Greenblatt says that this is going to be sort of an eternal market dynamic and its attractive sort of throughout the ages, and he said this in 1999, it’s 20 years later. We had a recent article, Ian sort of talks about some of the ways in which spin-offs may no longer be attractive, including that there’s now an ETF aimed at targeting spin-offs, the strategy has gone popular, Ian says. And just in general, this may no longer work as a strategy. And I think one of the counters to that is that Greenblatt sort of steps aside from a lot of the systemic strategy based investing and one of the great things about the case studies in chapter 3 is that he really emphasizes that you’re playing a bit of a game and you’re trying to figure out where management incentives are, and that’s one of the key drivers of investor success with spin-offs.

And that’s sort of separate from just passively creating or creating a vehicle that just systematically invests in spin-offs, and so I think there’s a little bit different strategy versus just the intrinsic opportunity to investing’s in spin-offs. Greenblatt says that, no matter what spin-offs are attractive, but then his playbook is really designed at sort of making sure that you as an investor are critically evaluating the situation and looking at the incentive systems and playing a game with other investors and I think that sort of brings you into a different opportunity set. It’s not that doesn’t – you don’t necessarily have to have spin-offs always work out well for you to be successful in using the strategy.

DS: Well, it’s interesting because again, I don’t know if we talked about this in the first episode, I can’t remember, but his baseline is market performance is 10%, spin-offs outperform by 10%, and then if you pick the best spin-offs you do even better. So, I know that we’ve had some decent returns this decade, but still 10% as a baseline for forward working returns just sounds not conservative.

MT: The hurdle rate. I almost never find opportunities that hit that. Yes, but I talked a little bit in the last episode about how – I was like ah, I think that values that quant strategies are playing out a lot of these opportunities on the long side, just forget about it, but this episode really brought me back home, and I think one of the reasons is that these case studies are just so sort of attractive.

DS: The last thing before we get into the example is, I would just say, to Ian’s point, first of all in the comments there is discussion of the spin-off has changed, the ETF has changed its benchmark and so, as always as Greenblatt said, in the first of couple of chapters, do your own homework, but I think what’s interesting to me is the point – Greenblatt I think was saying, even if investors are looking there, there are still going to be dislocations, there is still opportunities. I think it’s interesting tactically to think about whether you should buy a spin-off before it spins or whether you should buy it after, whether you should, you know as he said, the second is the out performance. Like how to think through that?

I think though the two things that are interesting to me are, number one, Ian makes the point that companies kind of know this and so you have that behavioral loop of companies know that spin-offs are going to be received well and so they have more license to load it up with debt or they have more license to spin-off units that they couldn’t sell or whatever else, like all of a sudden becomes this…

MT: It’s a genuine trash heap; it really is, if companies know that investors are going to go for it.

DS: Exactly and that’s – and I’ve got them burnt. You know, stuff happens to that ends up knocking out spin-offs the same as everything else, but – so that’s one and then the number two is I think the point we were saying 10%, then you add 10% and then if you do better you get better, but also it’s interesting to think about it’s easy and I don’t always look at the incentives, the insider incentives to see where the management goes or are they aligning the new management if it’s a smaller segment or whatever else, like it’s very easy to apply part of this analysis and not every part of this analysis and that’s where at the end of the book we’ll get to that in a later episode, Greenblatt talks about am I like your buddy cop who makes it out, but then gets you killed.

Like you still have to do your own work. You still have to be able to – it’s very easy to get motivated by this and go out and – I have a book mark of all the 10, 12B filings on Edgar, which I think captures most spin-offs and then they are into ton out there as far as I can tell, but it is easy to get inspired, but you still have to –, it’s still an investment you have to make the smart bet here, you have to understand what could go wrong, do all these things line up and it is easy and not to blame Greenblatt, but it’s just whether or not this strategy has played out, it’s also the onus is on the investor to really check all the boxes and make sure that this makes sense, that they understand. And I think he has a quote about at that at some point in these chapters about the need to understand what you are doing, and I think that’s really relevant as we go into some of these examples. Yes, so we wanted to do Strattec, we thought that that was the best example to go into, so why is that?

MT: Okay, Strattec is my favorite example. This was the case study and you can be a stock market genius that inspired me to try this, that inspired me to look for spin-off filings that inspired me to try to do individual company analysis and I basically applied this Strattec example to several analyses I’ve done of other spin-offs that have happened lately. So, I think what listeners can take away from that is that, I found this to be personally sort of most compelling case study in the entire book.

DS: Yes, what stands out for you? What do you like about this example? What inspired you? What can listeners take away from it today?

