How can you become a stock market genius? If you were to ask a hedge fund manager how to invest, what would they say?
In You Can Be a Stock Market Genius, Joel Greenblatt leverages his expertise as a hedge fund manager to inform laypeople about how they can begin investing in the stock market. He focuses on special-situation investing, a type of investing that relies on finding undervalued stocks.
Learn more about how you can begin investing with these strategies from You Can Be a Stock Market Genius.
Joel Greenblatt’s Approach to Investing
Investing firms can overwhelm laypeople with their sheer range of options: actively managed mutual funds, passive index funds, exchange-traded funds, and more. But according to hedge fund manager Joel Greenblatt, the amateur investor doesn’t need any of these options to earn above-market returns. On the contrary, in his 1997 book You Can Be a Stock Market Genius, Joel Greenblatt argues that an approach called special-situation investing can yield lucrative returns that outperform the vast majority of investing funds.
To outline this approach, Greenblatt examines an array of uncommon situations in the corporate world that spawn various promising securities (financial assets that you can buy and sell) at bargain prices. He discusses why corporate spinoffs often create incredibly cheap stocks, why bankruptcies can lead to underpriced equities, and why stub stocks can provide exponential returns with limited downside risk.
As the founder and co-manager of Gotham Asset Management, a hedge fund with a $4.6 billion portfolio as of September 2023, Greenblatt distills years of concrete financial experience and expertise into his discussions throughout the book. Having authored several other public-facing books, such as bestsellers The Little Book That Beats the Market and The Big Secret for the Small Investor, Greenblatt is skilled at making dense financial concepts accessible to the uninitiated.
In this article, we’ll discuss how special-situation investing uses insights from value investing, and we’ll outline some of Greenblatt’s general tips for investors. Then, we’ll examine the specific situations that Greenblatt considers:
- The new securities resulting from spinoffs and bankruptcies
- Securities arising from companies undergoing acquisitions or restructurings
- Leveraged investments in the form of stub stocks and long-term calls
Throughout this article, we’ll also discuss the risks associated with some of Greenblatt’s special situations and update his arguments with research that’s appeared since the book’s 1997 publication.
What Is Special-Situation Investing?
Before exploring the specific situations that offer lucrative investment opportunities, Greenblatt discusses the fundamentals underlying these opportunities. In this section, 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
In You Can Be a Stock Market Genius, Joel Greenblatt explains that 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 finding bargain investments. 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.
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 to special-situation investors. 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.
Greenblatt’s General Tips for Special-Situation Investors
Having shown how the tenets of value investing inform special-situation investing, in You Can Be a Stock Market Genius, Joel 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.
Tip #2: Invest Selectively
Next, Greenblatt contends that 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.
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.
Investing in “New” Companies: Spinoffs, Partial Spinoffs, and Orphan Equities
Having discussed Greenblatt’s general strategies for special-situation investing, we can now proceed to the first group of special investing situations—those arising when established companies beget new companies and stocks. In this section, we’ll focus on three such situations: spinoffs, partial spinoffs, and orphan equities.
How to Profit From Spinoffs
Spinoffs occur whenever a parent company decides to jettison one of its subsidiaries or divisions and create a fully independent company. According to Greenblatt, investing in spinoffs can yield above-market returns because shareholders of the new spinoff often seek to hastily sell their shares.
In You Can Be a Stock Market Genius, Joel Greenblatt clarifies that when a spinoff occurs, the parent company typically distributes shares of the spinoff to existing shareholders. For example, if Warren Buffett’s company—Berkshire Hathaway—decided to spin off Dairy Queen, one of its subsidiaries, then Berkshire Hathaway might distribute shares of Dairy Queen to its current shareholders to compensate them for the value lost when it jettisoned Dairy Queen.
In practice, this means that shareholders receive shares that they didn’t ask for—in the previous example, shareholders originally wanted to invest in Berkshire Hathaway, not Dairy Queen. Further, Greenblatt points out that these spinoffs are often too small for institutional investors, who only invest in large companies. The upshot is that investors sell the spinoff’s newly created shares in droves, often making the spinoff’s stock available at bargain prices. Greenblatt notes that, for this reason, spinoffs have historically outperformed the S&P 500 by 10% annually in their first three years, according to a 1988 study.
