Joel Greenblatt was previously a fund manager at Gotham Capital and delivered an annualized return of 50% from 1985 to 1994, before returning all capital to its partners in 1995.
In his book You Can Be a Stock Market Genius, Greenblatt shares his secret to generating parabolic returns by applying options to special situations.
(On using options) “There is almost no other area of the stock market where research and careful analysis can be rewarded as quickly and as generously.” — Joel Greenblatt
Marriott Corporation’s Business Model
During the 1980s, Marriott Corporation’s aggressive expansion of their hotels led to them being burdened with debt. Building and owning hotels is an extremely capital-intensive business—one that does not usually generate much intrinsic value for owners.
In addition to the capital-intensive activity of building hotels, Marriott had a separate arm which managed hotels owned by others for a fee—in short, franchising its Marriott brand.
Their strategy was to build these hotels and sell them while retaining the highly lucrative management contracts for themselves.
The challenge came in the early 1990s, when there was a real estate glut. Marriott was stuck with a large supply of unsaleable hotels and the billions in debt it had taken on to build those hotels.
Stephen Bollenbach, then CFO at Marriott, decided to spin-off Marriott’s lucrative management contracts business into ‘Marriott International’ and have a separate entity called the ‘Host Marriott’ to hold all the unsaleable hotels and debt.
On the surface, it seemed like Host Marriott was being used to hold all the “toxic waste”—the unsaleable hotels and billions in debt.
But was Host Marriott really that bad?
Let’s take a look at some other facts:
Bollenbach, who was orchestrating this spin-off, would become the new CEO of Host Marriott.
Further, Marriott International (“Good”) would be required to extend a $600 million line of credit to Host Marriott (“Bad”).
Lastly, the Marriott family would continue to own 25% stakes in both Marriott International and Host Marriott.
If Host Marriott was truly just a dumping ground, then it didn’t quite make sense for Bollenbach to appoint himself as the CEO of Host Marriott. It also didn’t make sense that the Marriott family wanted a 25% stake. Furthermore, the $600 million line of credit was more than sufficient to help Host Marriott meet its interest payments.
Characteristics of a Good Spin-off Opportunity
First, investment institutions don’t want it. At face value, Host Marriott looked like a really terrible investment. Furthermore, Host Marriott was going to be a small-cap company with valuations between $200 million to $300 million. Most institutions’ mandates do not allow them to own companies of small market capitalizations.
This could trigger indiscriminate selling, sending the stock price down and therefore create a buying opportunity.
Second, insiders want it. Bollenbach, the mastermind behind this spin-off voluntarily went into Host Marriott as CEO and the Marriott family was going to own 25% after the spin-off. This throws hints that the managers of the new spin-off were incentivized along the same lines as shareholders.
Third, a previously hidden investment opportunity is created or revealed. Analysts estimated Host Marriott to trade between $3 to $6 per share and to have between $20 to $25 per share in debt. Assuming Host Marriott’s equity was worth $5 per share with $25 worth of debt per share, this would put the approximate value of Host Marriott’s assets at $30 per share.
Imagine a 15% rise in the value of its assets—a $4.50 per share increase in asset value would almost double the stock price of $5.
Investing with leverage is different from investing in a leveraged entity (without employing leverage yourself). As an investor in a leveraged spin-off, you enjoy the upside of leverage but are not liable for the debts of the company (in the event of insolvency). As a result, your returns are magnified while your risk is capped at the amount you invest.
The rewards of sound reasoning and good research are vastly multiplied when applied in these leveraged situations.
Using Options on Spin-offs
In August 1993, Marriott Corporation was trading at $27.75 and Greenblatt purchased the 15 October 1993 calls with an exercise price of $25 per share for a cost of $3.125. The spin-off would be completed by 30 September 1993.
Both Marriott International and Host Marriott would be trading independently for two weeks before his calls expired. If Greenblatt exercised his call options, he would be entitled to receive shares in both the parent company (i.e. Marriott International) and the spin-off (i.e. Host Marriott), as though he had owned stock on the spin-off date.
In this case, he would receive one share of Marriott International and one share of Host Marriott by paying $25.
Greenblatt was betting on two things.
First: Marriott International would be stripped of its debt and unsaleable hotels, leaving behind only the crown jewel—the hotel management business. Investors who were on the sidelines waiting to buy into Marriott (without its “toxic waste”) could cause a significant price move once it was available for trading.
Second: Host Marriott’s stock price would face quite a bit of volatility. While Host Marriott’s stock price was expected to be between $3 to $6 (a 100% difference), after taking into account the debt of $25 per share, the percentage difference of asset value per share drops significantly. With the stock price fluctuating between $3 and $6, Host Marriott’s asset value per share would fluctuate between $28 and $31, which is a 10% difference.
There would be plenty of room for the stock price to run between $3 to $6 without affecting the valuation significantly.
In short, the first few weeks of October was going to be extremely volatile for both Host Marriott and Marriott International.
How It Went
By 15 October, the date of expiry for Greenblatt’s options, Host Marriott stock price was trading at $6.75 while Marriott International traded up to $26 per share for a combined value of $32.75.
Remember that Greenblatt’s options allowed him to purchase both Host Marriott and Marriott International at $25. This gave him a profit of $7.75 on his paid premiums of $3.125—a 148% gain within 2 months!
Why Use Options?
Let’s compare the returns between using options and buying the stock directly.
First, using options requires less capital outlay ($3.125 versus $27.75). If your thesis was wrong, the maximum you could lose was $3.125 as opposed to $27.75 if you had bought the stock instead.
Second, due to the low capital outlay, the returns are much higher. By using options, Greenblatt’s return was 148% in two months as opposed to 18% if he were to directly purchase Marriott Corporation’s stock.
Risk From Using Options
However, one risk from using options in this scenario was that if Mr Market only recognized your thesis after 15 October 1993 (date of expiry), you would lose your premiums and miss the gains captured.
Things played out according to Greenblatt’s thesis. Applying call options in special situations where the timeline is clear provides a much better risk/reward ratio. Options, when combined with sound fundamental analysis, can significantly increase your upside while reducing your downside.