MT: So, superficially and this is not really one of the reasons, but Briggs & Stratton is a Milwaukee company and I grew up in Milwaukee that’s my hometown, so I just had a little bit of home bias resonance there with it, and it’s a big employer in Milwaukee, it’s an important company in the region. But one of the reasons, and some of this is obvious in hindsight, and probably colors my opinion now, but it’s sort of the cleanest possible spin-off example, it’s like, if you were to have a spin-off text book, which this more or less is and you were to create a hypothetical example, you would probably look a lot like Strattec, Briggs & Stratton.

Here’s the situation. Strattec is the spin-off company of Briggs & Stratton, which is the larger company, it represented a very small portion of Briggs & Stratton earnings, 10%, Briggs & Stratton was about $1 billion company at that time. Putting Strattec in this great sweet spot of the $100 million market cap range, which is below the threshold where a lot of institutional investors can consider the company. As I said before, one of the key elements here and one of the things that Greenblatt does well is kind of play a game with the stock market and play a game with management and something that sort of turned a light on from you with Strattec and Briggs & Stratton is he just looked up evaluation multiples in value line and saw, okay companies like this can trade for PE between 9 and 13, and that was huge for me.

Thinking in evaluation ranges, what’s the bottom of the evaluation range and what’s the top of the evaluation range, and I think a lot of times investors, especially on Seeking Alpha are kind of dogmatic. They come up with evaluation and then they get sort of stuck to it. They are like this is a $500 million company and if the market is not pricing it there, then the market is wrong, and I am right. And Greenblatt is a little bit more sort of flexible in his thinking, he is like, the market could put this at 9 PE or could put it at 13 PE, and I’m not going to get upset if it’s anywhere else, but that’s where I’m sort of thinking about evaluation range and I think that’s really productive evaluation tactic that not enough people will apply.

It is just like the market could go crazy and saw this thing down too far, could go crazy and saw it is too high. Greenblatt is really good on that. Another thing that’s great about Strattec is that it is an industrial company, it makes locks for the automotive sector, it makes car locks basically and what’s great about that is that’s a widget factory. It’s a Milwaukee industrial, they have a plant sitting in the middle of the Midwest and they make widgets, you know who the customers are, everything about this is sort of intuitive, they have some strategic advantage, but basically they are just making [do hackies] and what’s cool about that is not only is that intuitively understandable, but GAAP accounting was created to create accurate picture of this type of company.

You got a factory, a fixed asset, it produces stuff, you sell it to customers and generate revenue, you incur costs and then you have profits. So, I love analyzing companies like this because there is very little sort of fussiness around it; it’s an area where the GAAP numbers are just much more likely without significant adjustment to reflect reality, that’s why I think Greenblatt is comfortable using a PE ratio here. You’re just looking at GAAP net income and you are looking at market cap, and that’s where I came up with my 10 PE. I slap a 10 PE on something, take the net income, ten times that gives you a stock price. Earnings per share times ten, that’s where you should start looking and Greenblatt did that, though it resulted in me not investing in very many individual opportunities, but it’s inspiring to me. What did you think about this case study, Daniel? To me this is really a paradigmatic and it’s something that I still use today.

DS: Well I think this is the dream of fundamental analysis and of what value and especially the situation investors do. Four part of the reasons you said, but then also what Greenblatt does is he looks at these companies, says alright great. The setup looks good. They’re a small part of the larger company. They look to be – we can figure out what their EPS is, which comes in the later filings you’ve figure out what the ratio is going to be of the spin-off and then you can start to translate that into an actual market cap and estimate a price. You don’t know where the stock is going to trade when it first spins, but then further he goes in and he says let’s look at their business, 50% of their business comes from GM, they are the largest supplier of locks to GM. They also provide almost all of Chrysler’s locks, 16% of their business. First of all, I just, that kind of gives you a nice sizing of Chrysler and GM at that time, which is a good thing. But then…

MT: GM also has encountered some issues later on in life.

DS: By the way Greenblatt does call out auto parts, which again if you want to get current examples of spin-offs that may not be working as well. Car parts, auto parts industry not a great business, and he says that, but he makes the point from this I guess that Strattec must be pretty good at making car locks, pretty simple in frenzy, probably did more work on this at that time, but you suspect that, it’s not a super attractive business to get into, but that they are pretty good if they can be Chrysler’s supplier, GM’s main supplier and then on top of that what he does is he spots that in the filings they say, this was in 1994, they say as of 1996 we expect Ford to be our number two customer, which means that they will either means that their business to Chrysler is going to decrease and I think they didn’t warn that that was going to happen or that Ford is going – and I think that they said that we don’t actually sell to Ford, but we anticipate them becoming our number two business, which means 16% revenue growth at a minimum.

