Deep Value Investing

Christopher Mayer
 Copyright © 2018 by Christopher Mayer

All rights reserved, including in whole or in part in any form.

 CONTENTS

Preface i

Introduction iii

Part I 1

Chapter 1: Small-caps 2

Chapter 2: Spin-offs 15

Chapter 3: Post-Reorganization Equities 25

Chapter 4: Ten Mistakes Investors Make 32

Part II 38

Deep Value Examples 39

Appendix 49

The Making of a Stock Picker 50

 DISCLAIMER

This publication contains the opinions and ideas of the author. It is not a recommendation to purchase or
sell the securities of any of the companies or investments herein discussed. It is sold with the
understanding that the author is not engaged in rendering legal, accounting, investment, or other
professional services. Laws vary from state to state and federal laws may apply to a particular transaction,
and if the reader requires expert financial or other assistance or legal advice, a competent professional
should be consulted. The author cannot guarantee the accuracy of the information contained herein. The
author specifically disclaims any responsibility for any liability, loss, or risk, professional or otherwise,
which is incurred as a consequence, directly or indirectly, of the use and application of any contents of
this book.
PREFACE

Before beginning a Hunt, it is wise to ask someone what

you are looking for before you begin looking for it.

Pooh’s Little Instruction Book by Joan Powers, inspired by A. A. Milne

The efficient-market hypothesis (EMH) posits that it is impossible to “beat the market” because the efficiency of the market
causes existing share prices to immediately incorporate all new relevant information. According to adherents of the EMH,
stocks will always trade at their fair value, making it impossible for investors to buy undervalued stocks or sell them when they
are overvalued. These adherents believe it is impossible to outperform the overall market through expert stock selection and
the only way possible for investors to increase their returns is to increase the risk. I completely reject this convenient but naïve
definition of the risk-return relationship. In this book I will explain how using a deep value investing approach will enable an
investor to find opportunities that are both low in risk and high in return.

Before we go much further, it is important to define what I mean by “deep value investing”, as my definition is likely to be
different from other value investors. I define deep value as being a situation in which a security is trading at less than half of its
estimated intrinsic value and where there is a high probability the security price will increase by 50% or more within a 1-2 year
period. This can include garden variety value stocks, special situations (such as spin-offs, mergers, and post-reorganizations),
and distressed securities. In this book I will cover deep value and special situations – two areas that have the potential to generate
the biggest returns. Distressed securities are not appropriate for individual investors (unless you are willing to quit your day
job) and will not be covered here. Deep value investing is as simple as it is sophisticated. More importantly, it is about a
willingness to stand apart from the crowd and look in areas other investors ignore.

This book is meant for serious investors who have a basic understanding of the stock market, enjoy the investment process, and
wish to earn returns higher than the overall market while employing less risk. While the examples only cover companies listed
in the United States, the principles covered work equally well across the globe. It is important to remember that the strategies
covered here rely only on information that is available to the public. All that is required is for the investor to have an interest in
finding opportunities that are off the beaten path, but have a high probability of market beating returns. This means a
willingness to look at many different prospective investments and choosing only the best prospects. Patience plays the most
important role in this process. The best deep value investors understand the need to allow an investment thesis time to unfold.

I have included a number of deep value investment examples in order to make the content practical and to illustrate the
possibility of market beating returns. In each example I explain how and when I found the company. I then give an overview of
the thesis and discuss which factors influenced my final decision. I want to avoid burying the thesis under endless details, but
allow readers to take a closer look at the information that was available at the time.

Readers will not master these strategies in just a few hours of reading. Learning them will require time and attention. Success is
not guaranteed and these strategies require proper application and judgment. With the right frame of mind and patience, these
strategies can shift the odds in their favor.

This book is not meant to provide a robotic investment approach that can be copied mindlessly. Rather, I hope to educate the
reader on an entire way of thinking that can be adapted by any thoughtful investor who is willing to understand why it works
and apply those fundamental principles to a wide range of investment opportunities. It is important to remember that each
individual investment has its own unique characteristics, but the principles remain the same. My goal is for readers to analyze

i
the strategies, understand the logic behind them, examine the evidence of their actual use, and come to the conclusion that
consistent superior performance in the market is a realizable goal.

This book is a preview of an expanded print version expected to be completed by spring of 2019. It will cover deep value, risk
arbitrage, options, hedging, and risk management.

Christopher Mayer

July 2018

ii
Introduction:

Knowing How to Find Deep Value

Where should investors look to find deep value stocks? In the age of the internet the possibilities seem
overwhelming. There is everything from reading the Wall Street Journal or watching CNBC, to running stock
screens, or even checking out the gossip on Twitter and Stocktwits, but really the most important question investors
should be asking is how to look. Once the how to look has been established, the where to look is easier to determine.

The reality is that with the superabundance of investment content available to investors, there are numerous great
places to look for potential opportunities. The more difficult challenge is filtering out the wheat from the chaff and
focusing on the small fraction of stocks that are worthy of further analysis. The top value investors know that their
time is a valuable asset. They have learned how to quickly identify the most promising deep value opportunities and
devote their time accordingly.

How do I do that? I decided to write this book after having been asked that very question countless times. I can sum
that up in a few sentences. I start by asking why a company or security is likely to be undervalued by the market.
That theory can be based on a number of factors: if it is a spin-off, if it is emerging from bankruptcy, if it was recently
removed from an index, etc. Once I have established my theory, I then analyze the company to see if the particular
security is, in fact, undervalued. In order to invest, I need to understand why the opportunity exists.

To put it in other words, I do not start digging into the financial statements and analyzing every company that I
come across. Instead, I start with a theory on why there could be a deep value opportunity and only then do I
investigate further.

The top value investors are successful because they have identified their “edge”. The goal of this book is to be an
introduction for investors searching for their own edge. The best way for investors to develop their edge is by
identifying and categorizing different strategies or situations that are most likely to offer mispriced opportunities. I
have attempted to provide an overview of some of my favorite opportunities and the key points to analyze when
readers are conducting their own research. Establishing a mental database of categories and special situations will
assist the reader in quickly determining which companies and situations are worthy of further analysis and which
are a waste of time. My goal is for readers to focus on developing their own edge which is paramount to investment
success.

I am certain that by internalizing some of the concepts I present in this book, investors will be on their way to
identifying deep value opportunities. After reading it, please feel free to use it as a refresher when focusing on those
areas of the market that offer the highest possibility of a deep value opportunity.

iii
PART I
Finding Deep Value Opportunities
Deep value investors want to buy stocks that are trading at a significant discount to their estimated intrinsic value.
The classic buying a dollar for 50 cents. Given the overall competitiveness of the market, which is not the same as
the market being efficient, it would be an overwhelming and time-intensive task to look for deep value stocks if the
investor does not know where to find them.

The best investors know that deep value opportunities are more likely to occur in some areas of the market than in
others. In order to avoid misusing their time on opportunities that do not warrant further analysis, they often look
for deep value in areas of the market where they understand the reason for the stock to be undervalued. On the flip-
side, they avoid areas of the market that are unlikely to offer a deep value opportunity.

Part I provides an analysis of favored areas in the market that I have identified as offering the highest probability for
deep value opportunities. In some cases I will provide examples of past opportunities that proved to be lucrative
investments.

1
Chapter 1

Small-Caps

One way of dealing with information being more available is to stop playing the game and seek out securities of
asset classes where there’s less information or competition.

-Seth Klarman, The Baupost Group

The first area of the market that we will explore are companies with a small market capitalization, also known as
small-caps. These are companies with a market value between $250 million and $2 billion. Companies falling below
$250 million are known as micro-caps and companies with a market cap below $50 million are known as nano-
caps. For the sake of simplicity I am going to lump small-caps, micro-caps, and nano-caps under the same umbrella.
None of these should be confused with penny stocks, which, quite frankly, are not worth the time or trouble. As a
group, small-caps have outperformed the market over long periods of time. This has not prevented small-caps from
having a bad reputation. The bad rap is due to the perception that small-caps are prone to financial fraud or
manipulation from “pump and dump” schemes. I would say that this is hardly a problem that affects only small-
cap companies. Look no further than Enron or Worldcom, two of the biggest corporate bankruptcies in history that
were mired in fraud.

Reasons small caps may be undervalued

Before discussing why investors should consider investing in small-caps, it is important to understand why a small-
cap is likely to be undervalued.

Small-caps are largely ignored by the larger market players including hedge funds and mutual funds

Many fund managers do not bother with small-caps because they may be illiquid and difficult to buy and sell in
large increments. Or it could be that their charter prevents them from investing in small-caps; this more so in the
case of funds that are only permitted to invest in stocks that are part of an index. Multi-billion dollar funds may not
even consider a small-cap because it would be hard to justify the effort and time required to analyze them. Mutual
funds are prevented from owning more than 10% of a company. If a mutual fund manager that oversaw $10 billion
in assets wanted to invest in a company with a $100 million market cap, he would only be able to buy $10 million
in stock. Even if the company’s stock outperformed the market, it would barely move the needle on the fund’s
overall performance.

Small caps are largely ignored by Wall Street analysts and the media

Small-caps are typically not known outside of their geographical area. Very few, if any, Wall Street analysts will
analyze and therefore promote a small-cap company due to the low trading volume. Low trading volume means

2
very little commission income. Furthermore, the media tends to only cover companies that have extensive analyst
coverage.

A good example of an undervalued small cap that was largely unnoticed and unfollowed by the Wall Street
community was Cepheid, a molecular diagnostics company. In July 2010, with virtually no Wall Street analyst
coverage and barely a mention in any mainstream media, the stock was trading at $16. That was when a small deep-
value oriented hedge fund took notice of the company and its undervalued stock. Before too long the hedge fund
began drawing the attention of other analysts and the media to this interesting and dynamic company. By the
summer of 2015 the stock was up to $60, for a return of 275% - a situation where patient investors were amply
rewarded!

Very little public information is available

When compared to large cap stocks, there is very little public information on small-caps, save for filings with the
Securities and Exchange Commission. Furthermore, what information that is available is likely to be only positive
since companies are more likely to emphasize positive news and keep out of sight the negative news. Subsequently,
investors that rely heavily on public information will be circumspect when it comes to investing in small-caps.

Small-caps inherently carry more risk

Large firms with well-established histories have a lower risk profile when compared to small-caps. Small- caps
appear to be less safe due to more volatility and less information. During periods of market disruption many
investors will flee small caps for the familiarity of established large caps. Small-caps do not benefit from the same
access to capital that larger companies tend to enjoy, putting them in a more precarious position during market
downturns.

Reasons for investing in small-caps

Now that we have covered why small-caps are likely to be undervalued, we can look at why they make good
investments, something the best value investors have known for a long time.

Easier to analyze and understand

Small-caps are easier to analyze than big companies and their business models tend to be simpler. They operate in
only one or a few lines of business. It is easier for investors to approach management with questions about the
company or financial results.

Growth potential can be significant

Most large cap companies were at one time small-cap companies. Small companies grow from a smaller arithmetic
base. It is easier to double the revenue of a $50 million company than the revenue of a $5 billion company. At some
point all companies stop growing at a fast rate, otherwise they would eventually outgrow the entire economy.

3
Small companies are often in growth industries and find it easier to change their strategy in the face of changing
market conditions. Smaller companies are often run by their founders or a small group of managers that own a large
share of the company and are therefore incentivized to increase shareholder value. Investors often lament over
missing the opportunity to have invested at the start of Wal-Mart or Microsoft. Today’s small-cap could be
tomorrow’s mega-cap.

Greater universe of opportunities

There are over 7,000 companies listed on the NYSE and the NASDAQ. There are an estimated 250,000 analysts
worldwide. Approximately 80% of all analysts focus their attention on just 20% of all publicly traded companies,
typically those with market caps of $2.5 billion or more. This leaves a large number of companies with negligible
analyst coverage. With very few fund managers performing in-depth research on small-cap companies and the rest
relying on conventional sell-side research, a staggering amount of small-cap companies are overlooked. By focusing
on this large number of unrecognized companies, investors can increase their chances of finding hidden value.

An inefficient market

Since few, if any, brokerage firms cover small-cap companies, there is a higher probability of market inefficiency.
Because small-caps have a smaller float and fewer available shares trading, a liquidity problem can exist. This
liquidity issue prevents many large institutional investors from investing in these companies. This reduces the
number of potential buyers for the stock and can lead the stock price to be unjustifiably low. Conversely, when a
large institution tries to buy an illiquid stock, the price can shoot up dramatically. This inefficient market works to
the advantage of the individual investor who is willing to accumulate undervalued shares and hold on to them for
the long-term. A small-cap company that grows and performs well will draw the attention of the bigger market
players and the increased trading volume will drive up the market valuation.

A favorite target of activist investors

Small-cap companies have historically been ripe targets for activist investors. An activist investor is a hedge fund,
or an individual in some cases, that buys a large stake in a public company with the goal of effecting major change
in the company. Oftentimes the goal will be to have the company sold to a larger competitor at a premium to the
market price, thereby unlocking value for shareholders. Investors would do well by paying attention to activist
investors and the moves they make. One of the key questions I always ask about a small-cap, or any company for
that matter, is would an activist investor have an interest in this company? Activist investors will target small caps
if they believe it has the potential to become a bigger company or it will make an attractive acquisition for a larger
player.