How to Profit From Partial Spinoffs
In a similar vein, Greenblatt discusses partial spinoffs, which occur when a parent company only spins off a portion of a division or subsidiary and keeps the rest. He argues that partial spinoffs can present promising investment opportunities—both in the partial spinoff and in the parent company.
Investing in partial spinoffs, Greenblatt points out, can be lucrative for the same reason it can be lucrative to invest in spinoffs: Shareholders receive unsolicited shares of stock in the partial spinoff and thus have an incentive to sell these shares at a low price. However, Greenblatt contends that the best investment opportunities from partial spinoffs often involve investing in the parent company. He reasons that when a partial spinoff occurs, the market not only prices the spun-off division, but also allows us to calculate the value of the parent company minus the entire spinoff.
How to Profit From Orphan Equities
Finally, in You Can Be a Stock Market Genius, Joel Greenblatt turns to so-called orphan equities—the new stock of companies that emerge from Chapter 11 bankruptcy proceedings. He maintains that orphan equities can be lucrative investments because their initial owners are former creditors with incentive to sell.
Greenblatt first clarifies that when a company survives bankruptcy proceedings, new shares of its stock are issued and distributed to the company’s former creditors—those who hold the debt that the company can’t repay. For example, if Netflix were billions of dollars in debt to banks and declared bankruptcy, then these banks would be compensated with newly issued Netflix stock if Netflix survived bankruptcy—after all, if Netflix were bankrupt, it wouldn’t be able to pay the banks back in cash.
Finding the Best Orphan Equities
Greenblatt recognizes, however, that stock in recently bankrupt companies is often deservedly low—these companies went bankrupt, after all. So, to distinguish between fairly priced orphan equities that are unpromising investments and genuinely underpriced orphan equities, he endorses Warren Buffett’s advice: Look for companies with sound underlying business models.
Investing in Evolving Companies: Acquisitions and Restructurings
In addition to the new investment opportunities arising from spinoffs and bankruptcies, Greenblatt also discusses how pre-existing companies undergoing significant changes can yield lucrative investments. In this section, we’ll discuss two such changes: acquisitions and restructurings.
How to Profit From Companies Undergoing an Acquisition
Acquisitions occur whenever one company purchases a majority of another company’s stock from its shareholders, thus giving the acquiring company controlling interest in the acquired company. In You Can Be a Stock Market Genius, Joel Greenblatt argues that acquisitions can create promising investment opportunities because so-called merger securities are often sold at bargain prices.
How to Profit From Companies Undergoing a Restructuring
While acquisitions enlarge an existing company, restructurings (the process of closing or selling an entire division) cut the size of an existing company. According to Greenblatt, corporate restructurings can yield lucrative investment opportunities for two primary reasons: They rid companies of unpromising divisions and they indicate that management is shareholder-oriented.
Investing in Leveraged Companies: Stub Stocks and LEAPS
Having seen how evolving companies can give rise to promising securities, Greenblatt turns to consider the more specialized opportunities that arise when companies are heavily leveraged—in other words, when they take on debt. In this section, we’ll discuss why highly leveraged stub stocks are desirable investments and then examine how long-term equity anticipation securities provide similar benefits to stub stocks.
How to Profit From Stub Stocks
Stub stocks, Greenblatt clarifies, emerge whenever a company chooses to recapitalize—that is, when it pays shareholders either cash or other securities so it can repurchase large quantities of its own stock. Greenblatt argues that stub stocks provide a favorable investment opportunity because they amplify companies’ increases in earnings while limiting downside risk.
How to Profit From LEAPS
Stub stocks, Greenblatt points out, are a relatively rare phenomenon. However, he writes that you can enjoy similar benefits to stub stocks by investing in long-term equity anticipation securities (LEAPS). According to Greenblatt, LEAPS are another investment vehicle that can yield outsized returns while minimizing downside risk.
Like stub stocks, LEAPS can amplify increases in stock price to yield disproportionately large returns. Returning to the previous example, if you purchased 1,000 LEAPS at $1 each that gave you the right to buy Disney at $90 down the line, then you could earn $10 per LEAP if Disney stock rose to $100 per share. Thus, your initial $1,000 investment would return $10,000, a tenfold increase. By contrast, those who owned Disney’s common stock at $90 would earn a meager 11% return on investment in the same period.