And so that’s something that is easy to miss, because again we’ve already heard that this is a small part of Briggs & Stratton. We already know that the auto parts industry is not one that’s exactly sexy or going to attract to lot of buyers. And so, now you have this really attractive opportunity because you know you are likely to get a good chance to get in at a reasonable PE as is, and then you have growth on top of it. So, it’s not just a dog in the sense of there is – it is cheap for a reason, and so that’s what essentially happens and then it plays out pretty well for Greenblatt right, I mean it works. He talks about - it spins-off at about $10 a share and I forget how long it took, but he had sort of said 11.8 per share would be a good price, which will be 10 times earnings.

So, let’s see where the – it was traded freely this year, another dated thing was that he says it traded freely between 10.5 and 12, going back to when stocks traded in eighths, but it ended up trading up to $18 before the end of 1995, 15% plus gain in less than 8 months. So, this stuff that’s just an example, and I think this is implicit in this. Again, we talked about marketing efficiency last time. I didn’t pull up what happened to Strattec, but you know 50% move in 8 months, it could have gone back down and some of the spin-offs we talk about like they do go down eventually and that’s fine like, if you know what you are getting into and that’s where I think implicit here is that this is not a buy and hold strategy for a lot of these companies, and so you just – you play for your advantage and then you move on. And so, I mean this is just, it’s obviously we are cherry picking because it’s already a cherry-picked set of investments by Greenblatt and then we are picking our favorite, but this is just how the game is meant to work.

MT: Yes, so I love this, I’ve applied it, I had a brief position in Advansix (ASIX) that I have talked about a couple of times on the podcast. We are 12, I got it booked it, you know quick gain of around 40% and something like 3 to 4 months and so it turns out I sold too early because the stock actually tripled from where I brought it. But that’s one of the important things that Greenblatt says is, if you don’t like the business you should probably sell when it hits fair value and that was when I was doing there. I just go back to – Greenblatt closes the section by saying okay, I know you are thinking the money is all fine and good, but auto part they are so darn boring. For me that’s actually a benefit, I love when there are spin-offs that are sort of straight out of the Econ or accounting text book.

I love that it reads like a microeconomic story problem where you are the head of some business and then a new customer comes in. I feel like that’s like a classic thing that a Econ teacher would do. Now, you have a new customer, Ford, and they are here to buy, and how does that impact your business. Give me these boring companies, I’m all about the boring companies. So, yes, he concludes this chapter with ten commandments that are actually seven commandments, and I think this is the worse Greenblatt jokes that he has in the book. He throws in like three junk commandments, but his basic takeaways are spin-offs beat the market. We think that that’s somewhat controversial today, although there is case and there is fundamental reasons for it.

Pick your spots. I think if you are going to take this strategy that that’s a critical element and he does a good job of emphasizing it, although I think one thing if you were to update this book you might have to sort of hammer own pick your spots a little bit more since we have at least Daniel and I some salient examples to spin-offs not working out too well according to this playbook. Great spin-offs are unwanted by institutions, wanted by insiders and how they hit an asset. Again, that’s one single commandment, that should really be three commandments, come on.

Read the filings directly, pay attention to what the parent companies are doing, partial spin-offs create opportunities, keep an eye on insiders, which he already mentioned before, and then the last three are Gilligan's Island joke. Sealant can be a good thing, and then finally call back to Lutèce, his finest, don’t ask stupid questions at Lutèce.

DS: So, any last thoughts on this subject on Chapter 3, anything else you want to make sure we hit or shall we move on to Chapter 4?

MT: I just want to emphasize first just this is the chapter, this is for the money chapter for Greenblatt, I think in both Daniel’s and my estimation. If you only read one chapter, then this should probably be the chapter. It’s great and it’s great not just because it outlines the spin-off strategy, but also it gives you a frame work. If you are interested in value investing for how to start looking at companies, and how to start looking at market pricing, and I think thinking in terms of ranges is my key take-away from the chapter, a PE from 9 to 13, don’t get anchored on one single point estimate, think about the market and what opportunities it might give you and think about the low end of evaluation range versus the high-end of a reasonable evaluation range and make decisions based on that. That for me is the key take away.

