Can you really be a stock market genius? - I - Views on News from Equitymaster

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Can you really be a stock market genius? - I

Jun 25, 2013

The broad meaning of value investing is investing in securities that are trading below their ' intrinsic value '. It's basically buying something cheap than its actual worth. A stock trades cheap when its valuations excessively discount the company's long term fundamentals. One more reason for a stock to be cheap could be Mr Market's hurried reaction to bad news. This, however, presents an opportunity for value investors to profit by buying when the price is deflated.

However, the big question is....are we genius enough to know when these opportunities come knocking? In other words, when you can fairly ascertain that the stock price is deflated and justifiably undervalued? Well, we should consider ourselves lucky to have received the wisdom of a stalwart like Joel Greenblatt. Just to refresh your memory Joel Greenblatt, runs a private hedge fund called Gotham Capital. His firm achieved 50% average annual return over a 10 year period which spanned from mid 1980's to the mid 1990's.

Greenblatt has also penned several books on value investing in which he has encouraged individual investors to grab best investment possibilities. In his book 'You can be a stock market genius'; he advises investors; through his first hand experiences; to keep their eyes open to opportunities which do not come out of the ordinary course of business. Rather, these could be specific corporate events such as spin-off, business restructuring, bankruptcies, risk arbitrage and mergers which may result in large profits.

As per Greenblatt, individual investors can have long term investment horizons as their performance is not being evaluated every quarter unlike money managers. Hence, they can patiently wait for special corporate events/situations to fold out. So let us very succinctly discuss a significant corporate event- spin-off that the author has talked about in his book.

In spin-off; companies separate a subsidiary, division or a business segment from its parent to create a new, independent company. The motives behind spin-off can be many. It includes unlocking a business division's hidden value, separating out a bad business or tax considerations. Moreover, sometimes a spin-off is a way to get value to existing shareholders for a business division which can't be easily sold.

This suggests spin-off can have certain characteristic that makes them an outstanding opportunity. Let's look at few of those:

  • Greenblatt says that insider participation is one of the key areas to identifying a profitable spin-off. One has to ascertain if the management is being incentivized for the spin-off. If the management is going to receive a good part of their compensation in form of stock or options; chances are high that they will be motivated to work hard and perform well which will boost stock returns.

  • Spin-offs could also uncover a hidden opportunity in terms of a good business or a cheap stock. Also, non-core divisions are a usual candidate for spin-offs. Since these divisions have always been neglected when they are a part of a bigger corporation. Once they are spun off, their management can focus to improve their business.
Greenblatt goes on to say that irrespective of the institutional motive behind a spin-off; it has been proven time and again that stocks of spun off companies and parent companies have significantly outperformed the market averages. But he also reinstates that there can always be few exceptions and you cannot always blindly follow this observation. Instead, you should weigh the pros and cons of a spin-off carefully before jumping the gun too quickly.

We shall discuss a recent spin-off of a FMCG major which may warrant more than a thorough research before we could term it as a prized catch.

Marico's Kaya spin-off: Marico, a FMCG major, spun off its subsidiary- Kaya skincare (Marico's skin care business under the Kaya Clinic brand) w.e.f. April 2013. The company plans to list Kaya as Marico Kaya Enterprises (MaKe) in 3QFY14. Shareholders of Marico will be issued one share of MaKE, for every 50 shares of Marico with a face value of Re 1 each.

The rationale behind the spin-off was to provide much needed thrust to loss making skin care business of Kaya. Kaya contributes around 7% to Marico's total turnover. In FY13, Kaya reported revenue growth of 21% Y-o-Y but had a loss of Rs 180m at EBIT level as compared to Rs 310 mln loss in FY12.

After the spin-off Marico will be able to focus back on its FMCG business. Kaya is also not supposed to carry significant debt on its balance sheet. The two businesses are not interdependent, so no synergies are being lost in the spin-off. Moreover, by hiving off an unprofitable business that was severing its cash and margins, Marico can now use its cash to reinvest in the consumer business. Kaya's demerger will also help Marico's profits up by 5 % as per analysts. Well, the rationale behind the merger seemed just appropriate.

However, the market did not think so! It is evident from the negative returns of 10.7% on the stock since the announcement of spin-off on January 07, 2013. On the face of it the stock almost shows all the characteristic of a good unvalued spin-off opportunity. So now can we say that it is a chance for investors to get into the undervalued stock of Marico? Probably not and this is where Greenblatt urges the readers to do their homework properly.

Well, at Equitymaster we did look at the other side of the coin and had a different take on the Marico - Kaya demerger. According to us, while the spin-off is likely to favorably impact Marico's financials but the impact is too small to accrue significant benefits in the immediate future. Moreover, the spin-off cannot be looked at in isolation and Marico's valuations need to be assessed in terms of the company's own fundamentals.

In addition Kaya faces stiff competition from Hindustan Unilever's Lakme Salon and also from other branded regional salons such as Javed Habib Hair & Beauty, Natural and Enrich salons. This means turnaround of Kaya business is going to be a challenging task.

Thus, Greenblatt has, in a simple and easy to follow rules, dictated ways to beat the market if one is ready to tread the uncommon path backed by thorough research and little common sense. While spin-offs is one such event; corporate restructuring, bankruptcies, risk arbitrage as well as mergers are few events where investors can explore hidden undervalued investment treasures. We shall discuss more such events in our next article.

Stock market Genius - Next Article | All Articles


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1 Responses to "Can you really be a stock market genius? - I"

Rahul Joshi

Oct 24, 2019

Stock market trading is not easy but its definitely not that hard as people assume. People make these assumptions because its a high risk high return investment. If you work smartly and try to learn more then you can become a top top personality in any field. Best way to improve your knowledge about stocks is blogs. There are a lot of experts who right blogs on their or a company website. Reading them will surely help anyone to become better at stocks investment.

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Equitymaster requests your view! Post a comment on "Can you really be a stock market genius? - I". Click here!

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