One of the first small-caps I paid close attention to was Cinar Corporation, an entertainment company based in
Canada. It attracted the attention of noted activist hedge fund manager Robert Chapman, who specializes in small-
cap activism, and soon after he became involved he pushed for a sale of the company. After much back and forth
between Chapman and the management, which included Chapman taking out a “help wanted” ad for the CEO’s

4
job, the company was sold to a private equity firm at a high premium to its market value and in the process
benefitting all shareholders.

In-depth research can be a game changer

Because small-caps receive little attention from Wall Street analysts, they offer an opportunity for the individual
investor willing to do the in-depth research necessary to understand a small company, its economic cycle, its
management, and its future prospects. By going beyond the information readily available on the internet or in public
financial filings, opportunities that were previously hiding in plain sight become available for investment. The
management and investor relations of small companies are not typically flooded with calls from Wall Street analysts,
making them far more accessible to individual investors that have questions or comments.

Risks associated with small-caps

• Small-caps have less trading liquidity, meaning there may not be enough shares available at acceptable
buying prices. When selling it may be difficult to quickly sell the shares at an acceptable price.

• Small-caps have less access to capital and limited financial resources compared to larger companies. This
can make it difficult for the company to obtain financing necessary for continued growth or to endure
economic and industry downturns.

• Small-caps may lack the long operating histories or the proven business models of larger companies. This
leaves them vulnerable to sudden shifts in customer demand or the aggressive tactics of larger competitors.
Not to mention, regulators tend to give more scrutiny to companies without long track records or proven
business models.

• Less information is publicly available and financial filings may only meet the minimum requirements
imposed by the Securities and Exchange Commission. This requires the investor to either be extremely
competent in the analysis of financial statements or to be willing to rely on the integrity of company
management, auditors, and the oversight of regulators.

A few words on time, volatility, and patience

Time

Finding undervalued small-caps worthy of investment is hard work and time consuming. Many investors are
intimidated by the serious research that is required to be successful at investing in small-caps. While financial ratios
and growth rates are widely publicized for larger companies, this is rarely the case for small-caps. All successful
small-cap investors accept that the tedious number crunching will be left up to them, knowing that the neglect and
lack of coverage by analysts is what provides the opportunity.

Volatility

5
Historically, small-caps have outperformed large caps, but this outperformance is coupled with greater volatility.
According to data from Morningstar, from 1926 through 2012, small-caps averaged an annual return of 12.28
percent, compared to 10.08 percent for large-cap stocks. With that reward comes higher risk. Over a 10-year period
that ended in 2013, the standard deviation for small-caps was 19.28, compared to 15.54 for large caps. What this
means is the returns for small-caps fluctuated by as much as 19.28 percent in either direction. This volatility scares
many investors out of small-caps and in turn, unwittingly deprives them of long-term market-beating returns.

Patience

Patience is one of the most important character traits a deep value investor can possess. In light of the volatility
displayed by small-caps, it is important for investors to remain patient and allow their investment thesis time to
play out. It is not uncommon for a deep value investor to buy the stock of a small-cap only to have the stock drop
40 percent in the first six months. An impatient investor that lacks discipline may sell out in a panic and lock in a
40 percent loss. That same stock could go on to return 200 percent over the next 3 years, rewarding the patient deep
value investor.

Rule of Thumb on Patience: When investing in a small-caps or in any other deep value opportunity – be prepared
to wait at least 1-3 years for the investment thesis to play out.

My Research Process

My research process for small-caps is extensive and thorough (and this goes for every strategy I employ). I
continually search for good candidates throughout the small-cap universe. Once I have identified a candidate, I
begin due diligence that goes beyond just crunching the numbers. I consider it important to act like an investigative
journalist. I investigate company management, take a tour of the company’s headquarters (or talk to someone that
has), and interview knowledgeable people about the industry and the company, including consultants and
competitors.

Visiting the company is important – it provides an opportunity to discover promising areas that are hidden in weak
numbers. On the flip-side, it provides an opportunity to find problems that have yet to show up in the numbers.
While I find reading reports from other analysts to be helpful, talking to management and viewing the facilities is
much more important. Only a small number of companies will meet my exact criteria. Once a company’s stock has
been purchased or added to my watch list, I stay in close contact with the company and continue to analyze all new
financial data to monitor whether or not my original investment thesis remains valid.

How I find new ideas:

Experience

As deep value investors continue to grow and learn by analyzing more and more companies, they compound
knowledge and gain experience. This experience will enable a deep value investor to quickly recognize what is a
potential opportunity and what is not. After two decades in this business I have analyzed thousands of companies
and special situations. Often, when a deep value opportunity presents itself it is possible that I have already been
watching the company for years, either having previously analyzed the company or a close competitor and

6
understood it very well. This allows me to quickly interpret new developments or changes in the stock price. Other
times I may have analyzed a company and made a decision to not buy due to overvaluation, but kept it on my watch
list. A sudden drop in the stock price or a favorable industry development can renew my interest. Due to my
previous analysis and familiarity with the company and management, I am able to move quickly and reach an
investment conclusion.

Screening

I am constantly searching for new investment opportunities that meet my exact criteria. This includes reading
through the Wall Street Journal or Financial Times and other financial publications or browsing through investment
surveys such as Valueline. I use my own customized screens or screens provided by third party vendors. When I use
a screen, I am able to narrow down the universe of potential opportunities that meet my stringent criteria such as
low price-to-earnings or low price-to-book ratios, attractive debt-to-equity characteristics or other preferred
metrics. This leaves me with a smaller and easier to manage basket of companies that I can add to my watch list for
further in-depth analysis and investigation.

Industry analysis (along with macro and regional trends)

I consider myself, first and foremost, to be a bottom-up analyst, focusing on individual companies and opportunities
rather than going after what is trendy. Although some of my ideas will come from noticing industry or macro trends,
I have never relied on economic forecasts or interest rate movements in making a buy or sell decision. But a market
crash or recession will cause me to pay closer attention to debt levels and look for companies that display
countercyclical characteristics. For example, a drop in oil prices could cause an overreaction in the stocks of oil
services companies and thus interest me in taking a closer look at companies across the sector.

Occasionally, stocks in an entire region or country may become cheap when compared to historical averages, much
like what appears to be happening in China at the time of this writing. The cause could be something as simple as a
currency devaluation or more complicated such as a recovery from a recession. An opportunity is created when
companies in affected regions or countries have opted to raise capital in the United States and list on American
exchanges and is now undervalued due to trouble at home.

How I evaluate an idea:

Once I have a company in my sights, I analyze it with all of the skepticism and curiosity of an investigative journalist.
I am looking for a “gotcha” that will cause me to discard the idea and look for the next one. Unfortunately, many
investors feel obligated to buy a stock after they have invested a minimal amount of time analyzing it – an attitude
that is not conducive to outperforming the market. I remind myself that stock picking is a messy business and that
I would rather spend 20 hours figuring out what not to buy than convincing myself I am obligated to buy it.
Analyzing companies is a multistep process. The following is a general outline of all the steps I take before I come
to a decision to buy or not buy. Please note that, in addition to small-caps, I use this same process anytime I analyze
a potential investment opportunity, whether it be a spin-off, a post-reorganization equity, or a bank thrift
conversion.

7
Reading the publicly available information

A company’s financial statements are the most important component to serious analysis. I use them to discover
what is behind the numbers, what is driving the growth (or lack of it), and come up with a prognosis for the
company’s future prospects.

I begin my financial quest by pulling the last 3 years of Form 10-Ks (annual reports) filed with the Securities and
Exchange Commission along with the last 6 Form 10-Qs (quarterly reports) and any Form 8-Ks (amendments to
the 10-Ks and 10-Qs). This gives me all of the numbers from the annual reports from the last 5 years and the all of
the quarterly reports from the last two years. This allows me to compare trends on cash flow, inventories,
receivables, and margins.

I find it helpful to divide the financials into small parts and then put them back together and see if they fit. I consider
the footnotes to the financial statements to be the most useful tool in determining if the numbers make sense. The
footnotes are where any red flags to creative or fraudulent accounting will pop up. If the footnotes are complicated
and difficult to comprehend I will assume it is deliberate. In addition to analyzing the numbers, I will review the
last 3 years of proxy statements looking for corporate governance issues such as bloated executive compensation or
management that is unfriendly to shareholders. I look for any kind of poison pill or change-of-control provision
that would prevent an activist investor from coming in and pushing for a sale of the company.

Crunching the numbers

Many professional investors build elaborate financial models – I do not. Models are only as good as their inputs –
which can often be nothing more than an educated guess. If you are looking through a telescope out at the night sky
and tilt your telescope a few degrees, you could change your view by a million miles. Instead, I spend my time doing
an extensive amount of numbers crunching. The primary questions I want to able to answer when I have finished
going through the numbers is, are these numbers solid and believable or is management pandering to investor
expectations with creative accounting?

The Balance Sheet

I first look at the most recent balance sheet and compare it to previous years’ balance sheets. I then start investigating
whether or not the assets are believable. Some of the questions I might ask right off the bat: Are the assets, such as
real estate, listed at inflated values? Are the inventories packed with obsolete product? Are loss provisions too low?
What is the policy for booking receivables?

I pay close attention to accounts receivable and inventories by comparing them to the growth in sales and the cost
of goods sold – if they are out of alignment it is a red flag and should be explained. Then I look at deferred charges
to see if the company is pushing expenses too far into the future; a bad habit that can lead to a sharp reversal if
revenues slow. I then move on to intangible costs like goodwill and amortization and look for evidence the company
could be capitalizing routine costs – a sure sign of earnings manipulation. Accumulated depreciation is another area

8
I check, if the company has recently changed its average life assumptions I will want an explanation. This is why it
is important to go over the footnotes with a fine-toothed comb.

I then move onto the liability side of the balance sheet. I want to know if there are any liabilities that are difficult to
comprehend – a red flag that management could be using the company as a personal piggy bank. Next I want to
know if short-term debt is growing and when long-term debt is due. I check the footnotes to see if the company has
any off-balance sheet liabilities.

The Income Statement

Much like with the balance sheet, I review several years of the income statement. I want to know if the company has
a history of relying on nonrecurring income to bolster results. This could be the sale of land or securities, tax credits,
and one-time credits from suppliers happening year after year. I look for a change in accounting policies and
revenue recognition. Again, this information can be fleshed out in the footnotes. What I am looking for is a business
that is stable and likely continue being stable for the foreseeable future. On the flip-side I look to see if one-time
charges are strictly one time.

I always look carefully at earnings-per-share (EPS). Are earnings per share up only because there are fewer available
shares? I compare the numbers using the previous year’s fully diluted shares outstanding, never relying on just the
undiluted average shares. Another trick is to take the number of shares from the 10-K, add in convertible shares
that are close to conversion, add in options that are close to being exercised, and add in warrants if there are any.
Add up all of those numbers for fully diluted shares outstanding. Inexplicably, Wall Street often fails to make this
calculation and gives EPS manipulation a wink and a nod.

The Cash Flow Statement

The cash flow statement is the toughest part of financial statements to understand and it is also my favorite. In a
nutshell I am looking for sustainable operating cash flow. Let me rephrase that; I am looking for sustainable
operating cash flow that is trading at a low valuation – if you are paying attention I have just given away my biggest
secret.

Cash flow statements are broken up into three parts: operating, investing, and financing flows. I look at the cash
flows from financing to see if the company needs to keep borrowing money in order to stay in business. I look to
see if the company has to keep issuing new shares every year to raise much needed capital. Then I look at
expenditures and what is necessary to keep the business going. One calculation I like is to take the net income and
add in depreciation, amortization, and deferred taxes and then subtract nonrecurring items (adjusted for taxes) and
then add or subtract changes in current assets. That calculation will give me a more accurate picture of what is truly
operating cash flow – getting to know the company inside and out will tell me if that number has room for
improvement or is sustainable.

I check cash flows from investing to see what exactly the company is investing in; I want to know if it is new real
estate or plant and equipment. Then I want to know if it is a necessary expenditure for conducting business. I then
check for free cash flow by deducting capital expenditures and dividends to find out if that number is negative or
positive. If it is negative I will do a year-by-year check to see if it is a one-time anomaly or if the situation is

9
deteriorating. If the company is a cyclical business with up and down cash flows I want to know if the company has
a strong enough balance sheet to weather the downturn or if it will need to raise cash through more debt or an equity
offering. I want to know that if the company will need to borrow money and if a cyclical downturn will make
borrowing difficult due to impaired coverage ratios?

I like to think of the balance sheet, income statement, and cash flow statement as individual parts of a 3-D puzzle.
The bottom line question is do all of the pieces fit smoothly?

My Checklist of Ratios

Keeping track of the various ratios is crucial to truly understanding the company and its numbers. While not an
exhaustive list, the following are just a few of the ratios I rely on the most.

Return Ratios:

• Return on equity
• Return on assets
• Return on invested capital

I look at return ratios over a course of several years, it lets me see the trends and the volatility of the returns over a
period of time. It also allows me to compare the numbers with other similar companies in the same sector or
industry. More importantly I want to know if the company is earning more than its cost of capital. One of my
favorite metrics is return on invested capital (I owe this one to famed short-seller James Chanos), it allows me to
spot which companies are not what they say they are. My calculation: earnings before interest and taxes divided by
average total capital. This is a hard number for companies to manipulate and it is a good indicator of a high quality
business.