And before we get into Chapter 4, I also have one other key take away, and it has to do with Seeking Alpha sponsoring this podcast. Specifically Seeking Alpha PRO Plus. So, quick word for listeners before we get to chapter 4. PRO Plus lets you filter all of Seeking Alpha’s investing styles and opportunities. So, if you wake up one morning and you say, “You don’t feel in a little Greenblattish today,” I think maybe a 10, 12 be kind of what I have in I would say for, maybe a little spin-off, maybe look for something like a Strattec. But anyway, if you wake up and you’re like, I feel a little bit like Joel Greenblatt today. I’m a little bit feeling like I’m a Mets, Jets, Knicks fan, little value investee.

Look, here’s what you can do. You can use the PRO Plus idea filter, a piece of software that helps you look for articles on Seeking Alpha that uses special situation style. And if you want to get even more deep in the leads, you can look for specific opportunities with the idea filter. We have a spin-off mode; you can enter spin-off mode using Seeking Alpha PRO Plus that’s amazing. And when we get to chapter 4, we will take about Greenblatt’s ideas about merger arbitrage. He does not like merger arbitrage.

Well, maybe you wake one morning, and you are saying, you know what Greenblatt I’m not feeling you today, I’m going to go after some merger arb opportunities. Well, guess what, the idea filter has you covered there, we have a merger arb category, you can look at Seeking Alpha authors ideas about merger arb. So, even if you don’t like Greenblatt there’s still something for you at Seeking Alpha PRO Plus. PRO Plus has you covered for any number of investment styles. To sign up for free trial go to seekingalpha.com/proplus; PRO Plus, you like Greenblatt, you don’t there’s still something for you there. They bring you this podcast and they bring you so much more. So, check them out. Alright Daniel, I think now we are ready, Chapter 4.

DS: Chapter 4. So, Chapter 4 is really interesting to me because it basically covers mergers as sort of a catalyst for corporate actions and for opportunities, but it was surprising to me when I read this five years ago or so, having been familiar with special situations with what we published in Seeking Alpha it was surprising to me to find out that Greenblatt is quite against merger arb. He is into merger securities, we’ll get to that next, but he was against merger arbitrage and it’s interesting for me to think about – I’ve actually found for myself that merger arbitrage is not a good fit because I don’t really have an edge except I guess behavioral, but even behavioral is not a great edge for me because of Seeking Alpha’s policies around you need to have positions for 90 days, or we’re allowed to ask for waiver, but I don’t like to do that. And so, it’s jut – I remember I invested in Hutchinson, which actually worked in the end and if you just picked it and then ignored it and in the end you would have made a nice return, but like, I think I got into – the deal price was at 4, I got into it at somewhere maybe 3.4 and it got up to 3.6, I was like if I were more nimble I would just close that and moved on and be like, oh great, and I will analyze it and it will look like a great return, but…

MT: We love doing that by the way, annualizing short-term returns.Just extrapolate it out there. Why not? You book at 10% gain in two weeks, just analyze that and I will do it right now, give me one second. 1.1 to the – we will call it 25. 10x, wow, big return. that’s amazing.

DS: You just seem to find something to immediately put it into and then it works.

MT: You just need scalable opportunities to line-up for you every ten weeks and they need to systematically without variation deliver 10% returns. All you out there annualizing your short-term returns, we see you, we don’t like it. Return to subject with variance and the implicit assumption there is that your style replicates on a systematic basis over and over again with regularity, come on now, don’t annualize short-term expected returns, it’s a suspect matter.

DS: I would say it’s suspect. I think you want to – I like annualizing long-term returns, but short-term over a year because then you can get the level set for all the different opportunities, but in any case that opportunity then sold off to about $2 a share and I think I had it in, I managed my sister’s account, anyway, so just to get rid of the headache and in the end the deal worked. So, it’s an example for me that merger arb is in a good fit, but I found it interesting for Greenblatt it’s not, and by the way I came to this realization after I read this book.

So, I could have learned earlier from somebody else and did it. But I think his points are interesting and fair to consider, too many people are going there and so your competing against – and there isn’t a – the alignment here isn’t such that you can sort of getting in an edge in most cases. So, there’s too many people going there. Spreads are not generally that attractive, especially he is talking about this again in the 90s, lower interest rates makes risks arbitrage look more attractive on paper, but it’s really less attractive for risk adjusted returns, which his point is that, he was talking about, I think I extrapolated that from what he said, but he is talking about in the 90s, interest rates are in the 5.

