This article is an excerpt from the Shortform book guide to "You Can Be a Stock Market Genius" by Joel Greenblatt. Shortform has the world's best summaries and analyses of books you should be reading.
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How do you find undervalued stocks? Can special-situation investing make a profit?
Special-situation investing is a method for finding stocks selling significantly beneath their actual market value, and it can help you make a profit. To use this method, you’ll need to learn how to research stocks independently from financial analysts and focus on your investments rather than diversifying.
Learn how to find undervalued stocks with this advice from hedge fund manager Joel Greenblatt.
The Foundation of Special-Situation Investing
Before exploring the specific situations that offer lucrative investment opportunities, Greenblatt discusses the fundamentals underlying these opportunities. We’ll analyze these fundamentals, focusing first on how value investing lies at the core of Greenblatt’s approach and then proceeding to Greenblatt’s general tips for special-situation investors.
A Brief Introduction to Value Investing
According to Greenblatt, successful special-situation investing rests on the foundation of value investing, which prescribes purchasing stocks at less than their fair value. He argues that by practicing special-situation investing, value investors can profit handsomely.
Greenblatt explains that value investing essentially involves figuring out how to find undervalued stocks. To illustrate, imagine that you’re a baseball card collector who regularly sells baseball cards at auction and you find a card at a garage sale that costs $50. If you know that collectors have recently bought this card for around $100, then the card at the garage sale is underpriced—it’s selling for less than its true value. Thus, by purchasing the card at $50, you can make a profit of $50 by selling it for $100 at auction.
(Shortform note: One attractive alternative to value investing is known as growth investing, which involves purchasing securities whose earnings (and therefore whose price) have the potential for explosive growth, even if those securities aren’t currently underpriced. For example, rather than purchasing a baseball card at $50 which has been recently selling at $100, a growth investor might purchase a card at $50 even if it’s only been selling at $50 because they believe its price could explode in the future.)
Analogously, investors who purchase underpriced stocks can profit when the market corrects the disparity between share price and true value. For example, let’s say you purchased Netflix stock at the beginning of 2023, when its share price was around $298. If Netflix had been underpriced because of some special situation—for example, if it had announced it was shutting down one of its divisions—and its true value was (say) $330, then you would profit handsomely when the market later corrected Netflix’s share price. Greenblatt argues that because stock prices correspond with companies’ true values over the long term, the market will likely fix any such discrepancy between share price and true value, leaving you poised to profit.
(Shortform note: Though Greenblatt introduces the notion of a stock’s “true” value, he doesn’t precisely define this notion or explain how to calculate it. To that end, Robert G. Hagstrom’s definition in The Warren Buffett Way is helpful. Hagstrom clarifies that, according to investors like Warren Buffett, a company’s true (or intrinsic) value is simply its expected lifetime net income, discounted for the time value of money. So, to find the true value of an individual share, you simply take the company’s expected net income and divide it by the total number of shares.)
How Value Investing Creates a Margin of Safety for Investors
Further, Greenblatt argues that value investing creates a margin of safety that minimizes the risk in special-situation investing. The margin of safety, he clarifies, refers to the difference between a stock’s true value and its share price. In the above Netflix example, your margin of safety would have been $32—the true value of $330 minus the share price of $298.
By investing with a margin of safety, you’ll be protected from loss even if your investment’s true value takes a dip. For example, even if Netflix’s true value drops to $300, you still likely won’t lose money, since you invested at $298 and share prices generally correspond with true values. A margin of safety thus mitigates the risk of loss by making it less likely you’ll lose money.
(Shortform note: In The Intelligent Investor, Benjamin Graham—the originator of the term “margin of safety”—recommends you seek a margin of safety that’s at least one-third of a security’s price. So, in the above example where Netflix’s true value is $330 per share, Graham would advise you to invest only if Netflix’s share price drops to $220.)
Greenblatt’s General Tips for Special-Situation Investing
Having shown how the tenets of value investing inform special-situation investing, Greenblatt then offers general tips for would-be special-situation investors. We’ll focus on three key tips: invest independently, invest selectively, and don’t blindly trust investment analysts.
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Here's what you'll find in our full You Can Be a Stock Market Genius summary:
- How amateur investors can earn above-market returns
- Why special-situation investing can outperform most investing funds
- When you should invest in "new" companies