Capital Structure:

• Long-term debt-to-equity
• Total debt-to-total capital
• Total debt-to-equity

It is important to understand how a business is capitalized. I compare several years of balance sheets to look for
trends in the ratios. I am wary of companies that are trending towards over-leveraged.

Valuation Ratios:

• Price-to-earnings
• Price-to-book
• Price-to-cash flow

I always keep a close eye on the valuation ratios of the companies I keep on my watch list. It allows me to check in
minutes if the stock is running up or if it is tanking. I also use them for a quick-and-dirty comparable with other
companies, which comes in quite handy if a competitor is taken over. Keep in mind that valuation ratios are relative

10
to the industry – lower in financial services and higher in retail companies. A high price-to-earnings (P/E) is an
indication Wall Street believes there is growth potential. A high price-to-cash flow (P/CF) is an indication Wall
Street believes there will be a buyout.

Other Useful Filings

Form 13-D

A big part of my overall investment philosophy is to look for companies that could become targets of activist
investors. Studies have shown that companies that undergo a campaign by an activist investor tend to outperform
the market. Through experience I have found that most market outperformance is the result of a catalyst that
unlocked shareholder value. The most efficient catalyst is some type of one-time event such as a spin-off or a merger
and this why it is handy to have an activist investor waiting in the wings. An activist investor’s reason for being is
to push for a catalyst that unlocks value.

The best way to find out if an activist investor is pushing management to take action is to check the 13-D filings.
These are required by the Securities and Exchange any time an institutional investor buys 5% or more of the
outstanding stock and intends to communicate with management. Aside from the boilerplate language, 13-Ds are
fascinating to read because it offers the activist investor an opportunity to communicate its ideas about the company
to the market. If you want to know what a top investor thinks the future potential of a company could be, read the
13-D. Many times I have read a 13-D and then contacted the activist investor to gain more insights into their
thoughts on the company. Paying attention to the top activist investors is not only a good way to learn how to think
about investing, but it can lead to market beating opportunities.

Proxy Statements

All publicly traded companies must file a proxy statement before their annual shareholders meeting. The proxy
serves as an announcement to shareholders on what they will be voting on at that annual meeting. It is packed with
information that gives investors insight in the company’s philosophy. In it can be found management salaries –
including bonuses, option awards, and perks. It also details employment contracts with key executives – always
good to know if management has golden parachutes. One game I like to play is to count how many times it says
“certain transactions”. It is also a good place to look for pending litigation.

Many institutional investors farm out the analysis of proxy statements to institutional proxy services such as Glass,
Lewis & Co. or Institutional Shareholder Services, who then recommend to the institution how they should vote.
The reason for this is beyond the subject of this work, but I have always felt it was an abdication of an institution’s
fiduciary duties. I prefer to read them myself and come up with my own conclusions and questions.

A short list of some of the questions I want answered by the time I have finished reading the proxy:

• What is the percentage of executive compensation to earnings?

• Does the company pay large bonuses?
• How is the bonus determined? Performance, return on equity, or some other measure?
• Are bonuses tied to EPS growth? (If so, there is motivation to fudge the numbers)

11
 • Does the company pay for stock options?
• Does the company pay a bonus to cover the taxes on options?
• How many shares do top executives own?
• Does the company have a severance payout in the event of a merger or buy-out?
• What are the terms of the retirement contracts?
• Are there perks such as apartments, planes, cars, etc.?
• Are there any “arm’s length” transactions?
• Are any of the officers related?
• Does the company do any deals with companies controlled by relatives of key executives?
• Does the company loan money to executives? If so, what is the interest rate?
• Are there any joint-ventures in which executives are limited or general partners?
• Are there any lawsuits? What is the potential liability?
• How independent is the board of directors?

Once I have done my homework with the financial and other filings, I will move onto the next step, contacting
investor relations and management as well as listening to earnings calls.

Contacting the company

One of the advantages of investing in small caps is that the company’s investor relations and upper management is
unlikely to be flooded with requests and questions from other analysts. Listening to earnings calls and talking to
management is a powerful tool for filling in the gaps left from simply reading the financial statements. By getting to
know the management, an investor can discern if management is trustworthy and competent. Investors should want
to work only with management that is candid when things are not going according to plan and when mistakes are
made. The question all investors should ask is, do I trust this management with my money?

Following small caps within a particular industry or region for many years and developing rapport with top level
management can pay off in other ways. There have been occasions I have been able to call an executive with a
company I previously covered and ask them for their thoughts on a competitor that I am looking at. Some of the
best analytical intelligence will come from a competitor.

Never underestimate a company’s need for an active and vigorous investor relations team. Their job is to increase
awareness and demand for the stock. How else will the stock ever go up if no one knows the company even exists?
I look for an investor relations team that is honest in discussing the company’s opportunities and challenges. One
that is willing to give presentations at investor conferences, and arrange conference calls between investors and
management. I avoid companies where investor relations is insincere and unwilling to engage in an all-out effort to
attract investors and promote the company. When I speak with investor relations one of the first things I want to
know is what is their strategy going forward.

Listening to earnings calls

12
Listening to earnings calls is one of the most overlooked sources of information about the company, its most recent
performance, and the management. During an earnings call, investors and analysts can call in over the phone to
hear management discuss the financial results of the most recent quarter. Most companies hold four calls a year,
shortly after the quarterly results are announced. Usually the call is available online as an audio or a transcript of
the call is available from investor relations. No matter how boring a call may be, I find them a valuable tool to gain
insight into management’s mindset.

Most calls follow the same format: an introduction by the operator, then the general counsel or CFO will give the
usual legal disclaimers; the following discussion will involve forward-looking projections, which are only
expectations and are not factual. Next up the CEO or CFO will give a recap of the earnings announced in the most
recent press release, covering what happened in the past. Management will move on to discuss what is happening
currently and what management expects performance to be in the future. It is always a good idea to go back and see
how optimistic or pessimistic management was in previous earnings calls and how those results mesh with the
current results. Is management prone to overstating or understating future performance expectations?

After management completes that part, the call is opened up to questions from analysts or significant shareholders.
I believe this is the most important part of the call as analysts and investors are able to pose questions about any area
of the company that requires elaboration from management. An investor can learn a lot about the quality of
management when they are in the hot seat. This can provide insight into concerns other investors have about the
company and how well management handles them. It is a chance to see whether management can answer the
questions candidly and confidently or whether they fumble the questions when pressured. More than anything,
earnings calls can be used to gain a gut feeling for the company’s management. The key is to differentiate what is
boilerplate conference call speak and what is useful information.

After taking in all of this information – the financials, future prospects, management, etc. – I decide whether or not
I am a buyer. A lot of that depends on how the company scores on my checklist. If I do not buy, the company could
stay on my watch list in the event something occurs that later makes me change my mind.

My Final Checklist

I look for investments that have all (or at the very least many) of the following:

Low valuation: I am looking for a cheap price in relation to earnings, cash flow, or book value. Without this there
really is no need for me to even consider the investment.

Financial Strength: Strong balance sheets with low-debt levels in relation to assets and sufficient working capital to
help the company survive downturns.

Profitable: I look for companies with a history of profitability. This is one reason why I generally avoid start-ups
because they are usually losing money, but, like with turnarounds, I will make exceptions if the near-term
projections are compelling.

13
Cash Flow: Cash is king and reported earnings mean little if there is no cash flow. I look for companies with strong
cash flows after accounting for capital expenditures. I steer clear of companies that are capital intensive as they may
need to raise cash through equity or debt to finance their needs.

Overlooked: I prefer companies with little to no coverage, any company being scrutinized by an army of analysts is
not likely to be undervalued.

Growth: I look for companies that have consistent growth rates of 15% or more. How else will a small-cap become
a large cap? If it is selling for super cheap, I will consider a small-cap with a slower growth rate.

Industry: I look for industries that are growing. The probabilities are against my finding a good undervalued
company in a declining industry.

Competitive Strength: Companies with a market niche or that dominate their industry can grow revenues and
margins even in downturns.

Solid Management: Taking a page from Warren Buffett, I only want to be in business with management I can trust
and respect. I look for management that is competent and knowledgeable. It is important to have management that
is candid and upfront when things go bad and that is capable of fixing the problem. On the flip-side, I want
management that does not get overly optimistic when things are good.

Significant Ownership: I look for management that has skin in the game, their interests are more likely to be aligned
with shareholders. At the same time, I do not want management that has majority ownership and runs the company
like their own private fiefdom.

Active Investor Relations: I look for an investor relations team that is actively promoting the company. Whether
that be conference presentations or setting up conference calls with analysts and investors. Investor relations need
to be in the trenches drawing the attention of other investors to the stock’s value.

Lawsuits and Regulatory Scrutiny: I typically avoid small companies that are fighting a major drawn-out lawsuit or
facing extensive regulatory scrutiny. Not only is it a distraction for management, it can have a negative impact on
valuation. Not to mention, an adverse ruling could have dire consequences for the company’s survival.

Key takeaways:

• Investing in small-caps requires hard work, discipline, and patience.

• Extensive due diligence and fundamental analysis is required.
• Short-term volatility is to be expected.
• Expect to wait several years for the thesis to play out.

14
Chapter 2
Spin-offs

Spinoffs of divisions or parts of companies into separate, freestanding entities often result in astoundingly lucrative
investments.

Peter Lynch, One Up on Wall Street

Value investing appeals to many investors because at its most basic, it is a simple approach to finding good
businesses with share prices at a deep discount to their estimated intrinsic value. It is a no-brainer philosophy and
I am always astonished that more investors do not embrace it. With that being said, I find many value-oriented
investors that have fooled themselves into believing they can outperform the market by focusing on easy to
understand opportunities that require little more than calculating financial ratios. However, in my experience I have
found that situations that require simple analysis are not going to be offered at deep discounts, due to the fact that
other investors are just as likely to take notice of the opportunity. Inefficiencies quickly disappear when there is
competition. What this means is that true deep value investors know they have to dig deeper and work harder if
they wish to outperform the market.

Special Situation Investing

The next couple of chapters are going to cover special situations. This is a category that covers a broad range of
opportunities, everything from spin-offs, recapitalizations, bankruptcies, large share repurchases, to mergers and
other one-time events. Essentially any one-time event that can significantly alter the near-term market value of the
company without affecting its long-term intrinsic value. With such a broad range of opportunities, it would be
impossible to cover all of them in one book, much less in a couple of chapters. What I hope to impart to readers is
how investors can improve their chances of outperforming the market by looking off the beaten path with special
situations. On Wall Street, these type of special situations are included in the field of risk arbitrage, the domain of
risk arbitrageurs. Some investors, specifically hedge funds, also call this event-driven arbitrage or event-driven
investing. While I consider my overall philosophy to be deep value, my thinking has always been as a risk arbitrageur
– focusing on one-time events, weighing the probabilities and risks, calculating the potential return, and arriving at
a conclusion.

What originally attracted me to event-driven investing is that the stock performance of special situations are largely
independent of the overall stock market in the near- and medium-term periods, that being a period of one to three
years. Well-chosen special situation opportunities should do well regardless of the overall market environment.
Another attractive trait of special situations is that the larger players on Wall Street, much like with small-caps, tend
to ignore special situations due to size constraints and liquidity issues. Experience has shown that the more obscure
the special situation, the higher probability that diligent individual investors will generate market beating returns.

15
The keyword being diligent, special situation success requires a willingness to work harder and dig deeper than in
ordinary stock picking. This hard work is rewarded, as numerous academic studies have shown the outperformance
of special situations over long periods of time. Money is to be made by investors willing to embrace the unusual and
atypical areas of the capital markets. The first area of special situations we are going to look at is also one of my
favorites: spin-offs.

An Overview of Spin-offs

The concept of a spin-off is actually quite simple – it is the analysis that is complicated. A spin-off involves the
divestment of a business division or subsidiary to shareholders through a distribution of the subsidiary’s common
stock in the form of a dividend. In most cases, a spin-off is structured to be a tax-free distribution to both the parent
company and the shareholders, making it an attractive restructuring option for companies looking to unlock
shareholder value. Normally, the division being spun off has non-core assets and the crown jewel remains with the
parent company. In a pure spin-off, the parent company’s shareholders receive a pro-rata distribution of the
subsidiary’s stock. The net effect is that, at the time of distribution, the ownership structure of the spin-off is
identical to that of the parent. A spin-off effectively removes the parent company from management and control of
the company. Spin-offs are close cousins of equity carve-outs and IPO divestitures.

The motivations for spin-offs are varied. Oftentimes a combination of businesses may be undervalued by the
market. This mispricing may be due to the lack of synergy between the parent company and its subsidiaries, or to
the market’s misunderstanding of the combined businesses, or to operating volatility of one of the subsidiaries that
can be a drag on the earnings of the stable businesses. Separating a subsidiary from the parent company can be for
strategic or financial reasons. It is not uncommon for disparate businesses under the same roof to require different
strategies and capital requirements for success, or even require different managerial expertise and talents. Finally, a
spin-off can eliminate inefficiencies and lead to a more focused organization in which operating performance and
managerial compensation are more closely matched.