So, let’s say, and so that puts pressure on deals, because people are kind of going to – the mindset is for example if hold 25% of my portfolio in cash, and then I see this merger arb, I say oh great, I can earn a quick essentially equivalent to some interest on my money that will risk, what seems like a risk, but nowadays everybody is doing that so that puts pressure on the spreads, which make the whole process even less attractive, and then the last thing that I think is interested because then Greenblatt walks through a couple of examples, hardest stories for him that actually didn’t work out all that poorly in the end, even though it’s fastening.

I’ll go into one just quickly in a second. But I wonder, Greenblatt points out, somewhere he says you are risking, you are hoping to gain $2 up, but you’re risking 14 down, and I think mergers because if a deal breaks you go back to where the stock was traded before. Mergers are usually done at a premium, et cetera. I wonder if this is probabilistic or if this is just Greenblatt upset because of the bad experiences, one of the bad experiences involves Bush Gardens and a sinkhole opening up in Florida, which is just fascinating example of what could go wrong.

MT: Sinkhole risk.

DS: Well that’s what he said, he said that’s not in the proxy, I didn’t see any risk of sinkholes. I wasn’t ready for this and Greenblatt is from New York or from New Jersey or wherever that area and he is…

MT: Everything is made of rocks out there, I think. Manhattan is just a giant rock, there aren’t any sinkholes in Manhattan, who knows they have the subway anyway.

DS: That is like for – you know that’s – the New York bias, but you are not thinking about Florida and a sinkhole opening up, and so I don’t know, what did you make of the case against risk arbitrage? Do you think this is just Greenblatt like expressing his own experiences or do you think there is something more universal here?

MT: To be honest with you, I don’t have like a super strong opinion about risk arb, it’s not interesting to me as a strategy, but I think that’s more dispositional than anything else. Smart people do it, and I think that that’s like AQR I think has a risk arb fund and Cliff Asness, one of the biggest hedge funds in the world, also offers mutual funds, a very systematic and statistical thinker. They run or at least used to run a merger arb strategy. I think that that’s a point against home gamers trying it. AQR is sophisticated and systematic and smart. They run this with a lot money behind this strategy, meaning that they’re going to be an active participant in compressing the spreads. I kind of do by the Greenblatt argument that this is sort of a $2 upside $14 downside.

I think in my observation, when a deal is announced, then the target company will shoot up in price and will go towards the acquisition price. I think M&A deals do tend to happen at a premium to the market pricing and probably estimations of intrinsic value, especially popular and well-known mergers. That means that there is probably some downside in there. There’s some fluff in the price action and your upside is capped. So, I kind of buy that. I haven’t looked at it rigorously.

Clearly, some people have looked at it rigorously and find an opportunity there. I think that Greenblatt is doing a good job of showing that you need to know yourself and your strategy and he has decided that this isn’t for him and I think that’s a key take away for anybody reading the book, especially if this aimed at sort a more sophisticated retail investor audience. He never says this about spin-offs, but probably if you asked him, he would say, look you got burned by spin-offs since not working for you and your [stomach churns] every time you think about them, then don’t run the strategy. And I think that’s just kind of – that would be my take away more than whether merger arb works or not is – if it doesn’t work for you, walk away from it.

DS: Yes, I think that’s right. I think there’s that and then there is – I think it fits into his mind set of you need to go where other people aren’t looking to have an edge, which again raises questions of where we are with that with spin-offs, but for merger arb, it seems fair to say that to really gain an edge and to do this more than at the systematic level is tough for the individual investor and he is also – it’s a nice, even though, I mentioned Annie Duke’s book last time and I was thinking about the talks about fielding things into skill versus luck. It’s questionable whether he is, I think he is ultimately saying, I can’t express my skill well in this bucket based on these experiences, so I’m moving on, you can decide whether that’s our [indiscernible], but to your point. If it doesn’t work for you, it doesn’t work for you, I think that’s important.

I found the same for merger arbs, I don’t remember what my track record was in playing them, but it wasn’t super high, and you kind of have to be super high track record, because when you miss it, you miss big. So, that leads to merger securities, which I think will go into an example quickly, but I think this fits in with that mindset in the idea of people aren’t looking for merger securities, I don’t think they’re quite as exotic as they used to be, because he talks about the big example you have some warrants involved, you have some subordinated debentures, you have contingent value rights, and I don’t think we usually get this wide in a ray of securities. You’ll see a CVR every now and then, the contingent value right. You don’t see like he talks in one example about preferred stock with $2 of face value and I don’t pay attention to every deal that comes across the wire or anything, but you don’t usually read about that, it’s usually a mix of cash and stock and that’s pretty much it, but I think that’s interesting …

MT: Well I wonder – I mean maybe that’s exactly the case here, is that the ones that he found, you know I don’t think we need to get too deep into Paramount and Viacom, which is kind one of the case studies, but The Wall Street Journal mentioned, but did not go into any details about the merger securities related to the deal, and I wonder if us not seeing these things is not – I don’t know if that’s evidence that they are not happening. We may just, that may be a consequence of at least me not following merger deals and you know Seeking Alpha doesn’t really have a lot of authors that are focused on merger arb or merger securities at the moment, and maybe there just aren’t that many deals happening right now. So, it’s not like a great time to go hunting for this, just a sort of throw account at you.

