Summary of "The Big Short" by Michael Lewis

Unlocking Profits in Special Situations: A Guide to "You Can Be a Stock Market Genius"

Joel Greenblatt's book, You Can Be a Stock Market Genius, is a comprehensive guide to finding profitable investment opportunities in areas often overlooked by mainstream investors. The book explores various "special situations" that can offer significant returns for those willing to dig deeper. These include bankruptcies, restructurings, spinoffs, risk arbitrage, merger securities, recapitalizations, LEAPS (Long-Term Equity Anticipation Securities), warrants, and options.

Greenblatt emphasizes the importance of understanding these special situations and provides readers with essential rules to navigate them successfully. Let's dive into the key concepts and focus on one particular area that stands out—spinoffs.

Foundational Rules for Special Situations

Before exploring the specifics of special situations, Greenblatt sets the stage with some fundamental principles that every investor should follow:

1. Do Your Own Research: In the world of special situations, information is often scarce. You won’t find much analysis from other investors or the media, so it’s crucial to conduct your own thorough research. Relying on the opinions of others can lead to poor investment decisions.

2. Choose Your Investments Wisely: Unlike in life, where you can't always choose your battles, investing allows you to be selective. Warren Buffett’s advice, “There are no called strikes on Wall Street,” means that you should only invest when you are confident and knowledgeable about the situation. Greenblatt echoes this sentiment, suggesting that you should focus on opportunities where you feel well-informed and certain of your decision.

3. Focus on the Downside: Traditional financial metrics like stock volatility (beta) are often used to measure risk, but Greenblatt advises against this approach. Instead, he defines risk as the probability of a permanent loss of capital. To mitigate this risk, you should prioritize assessing the potential downside of an investment and let the upside take care of itself. This cautious approach helps protect your capital and ensures that you only take calculated risks.

4. Optimal Portfolio Size: Greenblatt also touches on the optimal number of stocks to hold in a portfolio. While diversification is important, there is a limit to its benefits. According to Greenblatt, owning just a few stocks can significantly reduce nonmarket risk—the risk that is not related to overall market movements. For example, holding two stocks can eliminate 46% of nonmarket risk, while owning eight stocks reduces it by 81%. Beyond this, the benefits of adding more stocks diminish. He suggests that after holding six to eight stocks in different industries, the advantage of further diversification is minimal.

Spinoffs: A Lucrative Opportunity

Among the various special situations discussed in the book, spinoffs stand out as particularly profitable. A spinoff occurs when a parent company separates one of its divisions or subsidiaries into a new, independent company. Greenblatt explains that there are several reasons why a company might choose to spin off a division:

1. Market Appreciation: The parent company may believe that the market undervalues the combined entity. By spinning off a division, each company can be more accurately valued, potentially reducing the so-called “conglomerate discount.”

2. Separating Good from Bad: A spinoff can be a strategy to separate a weaker, underperforming division from a stronger, more profitable one.

3. Debt Offloading: The parent company may use a spinoff to transfer a significant portion of its debt to the new entity, improving its own balance sheet.

4. Tax Benefits: Spinoffs can be structured in a way that offers tax advantages for the parent company.

5. Strategic or Regulatory Reasons: Spinoffs can also be a solution to strategic challenges, such as regulatory pressures or antitrust concerns.

Identifying Profitable Spinoffs

Not all spinoffs are created equal, and Greenblatt provides guidance on how to identify the most promising ones. He suggests looking for the following signs:

1. Institutional Uninterest: Sometimes, institutions may sell off shares in a spun-off company for reasons unrelated to its investment potential. For example, the new company might be too small for a large fund’s portfolio, or it may no longer fit the fund’s investment strategy. These forced sales can create opportunities for individual investors to buy at a lower price.

2. Insider Interest: A good indicator of a spinoff's potential is insider activity. If the management or key shareholders of the parent company are heavily invested in the success of the new entity—through stock purchases or incentive programs—it suggests confidence in the spinoff’s future performance.

3. Hidden Value: A spinoff might uncover a valuable business that was previously overlooked within the larger parent company. For example, the new company might have a strong business model, be undervalued due to initial selloffs, or present a leveraged risk/reward opportunity. In such cases, the spun-off entity could offer significant returns as it begins to operate independently and the market recognizes its true value.

Finding Spinoff Opportunities

Opportunities to profit from spinoffs are frequent, and Greenblatt advises investors to keep an eye out for them. He recommends monitoring financial publications like the Wall Street Journal, which often report on upcoming spinoffs. Additionally, a simple online search can reveal potential spinoff opportunities.

Once you identify a spinoff that piques your interest, it’s crucial to stay updated on the parent company’s announcements and review the SEC Form 10 filing, which provides detailed information about the new company. This document can help you assess whether the spinoff meets the criteria outlined above.

Conclusion: Navigating Special Situations with Caution

In summary, You Can Be a Stock Market Genius provides valuable insights into special situations that can offer substantial returns for diligent investors. However, it’s important to approach these opportunities with caution. Greenblatt emphasizes that the announcements and filings related to special situations can sometimes be misleading, as they may be designed to serve specific purposes, such as offloading a failing business.

Therefore, thorough research and a careful analysis of the opportunity are essential to avoid potential pitfalls. Greenblatt’s advice, “Figures don’t lie, but liars can figure,” serves as a reminder to remain skeptical and always double-check the information before making an investment decision.

By following the principles and strategies outlined in the book, investors can uncover hidden opportunities in special situations and potentially achieve above-average returns. Whether you’re a seasoned investor or just starting out, You Can Be a Stock Market Genius offers practical guidance on how to navigate the complex world of special situations and make informed investment decisions.