Spin-offs became the method of choice in the early 1990s for companies looking to focus on core businesses and
deconglomerate. This was in response to the realization on Wall Street that the conglomerate movement that began
in the 1960s was a failure. For nearly 30 years corporate management incorrectly thought bigger and more
diversified companies would be rewarded by investors with higher price-to-earnings ratios. It did not work and
many of these mammoth conglomerates traded at prices below the sum of its parts – the conglomerate discount.
Much of the deal activity that began in the 1960s now looks bizarre in hindsight, the combination of RCA, a defense,
technology, and media company with Banquet frozen foods; or Jimmy Ling’s LTV combination of sporting goods,
pharmaceuticals, and meatpacking. Who can forget Textron’s crazy combination of companies that made zippers,
chainsaws, fountain pens, rocket engines, and helicopters? Much of the spin-off activity over the last 25 years has
been to undo the deals made in the 1960s. As investors have learned more about the value of spin-offs, breaking up
is back in favor. Shortly after ITT announced it was spinning off several businesses in January 2011, the stock shot
up 16 percent, instantly creating more than $1 billion in market value.

Fortune Brands: An Example

16
This is an example that perfectly illustrates why all investors should pay attention to spin-offs. It also shows why
investors should pay attention to activist investors and their ability to push for changes that unlock value to benefit
all shareholders.

Prior to its spin-off in October 2011, Fortune Brands was a conglomerate that made bourbon, golf clubs, faucets,
and home security systems. Somewhere along the way, management and corporate strategists thought these four
disparate businesses would have economies of scale and synergy. Unfortunately, the market disagreed and the stock
traded at a deep discount to its sum of parts valuation. For many years the stock languished and shareholders were
not rewarded for their patience while management tried in vain to come up with a long-term solution.

In October 2010, hedge fund manager William Ackman of Pershing Square Capital entered the picture and
announced he had taken a 10.9 percent stake in the company, making him Fortune’s largest shareholder. At the
time, Fortune Brands had a market capitalization of $8.37 billion. Mr. Ackman immediately began offering his
restructuring ideas to management. Ackman believed that a company that sold bourbon should not also sell golf
clubs and home security systems. Fortunately, the board of directors and management agreed with him. One month
later, in November 2010, Fortune announced that its board had approved a plan to split the company into three
businesses, including a business that owns Jim Beam whiskey and a golf equipment unit that owns Titleist. The plan
including holding on to its profitable liquor business, while spinning off its home products operations – which
owned Moen faucets – to its shareholders and spinning off or selling its golf unit.

First, the Titleist golf business was sold for $1.2 billion to buyout group Fila Korea. Then the company announced
that it was spinning off Fortune Brands Home & Security Inc. (FBHS), its faucets and home security business, on
October 3rd, 2011. The parent company would be renamed Beam Inc. (BEAM), and would retain the bourbon and
spirts business. The two separated companies began trading independently on October 4th, 2011. At the time of the
spin-off, BEAM was trading at $43 a share and FBHS was trading at $12 a share.

Then, in January 2014, just a little over two years later, Suntory Holdings, the Japanese spirts maker, announced it
was buying BEAM for $83.50 per share. A 25 percent premium over the previous day’s close and a total return of
91.9 percent from the date of the spin-off – not a bad return for just over two years. This came as competitors Diageo
and Pernod Ricard were both looking at acquiring Beam Inc. This might be a good time to point out that a high
percentage of spin-offs later make attractive takeover targets and is another reason why all serious investors should
be looking at spin-offs.

Let’s do the math. At the time that Bill Ackman took his stake in Fortune Brands, the total market capitalization of
the company was $8.37 billion. Just three years later Suntory acquired Beam for $13.6 billion. At that same time,
Fortune Brands Home & Security had a market capitalization of $7.8 billion. Add in the $1.2 billion for the sale of
Titleist to Fila Korea and the combined value of the three companies is $22.6 billion. That is a value creation of
$14.23 billion for shareholders in just over three years – a return of over 100 percent. Even investors that waited
until the spin-off could have earned over 90 percent in just over two years.

There are three important lessons here for investors. Lesson one: Pay attention to conglomerates with a hodgepodge
of businesses – they could result in future spin-offs. Lesson two: Pay attention to activist investors. Lesson three:
Always pay attention to spin-offs.

17
Why Spin-offs Occur

There are number of reasons cited by companies for pursuing spin-offs. These are usually listed in the initial press
releases and in the Form 10 registration filed with the Securities and Exchange Commission in connection to the
spin-off.

Enhanced business focus

Enhanced business focus is normally the primary reason for a majority of spin-offs. A spin-off will allow each
business to focus on its own strategic and operation plans without diverting human and financial resources from
other businesses. When Tyco International announced it was spinning off ADT in September 2011, the rationale
given was that the spin-off would provide the potential for a more focused and aggressive growth strategy and
increase the takeover appeal for the smaller and less diversified entity.

Business appropriate capital structure

A spin-off will enable each business to pursue the capital structure that is most appropriate for its business and
strategy. Each business may have different capital requirements which may not be optimally addressed with a single
capital structure. Recently, with low interest rates, parent companies have been able to spin-off subsidiaries and lock
in a low borrowing costs for the spin-off. For example, in January 2013, AbbVie was a $55 billion spin-off from
Abbot Laboratories. Simultaneously, AbbVie conducted a $14.7 billion bond offering, the largest ever investment-
grade bond deal in the United States, at a weighted average interest rate of approximately 2 percent. Just to show
the power of spin-offs, AbbVie is up over 100% in the two years since the spin-off – a feat that is rare for a company
of its size.

Distinct investment identity

A spin-off will create distinct and targeted investment opportunities in each business. A more “pure play” company
may be considered transparent and attractive to investors focused on a particular sector or growth strategy, thereby
counteracting the conglomerate discount and enhancing the value of each business. In April 2012, ConocoPhillips
completed the spin-off of Phillips 66. The rationale at the time, which has proven to be highly prescient, was that
Phillips 66, a mid-stream and down-stream subsidiary, was at the mercy of its parent, an exploration and production
company. As long as oil prices continue to wildly fluctuate, Phillips 66 would be punished by ConocoPhillips’
fluctuating market price. Since the spin-off, Phillips 66 has assumed its own market identity and that has brought
stability to its market value. So much so that Warren Buffett’s Berkshire Hathaway has been a buyer.

Effectiveness of equity-based compensation

A spin-off will increase the effectiveness of the equity-based compensation programs of both businesses by tying
the value of the equity compensation awarded to employees, officers and directors more directly to the performance
of the business for which these individuals provide services. This should play a role in every spin-off. In fact, I would
go as far as saying that I would not be interested in any spin-off where the management is not incentivized to
succeed. Otherwise, why bother? When Time Warner announced the hiring of Google’s Tim Armstrong to head
up its AOL unit in March 2009, it did not take the industry long to point out that change would be coming soon.

18
Armstrong, long known for being headstrong, and some would say out for himself, would want to be more than
adequately compensated for his services and recognized for his contributions if he managed to turn around AOL.
Less than 9 months later, AOL was an independent company and Tim Armstrong had plenty of equity-based
incentives to make things work.

Use of equity as acquisition currency

By creating a separate publicly traded stock, a spin-off will enhance the ability of the spun-off business to effect
acquisitions using this stock as consideration. In June 2015, Gannett Company completed the spin-off of Tegna
Inc., with Gannett keeping the publishing company and Tegna keeping the broadcasting and digital companies.
Even before the spin-off, Tegna’s CEO, Gracia Martore made it clear Tegna intends to add significant scale through
acquisitions of other broadcasting and digital assets.

Tax Advantages of Spin-offs

A spin-off is considered to be a dividend by the Internal Revenue Service. However, this dividend can be tax free to
shareholders if the transaction meets certain criteria found in Section 355 of the Internal Revenue Code (IRC). Spin-
offs are typically structured to meet this criteria. The parent company frequently seeks an opinion on the tax status
of a proposed spin-off prior to distributing the shares. Some of the criteria include the following:

Active conduct of business

Both the parent company and the subsidiary must be engaged in active trade or business for at least five years before
the distribution date. This requirement has torpedoed more than a few proposed spin-offs after the IRS determined
a subsidiary did not meet the five year requirement. The IRS will not allow a parent company to unload a poorly
performing start-up acquisition without paying a tax bill.

Control

The parent must have control of the subsidiary before the spin-off, at least 80 percent of the voting stock, and the
distribution must constitute at least 80 percent of the outstanding shares of the subsidiary. Additionally, any shares
retained by the parent company must not constitute control of the subsidiary.

Business purpose

The transaction may not be used as a means of distributing profits and must be done for a sound business reason.
This reason must be business related, not tied to shareholder interests. Believe it or not, enhancing shareholder
value is not a valid business reason. The usual business reasons including complying with anti-trust and other laws,
allowing key employees to participate in company ownership, enhancing capital market access and financing
opportunities, alleviating management differences, and disposing of unwanted assets.

Filing Requirements for Spin-offs

The filing requirements with the Securities and Exchange Commission vary with specific circumstances of the spin-
off. The Exchange Act of 1934 requires, in most cases, that the parent firm file a Form 10 with the SEC. The Form
10 includes most of the same information required to register an IPO in Form S-1. An investor that wants to be

19
successful with spin-offs must be willing to pore through these filings, which can normally run hundreds of pages.
Take note, Canadian companies will normally file a Form 20 and other foreign registers can either file a Form 10 or
an 8-K. The parent company must provide standard historic financial information for the spin-off as well as
unaudited financial statements showing the impact of the spin-off on the parent and the subsidiary. Shares in the
spin-off cannot be distributed until after the Form 10 is effective.

Prior to 1970, the registration requirements for securities offering as required by the Securities Act of 1933 did not
apply to spin-offs. The SEC considered spin-offs to be a dividend. This situation led to allegations that shell
companies were being created solely to acquire private firms and then later spin them off without registering the
acquired firm’s stock. In 1970 the SEC began requiring registration if the stock of the divested subsidiary was to be
traded. Since then, many spin-offs have been treated in many ways as IPOs.

Announcement of Spin-offs

A typical spin-off begins with a public announcement of the parent company’s intention to divest a subsidiary or
division through a pro-rata distribution of new shares to the parent company’s shareholders. From the time of the
announcement until the time of the distribution can be anywhere from six months to a year – providing investors
ample time and opportunity to fully investigate and follow the transaction. Prior to the distribution, the parent
company often seeks either an IRS ruling or a professional legal opinion on the tax status of the spin-off. The
appropriate filings, the Form 10, and public disclosure are then provided. When necessary, management will seek
shareholder approval. The size of the subsidiary, as measured by a percentage of the parent company, along with
the company bylaws, will determine whether or not shareholder approval is required to carry out the spin-off.

Once the Form 10, or an alternative filing, is filed with the SEC, an application is made for an exchange listing. The
parent company may either list the spin-off on an exchange or have it trade over the counter. Trading in shares
often begins before the actual distribution on a when-issued basis. This trading is often motivated by institutional
shareholders that cannot hold shares in the spin-off company. Initial pricing for the spin-off is determined by the
marketplace. Normally, spin-offs initially trade at wide bid-ask spreads while market makers and investors seek to
determine a value for the spin-off.

Why Invest in Spin-offs

Spin-offs Outperform the Market

Numerous academic studies over the last 20 years have shown that spin-offs, and their parent companies, have
outperformed the overall market by a wide margin. Even the most recent research indicates this is likely to continue.
For this reason alone, serious investors should consider including spin-offs in their investment portfolio.

In a study published in 1993, Patrick Cusatis and James Miles analyzed a sample of 146 spin-offs over the period of
20 years. They concluded that over a three year period, spin-offs produced a compound return of 106.6%, great for
investors looking to double their money every three years, for an annualized compound return of 27.4%. This is a

20
stark contrast to IPOs, which greatly underperform the market. They also found that spin-offs that were in the same
industry as their parent company returned on average 20% a year. An indication that investors looking for even
greater spin-off returns should focus on spin-offs that are in a different industry from the parent company. Cusatis
and Miles went on to speculate that the reasons for spin-off outperformance included superior operating
performance due to lower agency and overhead costs and the fact spin-offs attract takeover bids from buyers who
place a high value on the assets.

A study released in 2004 by John McConnell and Alexei Ovtchinnikov, both of Purdue University, found that spin-
offs outperformed the market by an excess return of 24.37% over a two-year period on average. Their study showed
the most profitable time to buy spin-offs was within the first 6 months after distribution and the most profitable
holding period to be 21 months. McConnell and Ovtchinnikov concluded that spin-offs in a different industry are
apt to perform better than average. They also concluded that one reason value is created through spin-offs comes
as a result of an increased likelihood the spin-off will be acquired.

In a follow up study released in 2014 by Horizon Asset Management, researchers concluded that spin-off
outperformance persists. In fact, if anything, spin-offs have performed even better over the last decade despite more
investors being aware of the benefits of spin-offs. According to the paper, the ideal holding period for a spin-off is
up to three years, making it ideal for investors not wanting to incur transaction costs that come with short-term
trading or have their gains taxed as ordinary income. After that, the performance of spin-offs tends to perform
similar to the overall market. Researchers also found that spin-offs have a low correlation to the S&P 500, a
barometer of the overall market, making it perfect for investor looking to outperform regardless of if the market is
up or down.