DS: Sure. I think that’s fair. I think the M&A part of this is cyclical. Usually the M&A is pro-cyclical right, and so usually signals a top when there is a lot of M&A, but again I think the market has made that argument two or three different times in the last few years and it keeps – so like the market keeps going and we’ve had big deals this year.

MT: I’ve also actually heard the argument that it’s counter-cyclical that after a crash there is a lot of mergers and private equity transactions as value investors commonly just take out companies that have reached really low valuations. I think it’s probably both, you know you think of the AOL Time Warner, the biggest mergers in history and are like the bell that rings at the top, but a lot of M&A activity may actually be a single level market rebound. I don’t know, I’m just putting out there that I’ve heard it on both sides.

DS: Well I think also what’s fun about this book is you get some larger than life personalities, not that Greenblatt is going into them so much, but John Malone comes up in Chapter 3 and he has got the rights offering and all the weird stuff that he does at an earlier stage of delivering media empire and John Malone is, I think is the more sophisticated investors version of the greatest of all time. I think a lot of people like to point to him and all the stuff that he has done building his empire and he still does. Another name that comes to mind – so Barry Diller comes in the example in this chapter that we want to touch on which is Paramount and Viacom and Barry Diller is another media industry smart guy.

MT: Great character. I feel like he is not in the spotlight as much now even though he is doing or has done interesting things in media, social media, had roles in Match.com and Tinder or at least was involved in some of those companies. I feel like he is not getting his due. He is kind of out of the spotlight and I don’t think that’s fair, because he is kind of this amazing character. He was like a frequent character in the New York observer, which was this kind of New York scene publication in the 90s, I worked there briefly in the late 00's when it was sort of in a different format, but he is this larger than life person. This interesting track record and he is out of the – where are you Barry Diller? Come back into the spotlight.

DS: There is a very good – for people interested in Barry Diller, there is a very good interview with him on Masters of Scale, the podcast that Reid Hoffman of LinkedIn hosts. I enjoyed, I learned a lot from that, just as from the business perspective.

MT: Yes, so just as soon as you get through the entire Behind The Idea catalog that can be the first thing on your list. You are only around 80 some episodes away from hearing that conversation.

DS: But I think the merger security stuff and again the spin-offs and the whole mindset of Greenblatt, there will still be sorts of opportunities, but they will look different. And what’s on my mind today is somebody that we talked about a few weeks ago, Michael Dell and Dell Technologies (DELL) and that stock is down as we record this on Friday August 23, is down quite a bit today because VMware (VMW), which Dell sort of owns 80% of just announced they were buying Pivotal (PVTL), which was a company that they spun out from the EMC Empire and now they are buying back. And they also bought another company and in the Pivotal case it’s a cash and stock deal. And Dell strikes me as somebody who in this day whether or not it will play out well.

Thomas Lott made the argument on our podcast that it will, but you know the stock is down since then and that’s just an interesting case to me of, there’s a lot going on and trying to trace the insider incentives and trying to figure out what’s going on at the business level will in theory should lead to some interesting opportunities I personally know positions in any of those stocks, but I’m interested in spending some time when I get the chance of trying to pick a part what’s going on here and what’s the opportunity, what is the best way to enter into it, if there is an opportunity et cetera, and I just think that’s an interesting example of this stuff does play out, it may not play out in the same way, but you know it’s sort of history rhymes, even if it doesn’t repeat, and that’s where because – Paramount and Viacom the example here, we’re are talking about a deal that – those were still relatively big companies at that time. You know in the Paramount movie studios still exist, Viacom is going through another merger story and it’s got a lot of board room drama with CBS and with Sumner Redstone.

MT: Let’s talk Viacom. Not in a good way.

