Sunday, March 13, 2011

You Can Be A Stock Market Genius: Chapter 6

Value investor Joel Greenblatt takes the reader through a number of categories of investing examples where market inefficiencies exist. This book has numerous case studies, giving the investor a chance to learn and then apply the lessons to current and future market opportunities

Greenblatt introduces yet another class of investments where he believes opportunity exists for value investors: recapitalizations. Companies with strong balance sheets will often borrow large amounts of money for the purpose of buying back shares. Sometimes, the debt is issued to the equity holders, who will often sell the securities (as they don't match the investor's mandate) to an attractive level.

But Greenblatt argues that the real benefit is in the small equity portion that remains. For one thing, the company's financiers now get to keep a bigger part of the company's earnings, as interest payments are tax deductible. For many companies, debt also has a lower cost of capital, so the company's value also increases. For companies with increasing earnings, the added leverage also magnifies the gains to equity holders. Investors must be careful, however, as the added leverage also increases risk.

Such transactions are difficult to find, however. Therefore, Greenblatt recommends a synthetic method to "manufacture" a recapitalization: using LEAPS. Greenblatt suggests long-term call options can often be a way to generate returns far superior to the risk taken, and this mimics what is possible during a company recapitalization.

Often, investors can take advantage of market inefficiencies in how options are priced. The mainstream finance industry uses an option's underlying stock price's volatility to price the option. But sometimes, events in the future (e.g. a spin-off) can result in higher volatility than past price movements would imply. It is here than investors can profit, by buying calls where past volatility is not a good guide for future volatility.

Some of the drawbacks of LEAPS in comparison to recapitalizations are the fact that the company does not gain tax benefits (unlike a debt issue), there are expiration dates to the options, and management is often not incentivized with shares as they often are in recapitalizations.

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