Spin-offs are becoming more frequent

With the rise of activist investors, corporations are coming under heavy pressure to quickly create or unlock
shareholder value. With this, a greater number of these companies are looking at spin-offs to be the solution. In the
last five years the number of spin-offs has almost tripled and is expected to continue to grow as more companies
seek to unlock shareholder value. This growth provides investors more opportunities and choices to pick the spin-
offs that are likely to outperform the market by a wide margin. While spin-offs as a whole outperform the market,
is important to be able to recognize which opportunities have the highest probability of tilting the odds in favor of
savvy investors.

Why Spin-offs Are Undervalued

Spin-offs are ignored by the larger players on Wall Street

In many ways spin-offs have many of the same attractive investment qualities that were covered in Chapter 1 on
small-caps. Most spin-offs are usually small-caps, or even micro-caps, at the time of distribution and for this reason
they are often ignored by most of Wall Street. For this reason I like to think of a spin-off as a small-cap with a
catalyst. Most analysts ignore spin-offs and not just for the reason it is a small-cap; many times spin-offs are in a
different industry than the parent company and analysts focus on one particular industry or sector. As soon as the
parent company spin-offs the subsidiary, analysts have no reason to provide coverage. In addition, the big funds

21
that own the parent company may have no interest in a small-cap spin-off that falls outside their parameters. Flying
under the radar allows smaller investors an opportunity to load up on a company before management has an
opportunity to implement their growth strategy.

Spin-offs are ignored by analysts

Wall Street analysts specialize in a particular industry or sector. When a parent company that specializes in oil and
gas exploration spin-offs its gas stations and convenient stores, the analysts covering the parent company are not
likely to cover the spin-off. For one, the spin-off now falls into an entirely different industry and the analyst will
most likely drop coverage for the spin-off. In turn, brokerages that employ the analyst will advise their clients to sell
their shares in the spin-off and buy something that their analysts cover. For much the same reasons with small-caps,
when there is an absence of analyst coverage there are fewer buyers.

Spin-offs are often undervalued in the first few months of trading

Due to structural selling effects, spin-offs tend to be undervalued in the first few months of trading. When compared
to the S&P 500, spin-offs usually underperform by a great deal. This is related to the significant selling pressure that
occurs post-spin when institutional investors are dumping the newly distributed shares for reasons other than its
merits. Many institutional fund managers operate as fiduciaries with a responsibility to minimize risk for their
clients and investors and this forces them to stay within an established investment guidelines or else they could be
held liable if an investment goes south. When an institutional investor dumps newly distributed shares in a spin-off
it is, more often than not, for forced technical reasons and may have nothing to do with the fundamentals of the
spin-off. This forced selling creates an opportunity for investors, not hamstrung by institutional investment
guidelines, to buy shares on the cheap.

Spin-offs are complex and difficult to analyze

A study by Amos Tversky and Daniel Kahneman showed that investors tend to regard situations they do not
understand as being higher risk and to regard situations they do understand as being lower risk, regardless if that is
not the case for either situation. To the uninitiated, spin-offs look complex and are difficult to properly analyze and
this weeds out all but the most serious investors. Prior to being spun-off, a subsidiary may have spent many years
hidden in the inside a large corporation. As a direct result, only partial or incomplete financial and operating
information may be available. Although companies are required to include pro form financial statements in the
Form 10 filing for the spin-off, management may be reluctant to provide sufficient information due to uncertainty
over how much the subsidiary contributes to earnings. This in turn makes valuation of the spin-off a challenge until
more information is available. This explains why spin-offs typically outperform the market in their second year of
independence – the market has had a chance to see a full year of independent results.

My Research Process for Spin-offs

My research process for spin-offs is nearly identical to my research process for small-caps covered in Chapter 1 (this
would be a good time to review it). The only difference is spin-offs require a bit more homework and analysis. In
some ways, analyzing spin-offs is similar to analyzing IPOs in that spin-offs are brand new companies except they
have existed for many years. In addition to reading the 10-Ks and 10-Qs of the parent company, investors need to

22
read and analyze the Form 10 filing – a disclosure document similar to the S-1 that is filed with an IPO. When
analyzing a spin-off I read anywhere from 500 to 1,000 pages. Investors willing to put in the work will be amply
rewarded.

Finding spin-offs

Spin-offs are for the most part hidden in plain sight. Investors do not notice they are happening until they actively
start paying attention and looking for them. Screening for spin-offs in the same manner as screening for small-caps
is largely ineffective. Spin-offs are a one-time event that cannot be quantitatively identified. The best way to identify
potential spin-offs opportunities is by paying attention to the news. The financial media’s reason for existing is to
cover strategic corporate events, including mergers, spin-offs, bankruptcies, and activist investor campaigns.
Among my favorite resources are the Wall Street Journal, the Financial Times, Barron’s, and CNBC. There are also
a number of blogs that I have found useful over the years such as Andrew Ross Sorkin’s Dealbook
(www.dealbook.com), Jacob Wolinsky’s Valuewalk (www.valuewalk.com), and Tadas Viskanta’s Abnormal
Returns (www.abnormalreturns.com). I have also found it helpful to set up customizable Google alerts with such
key words as “spin-offs” or “divestiture”, etc.

The SEC website (sec.gov) is another valuable resource. All serious investors need to know how to utilize the
EDGAR system to search for relevant filings, such as the Form 10 for spin-offs (usually filed a few months after the
spin-off is announced), and for specific words within each filing. It also helps to track noted activist investors that
specialize in event-driven investments such as spin-offs. Fund managers such as Carl Icahn, Dan Loeb, Bill Ackman,
and John Paulson are required to file a Form 13F-Hr listing all of their current holdings and in some cases they are
required to file a 13D if they own more than five percent of the outstanding shares and intend to communicate with
management their ideas. These filings are fertile hunting grounds for future spin-offs. Today’s 13D filing could be
tomorrow’s spin-off announcement.

The Announcement

When a company decides to spin-off a division or subsidiary it will issue a press release that will go out over the
newswires. The press release will be brief and not go into great detail about the actual spin-off. The actual details
will come later when the company files the Form 10 with the SEC. The press release is soon followed with an 8-K
(material event) filing with the SEC, which may give slightly more detail, such as the expected date of the spin-off,
than the press release. It is at this point that I will add the parent company to my tracking list and sign up for alerts
with the parent company’s investor relations – this will let me know when there are any changes or when the Form
10 is filed. Until the Form 10 is filed there is not a lot of information about the spin-off and it becomes a waiting
game. I may start reading up on the parent company and determining if it is undervalued. As a general rule of
thumb, if a spin-off’s parent company is undervalued, there is a greater probability the spin-off itself will also be
undervalued and that provides a greater opportunity for outperformance.

The Form 10

Once the Form 10 is filed, there is not much that will get in the way of the spin-off taking place. This also gives
investors an opportunity to start evaluating the prospective spin-off as a standalone company. All Form 10 filings

23
are required to include pro forma financial statements from previous years. This gives analysts an opportunity to
place a valuation on what the independent company should be worth. I personally like to come up with a range of
valuations on what I think the stock would be worth after the spin-off. When analyzing a Form 10 I like to have the
parent company’s past 10-Ks, 10-Q, and other filings handy for comparison. I am looking for red flags and anything
that does not add up. When it comes to valuation, I like to establish a range of valuations for the spin-off well before
the actual distribution happens. As a rule of thumb, I never want to pay more than 50% of what I have estimated as
the intrinsic value for the spin-off. As discussed previously, the rest of my research process for spin-offs is the similar
to my process covered in Chapter 1.

Rules of Thumb for Spin-off Investment Success

There is ample evidence that spin-offs as a whole outperform the overall market. An investor could randomly buy
a basket of spin-offs without regard to fundamentals or timing and still do pretty well. There is also evidence that
with careful selection that is backed up by deep fundamental analysis as well as timing, an investor can gain a greater
edge over random selection. After more than a decade of analyzing spin-offs these are some of the general rules of
thumb I have established for myself. Of course, like with most rules of investing, it is important to remember that
an investor needs to be flexible and pragmatic.

• If the parent company is trading at a low valuation at the time of the spin-off, there is a greater chance the
spin-off will also be undervalued. I generally focus on spin-offs where the parent company was trading at
a price-to-earnings ratio of 13 or less.

• Stick to buying within the first three to six months after the spin-off is completed. This is when the
downward selling pressure is the greatest and there is very little to no analysts covering the company.

• If the parent company’s business is similar to the spin-off’s business, it is less likely there will be a
compelling investment opportunity. Look for spin-offs in a completely different industry than the parent
company.

• If the parent company pays a dividend and the spin-off does not, then the spin-off will experience greater
downward selling pressure. Institutional investors that must adhere to strict yield requirements can be
expected to quickly sell after distribution.

• If the parent company is part of a particular index and the spin-off is not, then index funds and
institutions that are required to own only indexes will quickly sell the shares after distribution.

• If the spin-off has a high distribution ratio, (e.g. 1 spin-off share for every 10 parent company shares),
then it will spur selling as investors want to eliminate odd-lot positions. Institutions in particular, do not

24
 care to have small positions and are inclined to view the newly distributed shares as “found money” and
sell.

When any or all of these factors are evident there is a greater probability of a compelling investment opportunity
that warrants further analysis. In the words of Warren Buffett, “Great investment opportunities come around when
excellent companies are surrounded by unusual circumstances that cause the stock to be mis-appreciated.”

Key Takeaways

• The performance of spin-offs is largely independent of the overall market.

• Spin-offs, as a whole, outperform the market.
• Careful selection and thorough analysis can result in even greater returns.

Chapter 3

Post-Reorganization Equities

My analysts are now saying, “I know you’re going to hate this, but…”. That’s a great thing. If my initial reaction is
to hate it, so is the market’s, and that probably means it’s something we should look at more closely.

-Jeffrey Bronchick, Cove Street Capital

For the last few decades a small group of academics, led by Richard Thaler and Werner De Bondt, have argued that
not only is the market inefficient, but that value investing strategies outperform the market. This flies in the face of
Efficient Market Hypothesis (EMH), a belief that it is impossible to beat the market because stock market efficiency
causes existing share prices to always incorporate and reflect all relevant information. The EMH is a view held by a
broad range of academics at institutions that churn out a high number of graduates each year that have been
conditioned into believing they have no chance at beating the market. Yet, value investors, backed by research from
Thaler, De Bondt, et al., persist in believing and showing that it is possible to consistently beat the market over the
long haul. These value strategies call for buying stocks that trade at low prices relative to earnings, cash flow, book
value, or some other measure of value.

25
While there is agreement among value investors that value strategies do work over the long-term, there is
disagreement among investors as to why they work. After more than a decade of adhering to a value investing
philosophy, I believe they work because they are contrarian to the strategies non-value investors follow. The
strategies that non-value investors follow might range from extrapolating past earnings growth far into the future,
assuming a trend in stock prices, overreacting to good or bad news, or it could be simply equating a good company
as being a good investment irrespective of the price. Regardless of the reason, some investors get overly excited
about stocks that have done very well and continue to buy them even as they become overpriced. Similarly, they
overreact to stocks that have performed poorly, oversell them, and soon these out-of-favor stocks become
underpriced. This is the exact opposite or contrary to what successful value investors do. A contrarian value investor
goes against the crowd and buys stocks that are out of favor. Nothing could be more contrarian than buying shares
in a company that is emerging from bankruptcy, also known as post-reorganization equities.

You could have purchased American Airlines stock at $26.40 when it emerged from bankruptcy and began trading
on December 09, 2013. Just six months later, in June of 2014, the stock was trading at $44 for a return of 68%. While
I would generally never encourage anyone to buy shares of an airline, since they are prone to going bankrupt, they
do seem to consistently outperform the market once they emerge from bankruptcy. With post-reorganization
equities, I am not talking about buying the shares of a once high-flying company that is now trading for less than a
dollar. Nor am I am talking about buying the stock or the debt instruments of companies before or during their
bankruptcy and participating in the reorganization process – unless you are willing to quit your day job and become
an expert in bankruptcy law and accounting. I am talking about buying the depressed shares of a company after the
plan of reorganization has been filed and the company is emerging from bankruptcy. In many ways, this special
situation creates an investment opportunity similar what we see with spin-offs.

Chapter 11 Reorganization

Companies file for bankruptcy for a number of reasons. It could be due to a large legal liability that the company
has no means to pay, an inability to pay bills due to cash flow problems, or it could just be a poor business in a
declining industry. I recommend avoiding companies that have filed for bankruptcy for the last reason as they are
likely to end up back in bankruptcy. There are two types of corporate bankruptcies under the Bankruptcy Code,
Chapter 7 and Chapter 11. In a Chapter 7 filing, the Court appoints a Trustee and the company liquidates and uses
the proceeds to pay off creditors, employees, taxes, and shareholders – in that order. The more common, and the
one we will focus on, is Chapter 11 reorganization, where the company is given time to reorganize while continuing
normal operations. The reorganization process can include negotiating new debt terms, exchanging debt for equity,
selling off assets, and cutting jobs.