DS: And I don’t know all the details there, but we are talking about warrants, which give you a chance to own the company later on, and gives you sort of a chip and a chair as they would put it in the Poker industry. There’s just a lot going on here and Greenblatt, essentially. I don’t think we have the time to break every detail of it, but it’s – when you are talking about what you have here is, you have – on the headlines, if you are reading in the journal, if you are reading even on Seeking Alpha, headlines will have a lot of that drama, but it won’t talk about all the details and I imagine if Seeking Alpha was around at that time, you would have articles talking about hey, by the way there is opportunities here and there is close reads if you look at everything that’s going on. And I think that’s maybe – what’s interesting about Greenblatt as we go into it is, Seeking Alpha is in-part spawned out of investors like in Value Investors Club, which I consider one of our rival sites. A site I like quite a bit is literally spawned out of Greenblatt.

I don’t know if he founded it, but he is involved there and I think that’s part of it is that people pick apart these a lot more or at the very least the internet brings that to the floor more where you and I can sit at home as home gamers who aren’t super investors, aren’t super great at finding these opportunities, but now we can go to Seeking Alpha, we can use the Idea filter or whatever and – we can find those ideas at the same time, that means that those ideas are getting picked over, and so as with merger arbs, the equipment to the spreads are narrower, but also it means that if you don’t apply it right, you get stuck, you run the risk of getting overexcited about the approach without having the right due diligence or whatever else you get…

MT: Risk assessment has an exit plan.

DS: You have a couple of successes and then you think that that will play out in other cases and I think for example if were to tot up all of the spin-offs I’ve invested, I think on the whole I would come out ahead. I don’t know about as compared to the benchmark or whatever else, but I think I’ve had more winners or losers, but the losers stay with me quite a bit, yes it’s just interesting to think through that and I guess that’s what with merger securities to me is just another version of this spin-off story and how it works and so yes, I think that’s sort of what I take away from Chapter 4. What about you?

MT: There is a video floating around the internet somewhere of Greenblatt teaching of evaluation or security analysis course at Columbia Business School, I think he has a pretty close relationship with them. He is at the chalkboard and he is – I don’t know if it is, to me actually be Paramount or Viacom he’s talking about, anyway he is looking out one of these merger securities cases and he starts breaking down the securities and adding up their values on the chalkboard and it’s like brutal to try and sit through and listen through it, because it’s so boring. It’s incredibly dull. And I think that’s a point in favor of the strategy, but I think it’s also a risk factor, it’s complex, it’s hard to value the securities, that’s partly where the opportunity is, and it’s dull, valuing CVRs and valuing convertible debentures is not easy and it takes a lot of patience and diligence and discipline and it’s easy to be wrong.

I think the other thing that people should watch out for, we’ve had a couple of CVR driven ideas on Seeking Alpha and I think there are risks associated with these kind of derivative securities that the counter party has to pay them off for them to realize their value, and if you are a small player do you have the wherewithal to defend your rights if something goes wrong. That’s a concern, I feel like this is sort of big boy territory in some cases and I would be concerned about that. I don’t think the strategy is invalid or bad. I think it’s harder to pursue and one of the virtues of spin-offs Chapter 3, is it is like that’s hard too, but it is sort of approachable in a way that I’m not as comfortable with merger securities and I don’t love merger arb. That’s where I land.

DS: Okay. So, we’ve run a little long here, so, let’s wrap it up with our favorite quotes and our favorite jokes. What’s your favorite joke from these two chapters?

MT: The joke is the old story of the peasant who is brought before the king and sentenced to death. We don’t why the peasant is sentenced to death, but it’s a king, he gets to …

DS: Such is the lot of the peasant.

MT: I wanted to know what happened. What happened peasant, anyway. We don’t know what happened to the peasant, he probably milks the king’s cow or something. The peasant says, to the king, please your Majesty spare my life, if you let me live just one year, I will teach the royal horse to talk. And the king is an open-minded guy, says sure. If you teach my horse to talk in one-year, I will set you free. It’s good job by the king, to give the guy a chance.

As the peasants leaving the guard says, why on earth did you tell the king that you could make a horse talk, when the year is up you will surely be beheaded. And the peasant says, look guard, a year is a mighty long time and maybe the king will change his mind, maybe the horse will die, maybe I’ll die, or who knows. If you give him a year maybe the horse will talk, and I don’t know if that’s a funny joke, but I just like that is in there, it’s not funny, I think, but it does give this, it has a moral, it is a fable, and the moral of the fable is, if you are looking at derivative securities with a certain expiration date, a lot can happen to the upside and a lot can happen to the downside when you are holding those securities.

So, it’s a good way of thinking about risk I think, and also if you are ever brought before a king and sentenced to death, you might as well try and make an animal talk as a kind of way of – it’s a call option basically, you are selling the king a call option on yourself. If you can make, if this contingency occurs then there is a benefit to the king and that’s why the king went for it, because it’s the optionality, I think.

