Joel Greenblatt was previously a fund manager at Gotham Capital and achieved an annualized return of 50% from 1985 to 1994 before returning all of the capital to his partners in 1995.
In his book You can be a stock market geniusGreenblatt shares its secret with generating parabolic returns by applying options to specific situations.
(On Using Options) “There is almost no other area in the stock market where research and careful analysis can be so quickly and generously rewarded.” – Joel Greenblatt
In the 1980s, the aggressive expansion of their hotels by the Marriott Corporation resulted in them being burdened with debt. Hotel building and owning is an extremely capital-intensive business that usually doesn’t add much value to owners.
In addition to its capital-intensive hotel building activities, Marriott had a separate branch that managed hotels owned by others for a fee – in short, the franchise of its Marriott brand.
Their strategy was to build and sell these hotels while keeping the highly lucrative management contracts to themselves.
The challenge came in the early 1990s when there was a real estate glut. Marriott had an abundance of unsalable hotels and the billions in debt it had incurred to build those hotels.
Stephen Bollenbach, then CFO at Marriott, decided to outsource Marriott’s lucrative management contract business to “Marriott International” and set up a separate entity called “Host Marriott” to hold all unsalable hotels and debts.
On the surface, it seemed like Host Marriott was being used to hold all of “toxic waste” – unsalable hotels and billions of debts.
But was Host Marriott really that bad?
Let’s look at some other facts:
- Bollenbach, who orchestrated this spin-off, became the new CEO of Host Marriott.
- In addition, Marriott International (“good”) would have to issue a $ 600 million line of credit to host Marriott (“bad”).
- Eventually, the Marriott family would continue to own a 25% stake in Marriott International and Host Marriott.
If Host Marriott was really just a dump, then it didn’t make perfect sense for Bollenbach to appoint himself CEO of Host Marriott. It also made no sense that the Marriott family wanted a 25% stake. Additionally, the $ 600 million line of credit was more than sufficient to help Host Marriott meet its interest payments.
First, investment institutions don’t want that. At first glance, Host Marriott looked like a really terrible investment. Additionally, Host Marriott should be a small-cap company with valuations between $ 200 million and $ 300 million. Most institutions’ mandates do not allow them to own small capitalization companies.
This could trigger an indiscriminate sale, depressing the stock price, creating a buying opportunity.
Second, insiders want it. Bollenbach, the mastermind behind this spin-off, voluntarily joined Host Marriott as CEO, and the Marriott family should own 25% after the spin-off. This suggests that the managers of the new spin-off were motivated along the lines of the shareholders.
Third, a previously hidden investment opportunity is created or exposed. Analysts estimate that Host Marriott owes between $ 3 and $ 6 per share and between $ 20 and $ 25 per share. Assuming Host Marriott’s equity is $ 5 per share and $ 25 in debt per share, the approximate value of Host Marriott’s assets would be $ 30 per share.
Imagine a 15% increase in the value of the asset – a $ 4.50 per share increase in the asset would nearly double the stock price of $ 5.
Investing with leverage is different from investing in a leveraged company (without using leverage yourself). As an investor in a leveraged spin-off, you enjoy the benefits of leverage, but you are not liable for the company’s debts (in the event of bankruptcy). As a result, your returns are increased while your risk is limited to the amount you invested.
The rewards of sound thinking and good research multiply significantly in these leverage situations.
In August 1993, the Marriott Corporation was trading at $ 27.75, and Greenblatt bought the October 15, 1993 calls with an exercise price of $ 25 per share at a price of $ 3.125. The spin-off is expected to be completed by September 30, 1993.
To find out why you should buy the In The Money (ITM) calling option, click here.
Both Marriott International and Host Marriott would act independently for two weeks before its calls expired. If Greenblatt were to exercise its call options, it would be entitled to receive shares in both the Parent Company (ie, Marriott International) and the Demerger (ie, Host Marriott) as if it had owned shares on the Demerger Date.
In that case, he would receive one share of Marriott International and one share of Host Marriott for a payment of $ 25.
Greenblatt sat on it Two things.
First: Marriott International would be rid of its debts and unsalable hotels, leaving only the crown jewel – the hotel management business. Investors standing on the sidelines waiting to buy into Marriott (without its “toxic waste”) could cause significant price movement once it becomes available to trade.
Second: Host Marriott’s share price would be subject to some volatility. While Host Marriott’s share price should be between $ 3 and $ 6 (a 100% difference), the percentage difference in asset per share drops significantly after accounting for its $ 25 per share debt. With the share price fluctuating between $ 3 and $ 6, Host Marriott’s asset per share would fluctuate between $ 28 and $ 31, a 10% difference.
The share price could range from $ 3 to $ 6 without significantly affecting the valuation.
In short, the first weeks of October were extremely volatile for both Host Marriott and Marriott International.
Through October 15, the expiration date for Greenblatt’s options, Host Marriott’s share price was trading at $ 6.75 while Marriott International was trading up to $ 26 per share for a total value of $ 32.75.
Keep in mind that because of its options, Greenblatt was able to purchase both Host Marriott and Marriott International for $ 25. This gave him a profit of $ 7.75 on his $ 3.125 paid premiums – a profit of 148% in 2 months!
Let’s compare the returns between using options and buying the stock outright.
First, using options requires less capital outlay ($ 3.125 versus $ 27.75). If your thesis was wrong, the maximum loss you could lose was $ 3.125, up from $ 27.75 if you bought the stock instead.
Second, the returns are much higher due to the low capital outlay. Using options, Greenblatt achieved a return of 148% in two months, compared to 18% if it bought the shares of Marriott Corporation directly.
However, a risk with using options in this scenario was that you would lose your premiums and miss out on the profits made if Mr Market did not recognize your thesis until after October 15, 1993 (expiration date).
Things played out according to Greenblatt’s thesis. Applying call options in special situations where the timeline is clear offers a much better risk / reward ratio. When combined with in-depth fundamental analysis, options can significantly increase your uptrend while decreasing your downward trend.
Organic: Thomas Chua invests and contributes Steadycompounding.com. If you want to learn more about investing in quality businesses, check out the articles that helped him generate his first multi-excavators: https://steadycompounding.com/start/
If you’d like to find out how he’s using options as a tool to complement long-term investments, visit his page at https://learnoptions.substack.com/