In a Chapter 11 reorganization, the equity held by the shareholders is extinguished or diluted and the new equity is
given to the creditors. The creditors are usually banks and other senior lenders or bondholders with senior interests.
There can also be subordinated bond holders and unsecured note holders that may receive some equity or some
agreed upon fraction of the original debt value. The shareholders are almost always wiped out, which is why it’s a
bad idea to buy the common stock of a company heading for or in bankruptcy.

Investing in Post-Reorganization Equities

26
For value investors, companies emerging from bankruptcy offer some of the most compelling risk-reward
opportunities available in the markets. Stocks of companies that recently emerged from Chapter 11 provide for
fertile grounds for bargain hunters for similar reasons to spin-offs. Whereas with spin-offs, investors should do well
even with a random selection of spin-off stocks, random selection is not a recipe for success with post-
reorganization equities. Learning how to differentiate good and bad post-reorganization opportunities combined
with deep fundamental research is the key to outperforming the market with post-bankruptcy companies.

There are a number of academic studies that support the possibility of outsized gains with post-reorganization
equities. After analyzing the performance of 117 post-reorganization situations, John Cunney and Thomas Lee
published a research paper that showed the first year performance of companies emerging from bankruptcy
averaged returns of 85%. However the same study showed a high amount of volatility, with only 50% of the equities
outperforming during that period. Cunney and Lee concluded that investors would do well to conduct thorough
due diligence and to be selective in their stock picking. Not all post-bankruptcies are created equal. Some companies
emerge from bankruptcy without ever being able to accomplish a significant turnaround in operations or
restructuring their debt load and end up filing for Chapter 11 again (known by insiders as a Chapter 22) not long
after emerging from reorganization.

Why Invest in Post-Reorganization Equities

Despite the high volatility, there are a number of reasons why post-reorganization equities are mispriced by the
market; the greater the mispricing the better the opportunity to earn high returns. Below are just some of the reasons
why the inefficiencies exist and how that can generate high returns.

Creditors become equity holders

When a company emerges from bankruptcy, most of the new shareholders are former creditors. (There are a few
exceptions to this, such as during the reorganization of General Growth Properties, Bill Ackman took a large stake
in the company’s shares and actively worked to bring the company out of bankruptcy. His investment paid off ten-
fold, but do not let that give you any crazy ideas. ) The former holders of the company’s bank debt, bonds, and trade
claims become the new owners. Fortunately for savvy value investors, these new shareholders are not in the business
of being equity managers. They entered the situation as debt holders and may not even be allowed to own equity.
For example, banks and insurance companies prefer to recover cash or newly-issued debt in the plan of
reorganization rather than common stock for both regulatory and economic reasons. Landlords become the most
unlikely of shareholders after receiving shares in exchange for lease-rejections claims. The same goes for vendors
with outstanding trade claims. High yield bond funds that are only allowed to hold debt are sometimes issued shares
in exchange for subordinated debt. All of these shareholders can quickly become motivated or forced sellers once
the new shares began trading in the market. The mispricing occurs when a large group of sellers have to sell their
shares for noneconomic reasons. Look for situations in which the majority of new shareholders are non-traditional
equity holders – this information will be found in the Plan of Reorganization that is filed with the Court and usually
available through the company’s investor relations or through PACER.

Small market capitalization and illiquidity

27
A majority of the companies emerging from bankruptcy are small-caps (this might be a good time to review Chapter
1). Therefore, the large institutional investors that typically invest several hundred million dollars in a company will
not even bother with looking at post-reorganization equities. Additionally, post-bankruptcy companies are usually
illiquid. As with other small-caps, the trading float is quite small. Vulture investors that are seeking to control the
company (i.e. Eddie Lampert buying a majority of K-Mart during its reorganization) are often unwilling to sell any
of their positions, thereby shrinking the float even further. Since market cap and liquidity are an issue for many
institutional investors and portfolio managers, small-cap post-reorganization equities are often ignored by many of
Wall Street’s larger players.

Lack of coverage on Wall Street

Since post-bankruptcy companies are usually small-caps and illiquid, they often have little to no coverage by Wall
Street equity analysts. Wall Street is more concerned with the commissions that come from trading much larger
(and liquid) companies. Brokerage analysts are not incentivized to spend time and resources covering post-
reorganization equities given they are unlikely to generate substantial commissions. In addition, post-
reorganization companies do not require very much in the way of investment banking business. This lack of
attention is why post-reorganization equities have earned the moniker of “orphan equities” by much of Wall Street.
There are a limited number of boutique research firms on the sell-side, but even here the coverage is limited.

Information is difficult to obtain

Collecting information on post-reorganization equities can be rather difficult. During the reorganization process,
companies are not required to host earnings calls or file 10-Ks and 10-Qs (though some do) with the SEC. Most
companies go all but dark during the bankruptcy. To fully understand the company’s financial position post-
reorganization it is important to read the Disclosure Statement that is filed with the bankruptcy court. This filing
includes financial projections, the new capital structure, and liquidation and valuation analyses. Also filed with the
court are the company’s Monthly Operating Reports, which include detailed monthly financial data. All of these
documents are available for a small fee through electronic court system PACER (http://www.pacer.gov/) or
sometimes the company’s investor relations will make the documents available upon request. However, even
though this information is available, most investors are not even aware that it exists or they tend to be unfamiliar
with PACER and bankruptcy filings. For this reason most investors ignore post-reorganization equities altogether.

The stigma of bankruptcy

It is next to impossible for a company that has experienced bankruptcy to shake the stigma in the minds of investors.
There is an unavoidable perception that a company that has undergone a bankruptcy has irreparable damage to its
brand name and will have trouble attracting new customers and retaining old ones. Not to mention the problem of
retaining key personnel and reestablishing good payment terms with necessary vendors. While there is some truth
to this, it not uncommon to see a company do exceptionally well after reorganizing. This is more so the case when
the cause of bankruptcy was overleverage and not some fundamental problem with the company. Plus, the
reorganization process can serve as a catalyst for the company. The company can use reorganization to reject leases,
renegotiate more favorable terms for contracts with suppliers, trim the workforce, sell non-essential assets, close
unprofitable locations, install new management, as well as significantly reduce a debt load that has become

28
unmanageable. It may even be possible to receive a new capital injection in return for equity in the reorganized
company. In addition, many companies emerging from bankruptcy have significant net operating losses (NOLs)
that can be used to offset taxes due in the future.

Low expectations in the Plan of Reorganization

Much like with spin-offs, management is often getting stock options, in addition to warrants and a percentage of
the newly-issued equity, and this can lead them to provide cautious projections in the Plan of Reorganization. Lower
projections means they can price their options at a lower price and then earn great applause when they outperform
their own projections. I always look at where management is pricing their stock option awards as a starting point in
my own financial analysis. Another reason for low valuation is it allows the company to emerge with less debt on
the balance sheet. While it is not always the case, the practice of providing modest financial projections is fairly
widespread. When analyzing post-reorganizations it is important to keep this in mind.

In conclusion, post-reorganization equities are often ignored or not fully understood by investors. Every year,
approximately 25-30 companies emerge from reorganization as publicly traded companies. Compelling investment
opportunities with attractive risk-reward characteristics are available because many investors are unwilling or
unable to take advantage. Outsized returns may be achieved by investors willing to be selective and take the time
and put forth the effort to understand these situations.

My Research Process for Post-Reorganization Equities

Much like with spin-offs, my research process for post-reorganization equities is similar to my research process for
small-caps covered in Chapter 1. It is important to keep in mind that with the risk associated with post-
reorganization equities, a higher level of due diligence is required.

Finding post-reorganization equities

There are no specific forms a company files with the SEC when declaring Chapter 11 bankruptcy. The
announcement will usually include an 8-K, disclosure of material information filing. The best source for finding
opportunities is the financial media. My favorite resources are the Wall Street Journal, the Financial Times, Barron’s,
and CNBC. Financial related blogs such as Dealbook are also a good source for bankruptcy announcements.

There are several sources dedicated exclusively to distressed companies and reorganizations, although they tend to
be pricey. The Daily Deal, published daily for $500 a year or The Deal, published weekly, for $250 a year. Both
provide a wealth of information on transactions such as bankruptcies, spin-offs, and mergers. My favorite part is
the bankruptcy calendar. Both publications are available at www.thedeal.com. Another of my favorite sources is
BankruptcyData.com, a user-friendly site with plenty of information for investors looking for key details of specific
filings, timetables, and court dates all for $500 a year. The Bankruptcy Week newsletter is available for $500 per
year.

29
The reorganization process is a long wait

Once a company files for bankruptcy I include it on my tracking list with the understanding that it could be 18 to
24 months (or longer) before the company emergences from bankruptcy and files the Disclosure Statement. In the
meantime I will continue to monitor the progress and occasionally check court filings through PACER or call the
investor relations to inquire about any material updates. Patience is key.

Investors wanting to be successful with post-reorganization equities need to understand the process of
reorganization. When a firm files for Chapter 11, a judge is appointed to oversee the process. Judges are tasked with
moving the process forward fairly and quickly, since bankrupt companies are faced with disintegration of value as
employees, vendors, and customers walk away. However, it is no easy task as there are often multiple creditors each
with their own claims (and lawyers) fighting to maximize their own recoveries. Each class of creditor will work to
outmaneuver the other classes in a three-dimensional chess game.

The Plan of Reorganization

Typically, the debtor company will try to assemble a Plan of Reorganization that satisfies the various claims and
creditor classes while continuing operations. During this process, a business plan is developed along with multi-
year financial projections which enables the company to value the reorganized company. This allows the creditors
and management to decide who gets what, based on the priority of claims and the size of the original investment.
Oftentimes, creditors end up with a combination of securities that can include restructured debt, preferred or
convertible shares, common stock, and even warrants. (Tip: Pay attention to the warrants – they can be bought for
pennies and be very valuable one day) Once the plan is approved by the judge, it is put to a vote by all parties with
claims. Once the plan is approved by the creditors, new securities are issued and the company is absolved of its pre-
bankruptcy claims and emerge from Chapter 11. The length of time this process takes varies from one to three years,
all depending on the company’s size, complexity, and the number of creditors.

As the company completes the reorganization, the Disclosure Statement is filed with the court. This statement
includes the Plan of Reorganization as well as all the supporting information such as financial projections.
Oftentimes companies will file the Disclosure Statement with the SEC along with an 8-K. This filing is a treasure
trove of information written in high-priced legalese.

There are several different ways to obtain the Disclosure Statement. One way is contacting the law firm that
represented the company during the bankruptcy and asking them when and where it was filed, then looking it up
on PACER or sometimes they may even be willing to send you a copy. Another place to look is on the SEC’s website
under 8-K filings, which there can many different filings that make the process tedious. I prefer to call the company
directly and speak to the investor relations and ask them for a copy of the Disclosure Statement or for more
information on when it was filed – this gives me a chance to get a feel for how well the investor relations team does
its work. It could also be found on the company’s website under “News” or “Chapter 11 Reorganization”.

Rules of Thumb for Post-bankruptcy Success

By now it should be clear that not every company emerging from bankruptcy is worthy of investment. Many
companies emerge with dangerous levels of debt or with declining businesses. These companies are in danger of

30
ending up right back in bankruptcy court, known among industry insiders as a “Chapter 22” bankruptcy. Therefore,
it is imperative for investors to go beyond just what it is the Disclosure Statement. I apply the same research process
I outlined in Chapter 1.

• Look for companies that are small-caps with market caps between $100 million and $2 billion. With the
larger capitalization companies, investors are competing with the big private equity and vulture firms that
are seeking to control the company well after it emerges from bankruptcy.

• Look for companies with balance sheet strength and avoid companies with high levels of debt – the primary
cause of companies returning to bankruptcy.

• Look for companies with incentivized management that take most of their compensation with options,
restricted stock, or bonuses tied to specific performance metrics.

• Avoid companies that operate in industries with excess capacity such as textile firms and auto parts.

• Don’t be in a rush to buy right after the company begins trading again. It is important to give the new
shareholders time to unload their shares. The ideal buying time is a couple of months after the stock begins
trading again.

Post-reorganization equities offers unique investing opportunities with an attractive risk-reward. Patient investors
can find tremendous bargains obscured by uncertainty and the social stigma of bankruptcy. Again, patience is the
key.

Key Takeaways

• Post-reorganization equities offer some of the best risk-reward opportunities in the markets.
• Extensive due diligence is required to be successful.
• Avoid highly leveraged companies that could end up as Chapter 22s.

31
32
Chapter 4

Ten Mistakes Investors Make

An investor that has become overconfident by using a bad process is like somebody who plays Russian roulette three
times in a row without the gun going off and thinks they’re great at Russian roulette. The fourth time, they blow
their brains out.

Daniel Loeb, Third Point Partners

The previous chapters covered a few of the strategies that I have found that are consistently capable of providing
market beating returns. Unfortunately, many investors will find it difficult to put those strategies into practice.
Which is why those strategies are so effective in the first place. The biggest mistake investors make is not adhering
to a strict discipline when it comes to buying, holding, and selling. All too often, investors rely on their gut feelings
and intuition and whatever may be their limited understanding of investing. Investors that struggle to find success
base their decisions on impulse and fail to follow a coherent strategy that takes into account the concepts of value
investing. Too many investors that think they are pursuing value investing end up making decisions that make the
top value investors cringe. As I hope to show in this chapter, the most common investing errors are the result of a
poor understanding of the markets, the lack of a coherent strategy, and psychological biases – we all have them. To
paraphrase Warren Buffett, it is my hope that my readers will profit from folly rather than participate in it.