DS: Live to fight another day. Live to fight another day.

MT: How about you Daniel, what was your joke?

DS: When discussing one of the mergers arbs that gave him a heartburn, Greenblatt says remember the kid that used to stick out in right field, you know the one who would always circle under the bowl yelling, I got it, I got it, oops, I ain't got it. Well, they ended this next deal, I was that kid. Let me tell you, it ain’t no fun.

I like the try to slip into sort of the street talk of New York in the – you know Greenblatt probably grew up in the 60s or 70s. I like the use of ain’t, I like the idea of sticking the bad kid in right field, which is what you did. I remember the revelation that let us, you know in the pros in the majors right field those are actually good fielders because you have to have a good arm, left field is actually crappy, but as a kid you are just basic, where they hit it the least and …

MT: They'll never hit it there, yes.

DS: Lefties are less frequent than righties et cetera. So, I just like that, and also the artifact is that kids don’t play baseball as much anymore, it’s not. Nowadays if you wrote that it would be, I think soccer related, if I had to guess.

MT: Soccer, left back.

DS: The kid you are hiding, goalie.

MT: I picture Greenblatt and like a little cap, they are playing like stick ball or something like old beer bottles as the bat and like…

DS: They’ve all got smudged uniforms.

MT: They are all smudged, yes. They are wearing knickers.

DS: Their mom is about to yell at that them to come in for dinner.

MT: From the tenement window there is like laundry going across.

DS: They are playing against the stoop. So, yes. If Greenblatt is a nice narrator just takes you to a world long ago, not that – we love you Joel, we hope we can have you on the podcast.

MT: He has got this great persona of being just a sort of weird corny backslapper type of guy. You know what I mean. It is just – go out there, you guys, there is YouTube videos of Greenblatt. You will see him, he is self-effacing in a way that’s sort of unusual I think for a lot of these sort of big-time investment figures. And it’s both enduring and a little, I don’t know, it’s mostly enduring, I would say, but it’s very dad-ish, he is a very dad-ish guy, I feel like, and it’s nice. If I go on there and get corny jokes, it makes for great reading, I think that’s one of the reasons this book has been so successful.

DS: So, the key quote for me from these two chapters, I think I alluded to it earlier, but he is talking about merger securities and merger deals, and he says, just remember to read about them only invest in the ones that are attractive and that you understand. And I think that’s really, really that’s his philosophy is essentially attractive and that you understand. I think it comes out of, you know he is coming out of the Ben Graham School, as far as security analysis, but then just remember to read about them and what – he is referring to merger deals, but it’s essentially the Lutèce point, and his idea of be in the right place, look in the right area, and then look for swing of the pitches that you can see that you can hit and don’t, if you don’t like you don’t have to reach for it, and I think that is really hard, and it is really hard for us to sit in cash or the equivalent, but – and we get so excited when there is a spinoff of that looks understandable and attractive and then we jump in. But I think that is what it is about is. They got to be attractive. You’ve got to understand them and you got to be looking in the right place. So, that’s my key quote from these chapters. What about you?

MT: Great. I’m stuck on the Lutèce reference. I notice here that in popular culture it’s not, I don’t think you can be a stock market genius on the Wikipedia page. So, Wikipedia editors, get out there and give Greenblatt or throw him a bone there. Don’t ask dumb questions at Lutèce, it’s actually a good line. So, that’s not an investing quote, but that’s my money quote, it's funny, it seems like something that you would hear in a movie and would stick with you. sticking with me now, and I’m going to start saying it to Daniel all the time. So, you can look forward to that.

DS: Thanks Joe.

MT: Look forward to that.

DS: Alright. Let’s wrap it there. So, that’s Chapters 3 and 4. The heart of ‘You can be a stock market genius.” Join us next time for Chapters 5 and 6, which are still good. Chapters 5 and 6 still good.

MT: Still good. La Grenouille. Daniel, let’s make next summer in New York. Let’s go there.

DS: Alright.

MT: The Bastian of Alsatian Onion Tarts.

DS: Oh man, I could really go for a good tart flambee.

MT: I could go for some grenouille right now.

DS: Well that’s your prerogative. Mike…

MT: It is undervalued hidden assets. Alright, let’s wrap.

DS: Alright. Thanks Mike.

MT: Alright take care, Daniel. Bye.

DS: Bye.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Daniel is long GOOG. Mike has no positions in any stocks mentioned. Nothing on this podcast should be taken as investment advice.