You Can Be a Stock Market Genius

1. Spinoffs consistently outperform the market

Stocks of spinoff companies, and even shares of the parent companies that do the spinning off, significantly and consistently outperform the market averages.

Spinoffs create value. When a company spins off a division, it often creates value for shareholders of both the parent company and the spinoff. This is because the spinoff allows each business to focus on its core competencies and allocate capital more efficiently. Additionally, spinoffs are often initially undervalued because they are sold indiscriminately by institutional investors who received shares but don't want to own them.

Key factors for success:

• Look for spinoffs where insiders have significant ownership
• Focus on situations where the spinoff reveals a previously hidden investment opportunity
• Pay attention to spinoffs of smaller companies that may be overlooked by larger investors

2. Focus on insider participation in spinoffs

Insider participation is one of the key areas to look for when picking and choosing between spinoffs—for me, the most important area.

Aligned incentives drive performance. When insiders have a significant stake in a spinoff, their interests are aligned with shareholders. This often leads to better decision-making and stronger performance. Look for situations where management receives a large portion of their compensation in stock or options tied to the spinoff's performance.

Insider actions to watch:

• Large stock purchases by executives or directors
• Significant option grants tied to spinoff performance
• Management foregoing cash compensation for equity

3. Merger securities offer unique investment opportunities

Like Rodney Dangerfield, they get no respect.

Overlooked opportunities. Merger securities, such as bonds or preferred stock issued as part of an acquisition, are often overlooked by investors. This can create opportunities to purchase these securities at attractive prices. Most investors who receive merger securities as part of a deal want to sell them quickly, creating selling pressure and potential bargains.

Types of merger securities to consider:

• Convertible bonds
• Preferred stock
• Contingent value rights (CVRs)
• Warrants

4. Look for hidden value in bankruptcy situations

If you limit your investments to those situations where you are knowledgeable and confident, and only those situations, your success rate will be very high.

Opportunity in distress. While bankruptcy is often seen as a negative, it can create investment opportunities. Companies emerging from bankruptcy have often shed debt and streamlined operations, potentially positioning them for future success. However, these stocks are often overlooked or avoided by many investors, creating potential bargains.

Factors to consider in bankruptcy situations:

• Quality of the underlying business
• Strength of the post-bankruptcy balance sheet
• Management's track record and incentives
• Potential catalysts for value realization

5. Corporate restructurings can unlock significant value

One way a company can create value for its shareholders is to recapitalize its balance sheet.

Unlocking hidden value. Corporate restructurings, such as selling off divisions or recapitalizing the balance sheet, can reveal hidden value within a company. These actions often lead to a more focused and efficient organization, potentially driving higher returns for shareholders.

Types of restructurings to watch:

• Spin-offs of non-core businesses
• Sale of underperforming divisions
• Recapitalizations to optimize the balance sheet
• Management buyouts or going-private transactions

6. LEAPS provide leveraged upside with limited downside

There is almost no other area of the stock market (with the possible exception of stub stocks) where research and careful analysis can be rewarded as quickly and as generously.

Leveraged returns with defined risk. Long-term equity anticipation securities (LEAPS) are long-dated options that can provide leveraged exposure to a stock with limited downside risk. By purchasing LEAPS instead of the underlying stock, investors can potentially achieve higher returns while risking less capital.

Key considerations for LEAPS investing:

• Choose companies with strong fundamentals and catalysts
• Consider the time value of the option and potential for decay
• Balance the potential for higher returns with the risk of total loss
• Use LEAPS as part of a diversified portfolio strategy

7. Do your own research and focus on a few good ideas

It's better to do a lot of work on one idea than to do some work on a lot of ideas.

Quality over quantity. Successful investing is not about finding dozens of mediocre ideas, but rather identifying a few exceptional opportunities. By focusing your efforts on thoroughly researching a small number of promising situations, you increase your chances of finding truly outstanding investments.

Research process:

• Start with a broad screening of potential opportunities
• Narrow down to a few promising situations
• Conduct in-depth analysis of financial statements and SEC filings
• Understand the business model and competitive landscape
• Identify potential catalysts for value realization

8. Pay attention to special situations and corporate events

Just being aware that merger securities can provide extraordinary profit opportunities puts you at a huge advantage.

Capitalize on market inefficiencies. Special situations, such as spinoffs, mergers, and restructurings, often create temporary inefficiencies in the market. By paying attention to these events and understanding their implications, investors can identify opportunities that others may overlook.

Types of special situations to monitor:

• Spinoffs and carve-outs
• Merger arbitrage opportunities
• Restructurings and recapitalizations
• Rights offerings
• Bankruptcy emergences

9. Use free cash flow analysis to evaluate companies

In most cases, free cash flow gives you a better idea than net income of how much actual cash is flowing through a company's doors each year.

Focus on cash generation. Free cash flow (FCF) is often a better measure of a company's financial health and value creation than reported earnings. By analyzing FCF, investors can gain insight into a company's ability to fund growth, pay dividends, and weather economic downturns.

Calculating free cash flow:

1. Start with net income
2. Add back non-cash expenses (e.g., depreciation and amortization)
3. Subtract capital expenditures

Key benefits of FCF analysis:

• Provides a clearer picture of cash available for shareholders
• Helps identify companies with strong cash-generating abilities
• Reveals potential discrepancies between reported earnings and actual cash flow

Last updated: August 8, 2024