Mistake Number 1: Investing with emotion

Humans can get very emotional. People have a natural tendency to overreact to surprises, especially when the
surprise is bad news. Investors all too often develop a love for a company or its stock. The best value investors will
postpone buying or selling when their emotions are running high in order to keep emotions out of the decision
process. In contrast, the average investor will get into trouble by making investment decisions based on emotion.
Some examples;

• Impatient investing. Errors are made when an investor thinks they must buy a stock quickly before the
opportunity passes. Or they only start buying after much procrastination when the stock is about to reach
a new high. Alternatively, investors are impatient and sell when the thesis takes too long to play out.
Investing motivated by impatience often leads to poor performance if not outright disaster. Instant decision
making is rarely required for opportunities that outperform the market over the long haul. As I keep
stressing, patience is key.

33
 • Falling in love with a stock. Investors fall into the trap of falling in love with a stock after it has performed
well. It can also happen with investors that have a bond with a company due to it being based in their
hometown or selling products they personally like. The biggest risk to falling in love with a stock is losing
objectivity and becoming complacent. Enamored investors do not look at their holdings with a critical eye.
This leads to overlooking negative information and only focusing on information that supports their
positive feelings. Investors need to maintain a sense of tough love to stocks that have performed well for
them.
• Buying after good news and selling after bad news. People are tempted to buy a stock when the news is
good or they sell when the news is bad. This impulsiveness is unwise. Judgement is clouded when acting
on the emotions of the moment and how investors process the news is corrupted by biases. The problem
with this is that if too many investors feel the same way it becomes the worst possible moment to buy or
sell. If investors are selling in a panic the price will collapse. If investors are buying on euphoria prices can
rise dramatically. The patient investors waits out the news cycle and thoughtfully reevaluates the situation
thoroughly before making any decisions.
• Selling during a panic. Investors selling in a fit of panic is all too common on Wall Street. Panic can happen
during or after a market crash. Panicked sell-offs can occur when there is a cascade of negative news and
the momentum of crowd behavior takes over. When investors are stressed they revert to following the herd
especially when the future is uncertain – the average investors believe there is safety in numbers. Wise value
investors know that panic and crowd behavior should not be the cause for selling and that selling decisions
should be based on value and price considerations.
• Desperately trying to recover losses. When investors cannot afford to lose, a loss can bring on emotional
stress. This can happen when an investor is overleveraged through margin or when the money lost had
been intended for something specific such as college expenses or the down payment on a home. Under
these circumstances investors can be under enormous pressure to make up for the losses and to do it
quickly. Upon realizing these losses cannot be made up in a conventional way, investors may feel compelled
to take on more risk or to take desperate gambles. Both of which are recipes for disaster. Successful value
investors know that departing from a disciplined investment strategy will rarely pay off with success.

Mistake Number 2: Trying to time the top or the bottom

Too many investors believe they can time when a stock has hit bottom or time when a stock has hit a top. Investors
like to believe they are bottom fishers and buying only when a stock has hit rock bottom. The same investors may
believe they are stellar at calling the top and trying to squeeze every last cent out of a stock before selling. All of this
is due to overconfidence. Behavioral finance has shown time and time again that the average investor has an
unjustifiable confidence in their ability to time their buying and selling. Psychologists believe this is because most
investors have been lured into thinking investing is easy, when in reality it is quite complex and difficult. After all,
CNBC has convinced us that all we need to be successful investors is a brokerage account and to watch Jim Cramer’s
Mad Money television show. Even worse, investors have been lead to believe that bottoms and tops can be
recognized with some technical chart readings and past market movements.

34
Investors have been conditioned to believe that predictable and understandable patterns can be found in everything.
Therefore, investors believe that stock prices move in predictable patterns and they are willing to listen to people
that claim they can read and interpret these patterns. It is no surprise that once investors are armed with this
knowledge they believe they can time the tops and bottoms of an individual stock or the market as a whole.

The best value investors categorically reject the concept of bottom fishing or top picking. They do not believe that
anyone can perfectly time the bottom of a stock or the top because stock price movements are far too random. True
value investors see bottom fishers and top pickers as reckless speculators. When reading the letters the top value
investors write their investors or shareholders, the consistent refrain is to warn against this practice. Bottom fishers
are far more likely to miss out on great value opportunities on the way down because they wait too long to buy.
Once an opportunity is missed and the stock begins to rebound, they are hesitant to buy the stock on its way up
because it goes against their bottom fishing philosophy. The end result is a missed opportunity. In a similar fashion,
those that try to time the top are prone to hanging on to a stock for too long. They miss out on selling at the top and
if the stock drops below that, they are reluctant to sell and get caught in a downdraft.

The main lesson for value investors is to not aim for the best possible buying price or the best possible selling price.
While it is great to buy or sell within a 10% range of the bottom or the top, most of the money is made in the
remaining 80% range. The best value investors base their buying and selling decisions on fair value considerations
and common sense. Random price movements are accepted as part of successful investing. They are willing to
accept the possibility that a price will drop after a purchase or move higher after a sale. Successful value investors
buy gradually at low valuations and sell in pieces when the stock reaches full valuation. Due to gradual accumulation
and reduction, random price fluctuations are not an issue.

Mistake Number 3: Getting rid of winners and hanging on to losers

It is a natural reaction for investors to want to sell winning stocks and hang on to, and in some cases buy more of,
the losing stocks. Behavioral finance has showed us there are several reasons for this. One reason is that investors
have a habit of using the stock price before a sudden move as an anchor and it becomes hard to imagine that a stock
could go any higher or that a stock has suddenly dropped could go any lower. The average investor believes that a
winning stock has lost its upside potential and should be replaced with someone that has not increased in value as
much. That same thinking makes investors believe that a losing stock is due for a major bounce and therefore it
should not be sold.

Another reason is regret and pressure from others. Financial advisors will tell their clients that no one has ever gone
broke by taking a profit and to sell their best performers. Investors worry their sudden gains will evaporate if they
do not sell and the financial media does its best to reinforce this thinking. With losing stocks, investors would rather
wait and see if the stock will later go up and avoid the regret of selling too early.

The concept of “asymmetric loss aversion” is probably the biggest reason investors hang on to losers. Research has
shown that a financial loss hurts twice as much as the enjoyment that comes from an equally large gain – losing $50
hurts twice as much as the enjoyment of winning $50. Therefore, investors are reluctant to take a cash loss. As long
as the stock is not sold, the loss is only on paper and the hope remains that the stock will rebound to at least break
even.

35
Buying and selling solely based on price action is unwise and is a recipe for disaster. Without basing these decisions
on a thorough fundamental analysis, it is not possible to tell if these sudden changes in prices are based on intrinsic
value. Investors run the risk of “pulling out the flowers and watering the weeds” if they fail to take into account the
fundamentals. Top value investors are adamantly opposed to automatically selling a stock that has doubled or
automatically deciding to hold when the stock drops by half – with apologies to Benjamin Graham. It is a mistake
to sell a standout performer after a run up in the price if the company has more room to grow. Is it a mistake to hold
on to losing stocks in the hopes of breaking even when the stock rebounds. These are the two costliest mistakes
investors can make and they should be avoided at all costs. As counterintuitive as it is sounds, be reluctant to take a
profit and be willing to take a loss if the decision is based solely on price action.

Mistake Number 4: Trading too much

In a race for profits and investment success, many investors fall into the trap of believing successful investing
requires hyperactivity and a relentless action. Part of this goes back to overconfidence in their abilities to time the
market and the tops and bottoms in stock prices. It is no secret that hard work is necessary for success in any
endeavor, but investors make the mistake of confusing constant action with hard work. Combine this with a lack of
patience and the unending desire for action. The average investor finds it hard to resist the hottest stock of the day
and sell the stocks they recently bought in order to buy it. Not to mention most investors underestimate the
transaction costs that come with active trading including the bid-ask spread, broker commissions, fees, etc.

What investors fail to realize is that, with the exception of a brilliant (and lucky) few, the track records of active
traders is not very impressive. Studies have shown that the long-term records of active investors are rarely
comparable to passive investors. The best performing value investors know that the high turnover game is not a
path to success. The average holding period for successful value investors is two to five years. Warren Buffett
regularly keeps stocks in his portfolio for decades and that has worked out pretty well for his shareholders. Value
investors know the low turnover approach works and they do not buy or sell based on hunches or the latest news.
They only buy or sell when well-defined criteria is met. Over the long-term value investors pay less in transactions
costs and taxes, which helps them compound at a higher rate of growth.

Mistake Number 5: Keeping a stock out of a need to be right

Just like with any other field of endeavor that measures its results based on performance, ego plays a large role in
the investment world. Investors want to be right and are reluctant to change course when it means admitting they
were wrong. Investors mistakenly confuse an admission of error with defeat. Smart value investors know that they
do not always have to be right 100 percent of the time, they can still be successful with a less than perfect record.
The best investors know to keep their egos in check and stay humble. George Soros, one of the most successful
investors of all time, has said he was successful in spite of the many mistakes he made.

Mistake Number 6: Believing this time is different

One of the most dangerous things an investor can ever say is “this time is different”. Investing based on new theories
that come along with each new market surge, depression, or bubble is a mistake. We saw this during the dot.com
boom when investors were told to forgo the traditional methods of valuation and value companies that were not

36
making any money on a new paradigm – and we saw how that worked out. Successful investors do not fall for new
era theories or forget the troubles of the past. History repeats itself.

Mistake Number 7: Paying too much attention to the economy

Many investors believe they must have a solid understanding of the economy in order to buy or sell correctly. Or
they only buy stocks that fit into their view of the economy. The top value investors know this is a mistake. Wise
investors understand that the economy is too complex and difficult to predict and is therefore a waste of time. One
of my mentors, one of the most successful investors over the last thirty years, once told me he spends less than 20
minutes a year thinking about the direction of the economy. Even if an investor were able to read the economy
correctly, there is no guarantee the market would behave accordingly and they would have trouble profiting on their
insights. Making things even more complicated is the central banks and their ability to push the market in any
direction on their whim based on their own view of the economy and its direction. Investing based on economic
predictions that can change quarter-by-quarter tempts the investor into an active trading pattern and high portfolio
turnover, which carries its own problems. True bottom-up investors champion the idea that fundamentals of the
company in question are of more importance than the economic picture. That is not to say investors should ignore
bubbles and not structure their portfolios around them. A small band of value-based investors profited off the
collapse of the housing bubble in 2008.

Mistake Number 8: Buying and forgetting

Warren Buffett is arguably the best investor of all-time and his numbers speak for themselves. This has led to an
almost cult following of Buffett and every move he makes and investor letter he puts out. Buffett often says that his
favorite holding period is forever. All too often, some investors take this too literally and never learn when to sell.
What investors forget is that Buffett is working with $200 billion and that requires a completely different strategy
than what works for investors with a much smaller portfolio. Therefore, investors take a mindless approach to their
portfolio and stick to their stocks long after the value is gone.

While it may be convenient to buy-and-hold and not have to keep track of each piece of news that comes out on a
company, it is not likely to lead to outperforming the market over the long-term. Simply because companies that
are able to grow 12-15% annually for more than a decade are actually quite rare. In a buy-and-hold approach the
best one can hope for is returns of 12-15 % and the most likely scenario is around 10%, something that could be
achieved with an index fund and a far cry from outperforming the market.

Even Warren Buffett’s favorite holding period does not hold up to scrutiny. When looking at Buffett’s personal
portfolio, outside of Berkshire Hathaway, it is clear that Buffett’s average holding period is 2-3 years. During the
years of his private partnerships, 1956-1969, and before his involvement with Berkshire Hathaway, Buffett followed
a deep value and special situations strategy similar to what I have outlined in this book and it resulted in the best
returns of his long career – an average of over 30% per annum compared to the 15% he has averaged over the last
two decades. Rule of thumb: Until investors are managing $200 billion like Buffett is now, stick to the investing
strategies he was using when he was managing less than $100 million.

Mistake Number 9: Buying glamour stocks

37
Trying to find investment success by buying popular well-known companies along with large number of other
investors is not likely to succeed. While I reject that the Efficient Market Hypothesis outright, I do acknowledge that
the market is competitive. The more eyes on a particularly company, the more likely the company will be fairly
valued by the market and that each new piece of information that comes out will quickly be factored in to the price
by the market. More competition means less opportunity for a mispricing by the market. Investors would be well
served to stop paying attention to companies that are in the news every day and focusing their attention on the outer
edges of the market and looking for companies that get a brief mention in the news because of some upcoming event
such as a spin-off or bankruptcy. If the average investor has never heard of a company that meets the criteria covered
in this book, it is a good bet the majority of the market has not heard of it either.

