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.
Tip #1: Invest Independently
First, Greenblatt argues that you should perform your own research to find bargain investments. He writes that this advice stems from the nature of bargain investments—because such investments are ignored and unappreciated by other investors, they’re not heavily discussed by mainstream investing sources. For example, if The Wall Street Journal ran a front-page story on an allegedly underpriced stock, swarms of investors would likely invest in it, driving its price up and making it no longer a bargain.
(Shortform note: In The Most Important Thing, Howard Marks argues that those who don’t do their own research often suffer because they just follow the crowd. He argues that because the pressure to conform often leads investors to abandon due diligence and join misguided trends, investors who habitually conform to the status quo will make many irrational investing decisions.)
Tip #2: Invest Selectively
Next, Greenblatt contends that when special-situation investing, you should invest sparingly, focusing on the stocks that you’re most sure about. He asserts that by practicing this strategy, you’ll maximize your chances of finding profitable investments while excluding those you know less about (and which are therefore riskier). After all, you never have to invest, so you can wait patiently to ensure your investments are always well-informed.
(Shortform note: While Greenblatt’s advice is geared towards investors with the resources to assess individual companies, many investors lack these resources. For them, it might be better to follow John C. Bogle’s advice in The Little Book of Common Sense Investing. Rather than focusing on a few stocks, Bogle recommends investing in index funds—funds that track a broad underlying index, like the S&P 500. He argues that investing in index funds will earn you results better than the vast majority of investors, who instead invest in actively managed mutual funds—funds managed by financial professionals who frequently buy and sell stocks—because mutual funds have much higher expenses and fees that cut into their returns.)
Greenblatt acknowledges that selective investing conflicts with diversification—investing in a wide range of companies to minimize your portfolio’s volatility. But he argues that the slight increase in volatility is worth the potentially outsized returns that come from investing selectively.
To illustrate, he notes that historically, the US stock market’s returns have had a standard deviation of 18%, with typical returns falling between -8% and +28%. By contrast, a focused portfolio composed of eight stocks has historically had a standard deviation of 20%, with typical returns falling between -10% and +30%. Thus, Greenblatt argues, a focused portfolio is only slightly more volatile than a fully diversified one. However, he adds that the focused portfolio offers potentially much greater returns—if you carefully invest in the stocks you’re most certain about and take advantage of the special situations we explore below.
(Shortform note: Like Greenblatt, Warren Buffett is also famously opposed to diversification. Buffett points out that, because a diversified portfolio more closely resembles the overall market, it inevitably leads to market-average returns. Thus, for investors who aren’t content with the average, it’s a logical truth that they must avoid diversified portfolios).
Tip #3: Don’t Blindly Trust Analysts
Finally, Greenblatt argues that you should avoid deferring to analysts because their interests compete with yours. For example, many analysts are paid by stockbrokers who earn commissions on stock sales. Thus, analysts are incentivized to recommend buying companies even when these companies might be objectively unpromising. Moreover, analysts who criticize a company’s stock often lose their access to inside sources, which makes them reluctant to issue “sell” recommendations. For these reasons, Greenblatt believes you can’t trust analysts to provide you with impartial recommendations.
(Shortform note: In Calling Bullshit, professors Carl T. Bergstrom and Jevin D. West explain that whenever people want to sell you something—for instance, like investing analysts trying to sell you on hot stocks—they’re likely to use bullshit to do so. Bullshit, they argue, involves the use of statistics or data, without regard for the truth, to attempt to persuade an audience. By this definition, it seems clear that Greenblatt believes financial analysts are prone to bullshit: They use investing metrics, like free cash flow, price-earnings ratios, and debt-to-equity ratios to convince you to purchase stocks that benefit them, even if these stocks are actually unpromising.)