Mistake Number 10: Focusing too much on tax considerations

No one likes having to deal with tax issues or even paying them, but some investors let tax considerations interfere
too much with their buying and selling decisions. With gains, investors may try to time their selling to minimize
taxes and to benefit from the lower tax rates on long-term capital gains. Alternatively with losses, investors may sell
too quickly to benefit from the higher deduction on short-term losses. There is also the selling of losing stocks to
offset the gains of winning stocks. This kind of behavior is dangerous. What should matter most to investors is the
after-tax rate of return, not so much the amount of taxes paid. Minimizing taxes should not be the primary objective.
Maximizing and earning the highest rate of return after-taxes should be every investor’s goal. By staying true to the
investment process and basing decisions on value while giving tax considerations a minor thought is the key to deep
value investing success.

PART II

Deep Value Examples

With any field of study it is important to use examples and case studies for highlighting and extracting practical
principles and methods for solving problems. Here I have included 5 real life examples to show I how I have used
the research process outlined in the first three chapters to outperform the market. From March 2012 until December
2013, I released profiles of my research on 18 companies. Out of the 18 companies, 16 had stocks that outperformed
the market by a wide margin and 9 of them returned 100% or more in less than a two-year period and several of
them returning 200% or more. Proof positive that looking for opportunities in the right places and using a thorough
due diligence process will increase the probabilities of investment success.

38
Example 1
C&J Energy Services, Inc. (CJES)
Bought: $17.45 (April 2012)
2-Year High: $33.85 (June 2014)
Total Return: 93.9%
C&J Energy Services (CJES) is an oil and gas services company that I found through a deep value screener
in the early spring of 2012. At the time the stock was down more than 40% due to investor worries that
that the Obama administration was going to issue a moratorium on fracking. Having studied the oil and
gas industry for the better part of a decade and knowing the prevalence of fracking in the industry, I
believed these concerns to be unfounded. After analyzing the company and studying its fundamental, I
determined that the stock was drastically undervalued and the fundamentals sound. After releasing a
research profile in March 2012, the stock would nearly double over the next two years. The stock would
reach a high of $33.85 in the spring of 2014 and I put out a follow-up research profile shortly thereafter
recommending a sale. At the time of this writing CJES appears to once again be an attractive deep value
opportunity. This was a perfect example of the importance of being patient and waiting for the thesis to

39
unfold. In the first 14 months, the stock moved very little and then in the following 8 months it nearly
doubled. Investors that threw in the towel after just one year missed a great opportunity.

Key Figures
Market cap: $900M
P/E Ratio: 5.73
Earnings Yield: 25.63%
P/CF Ratio: 3.79
Return on Equity: 64.21%
Return on Assets: 42.9%
Net Profit Margin: 21.36%
Thesis
The stock was down over 40% on investor concerns of a moratorium on fracking. Any moratorium was
unlikely and impractical due to the fact that fracking was used in 9 out of 10 natural gas wells in the United
States. CJES had six fleets operating throughout the United States and was expected to add three more
by the end of 2012. Projected revenues for the end of 2013 were expected to be $1.5 billion, almost
double the revenues for 2011. CJES was debt free after having retired all debt the previous year. The stock
was trading at a P/E ratio of less than 4 and a price-to-cash flow of 3.79. It was a profitable company with
a net profit margin of 21.4% and a free cash flow margin of 19.6%. The return on assets were 42.9% and
the return on equity was 64.21%, both very high numbers. The management was shareholder friendly and
scored well. All of these factors combined with the stock trading for less than $18 made it an attractive
opportunity.

Very few stocks looked as attractive as CJES at the time. The fear of a moratorium had caused to the stock
to be unfairly punished by the market. The previous year had seen an increase in sales by over 150% and
an increase in operating earnings by over 180%. Free cash flow was $150 million the previous year and
expected to continue growing for the next two years. Aside from having no debt, the company had nearly
$50 million in cash on the balance sheet. I pointed out at the time that the company had the financial
means to buy itself and go private. Between expected growth in the company’s fundamentals and a
revaluation by the market, I predicted the stock could double within two years.

Other Factors
Management

John Comstock was the founder and the CEO of the company. I consider it to be a major plus that the
company was run by its founder. In addition, he owned an 8.2% stake in the company, insuring that his
interests were aligned with other shareholders. The rest of the executive team was made up of industry
veterans that provided strong bench strength. Compensation was in line with the industry averages and
compensation was in the form of stock options, further aligning management interest with shareholders.

40
Financial Strength

The financial strength of the company is what appealed to me most. In 2011, CJES generated $150 million
in free cash and that number was expected to grow to $220 million the following year. In addition, the
company was debt free and had almost $50 million in cash on hand. The 30% operating profit margin
looked sustainable well into the future.

Competitive Advantage

In the fracking arena, the competitive advantage was based less on pricing and more on experience and
capability – CJES had plenty of both. This provided an economic moat against competitors that were new
to the fracking industry.

The Last Word

CJES was a classic deep value opportunity. It was being unfairly punished by the market while remaining
fundamentally sound. Plus its expanding free cash flow and growth opportunities made it especially
attractive. The key here was to remain patient while the thesis unfolded.

Example 2
United Therapeutics Corporation (UTHR)
Bought: $41.64 (May 2012)
3-Year High: $190.29 (April 2015)
Total Return: 356.9%
United Therapeutics is a biotech/pharmaceutical company I found in late spring of 2012 using Joel
Greenblatt’s Magic Formula screen. The company makes the drug Remodulin which is used to treat
pulmonary arterial hypertension, a rare but dangerous condition that affects more than 200,000 people
worldwide. What initially attracted me to the company was that it was consistently growing and delivering
strong results and it was trading at a high earnings yield, which meant it was cheap. After conducting a
thorough bottom-up fundamental analysis and talking to the company’s investor relations, I was confident
in my assessment that the company was drastically undervalued. In the three years that followed my
releasing a research report on the company, the company has outperformed the overall market by a mile
and returned well over 300%. It is worth pointing out, that at the time, it was a heavily shorted company
– a perfect example of combining due diligence with a contrarian mindset.

41
Thesis
Despite consistently delivering strong results, UTHR was deeply undervalued with an earnings yield of
21.6% (the higher the number the cheaper the stock) and a price-to-cash flow ratio of 6. UTHR’s entire
roster of drugs, led by Remodulin, continued to show improving sales growth. Sales of the drug Adcirca
had nearly doubled over the previous year and Tyvasco was up 47% in the same time frame. Operating
profit margin expanded to 43% from the previous year’s 22%. Management was projecting that sales of
Remodulin would continue to grow in the European and Asian markets. Overall revenues were projected
to grow by 15% a year for the foreseeable future. Financial stability was a plus with over a net cash position
of $500 million. The company had a return on tangible capital of 62%, the hallmark of a great company
with a competitive advantage. The company showed it knew how to make money with a net profit margin
of 34% and a consistent free cash flow of $200 million-plus. UTHR reminded me a lot of Questor
Pharmaceutical, another company that had a high short interest (meaning a negative sentiment), yet the
stock went from $5 to over $40 in just over a year. The primary catalyst was the expectation that sales
growth in Europe and Asia would soon match sales in the United States as well as the expected approval
of several new drugs. The seal of approval came in the form of an 11% ownership stake by pharmaceutical
giant Eli Lilly, which also gave hint of a possible future takeover.

Key Figures
Market cap: $2.09B
P/E Ratio: 8.92
Earnings Yield: 21.26%
P/CF Ratio: 6.0
Return on Equity: 27.54%
Return on Assets: 18.13%
Net Profit Margin: 34.69%
Other Factors
Management

United Therapeutics was founded in 1996 by Maritne Rothblatt and she had held the position of
chairwoman and CEO ever since – again another situation with the founder running the company. She is
a talented manager with an impressive resume, having played a key role in the invention and development
of 3 key Remodulin patents. She was also one of the co-founders of Sirius Satellite Radio. With a 5%
ownership stake in the company, I was confident her interests were aligned with shareholders. Most of
the board had been in place for at least 10 years. Management’s record had been impressive having
overseen a 7-fold profit increase since 2003.

Financial Strength

With over $750 million in cash on hand against $270 million in debt, UTHR had a strong financial position.
Free cash flow was 30% of total sales and was over $200 million annually. I had no concerns with short-

42
term debt as the cash flow covered interest expense 25 times over. The patents for Remodulin and Tyvaso
insured many years of stable and predictable cash flow.

Competitive Advantage

Competitive advantage was a strong point; the treatments for PAH made up a very small sector of the
pharmaceutical industry. The bigger industry players largely avoided putting any resources into competing
in this sector. Remodulin’s closest competitor was the drug Flolan produced by GlaxoSmithKline.
Remodulin’s primary advantage over Flolan was that Flolan had to be administered through IV.

The Last Word

UTHR was a perfect example of being a contrarian in the face of overwhelming negative sentiment in the
form of a high short-interest ratio. Sometimes the short sellers get it wrong, especially when it is a
fundamentally strong company with an already underpriced valuation.

Example 3
j2Global Communications Inc. (JCOM)
Bought: $24.06 (June 2012)
3-Year High: $75.62 (August 2015)
Total Return: 214.2%
j2Global Communications provides web-based communications services. The lead product is eFax, which
provides fax-to-email and email-to-fax services. I found the company in late spring using a deep value
screener, coincidentally it later showed up on a Greenblatt Magic Formula screener. After having
thoroughly analyzing the company I could not understand why the market was missing out on a company
that delivers consistent results. While I normally prefer to avoid companies that grow through
acquisitions, I found the story behind JCOM to be compelling for a number of reasons, one of them being
that the company delivers a consistent net profit of 35%, more than double its industry competitors and
triple the average for the S&P 500. Not to mention a fortress balance sheet.

Thesis

43
The stock had dived more than 25% in the previous year despite showing consistent fundamentals. JCOM
had a strong balance sheet with almost $200 million in cash and no debt. Free cash was very strong, being
nearly 40% of total sales and that had been the case for the previous 5 years. Despite having a healthy
dividend of 3.5%, it was only 20% of the free cash flow. At the time the company was doing a large
buyback, an indication that at least the management believed the company was undervalued. Along with
high profit margins, the company had a consistent return of equity of 25% or more. My research showed
that management had a good track record for financial management. This was another stock with a high
short interest of more than 30%, a potential catalyst for a dramatic rise in price when the shorts would
inevitably move to cover. I thought at the time the stock could be worth $40 within two years, which
turned out to be a conservative estimate.

Key Figures
Market cap: $1.15 Billion
P/E Ratio: 9.20
Earnings Yield: 16.01%
P/CF Ratio: 7.24
Return on Equity: 24.4%
Return on Assets: 19.8%
Net Profit Margin: 34.6%

Other Factors
Management

I rated management to be of the highest caliber. A lesson I have learned from Warren Buffett is to only
work with competent management especially with the fast moving industry that requires management
able to turn on a dime. Management had a track record of growing sales, consistent margins, and market
beating returns. Management compensation was modest by industry standards. With well-timed share
buybacks and increased, it was clear that management was shareholder friendly. This impressive track
record was accomplished by a management team that had largely been in place for the better part of a
decade. The chairman, Richard Ressler, had been CEO from 1997 to 2000 and also owned 5% of the
company. CEO Hemi Zucker had been with the company for 15 years and had served as the Co-President,
Chief Operating Officer, and Chief Marketing Officer before becoming CEO. Most of the board members
had been with the company since its founding. Institutional Shareholder Services (ISS) rated the company
high for audit quality, board quality, and shareholder rights.

Financial Strength

Even with the many acquisitions and hefty dividends, the company managed to keep an excellent balance
sheet with $200 million cash and no debt. Free cash flow had consistently been 40% of total sales. The
free cash flow had consistently been $150 million and had wisely been used to buy back shares at

44
opportune moments and thereby increasing earnings per share. I gave the company an A+ for financial
management.

Competitive Advantage

If there was one drawback with this company, it was that it was in an intensely competitive industry. JCOM
was competing with several providers of fax/email services as well as several companies that combined
fax/email services with print/scan/fax services. JCOM was able to claim several advantages, despite these
headwinds, such as being the largest internet message service provider with a 30% (and growing) market
share. The client roster was impressive, with more than 70 top-tier clients (contracts with more than 1,000
phone lines). With the scale and brand recognition of eFax, JCOM was able to command premium pricing
over the competition. The cost and hassle of switching vendors worked to JCOM’s advantage. Cancellation
rates were less than 3% and falling every year for three consecutive years thanks to acquiring some of its
competitors.

The Last Word

JCOM is a perfect example of how the market (and the short sellers) can be flat out wrong about a
company. I never understood the wisdom of shorting a company that is not only profitable, but is growing
and includes a pristine balance sheet. At any time the company could have bought back more shares and
put a real squeeze on the shorts.

Example 4
Voya Financial (VOYA)
Bought: $22.15 (May 2013)
2-Year High: $48. 30 (May 2015)
Total Return: 118.1%
Voya Financial was a spin-off from parent company ING that was masquerading as an IPO carve-out. It
was a forced divestiture brought on by new regulations imposed after the 2008 credit crisis. It is a financial
services company specializing in retirement, pension management, annuities, brokerage, and term-life
insurance. The company had over $100 billion in assets under management, which would be a reliable
source of management fees. I found the opportunity tucked away in an announcement of upcoming IPOs
covered by The Daily Deal. I normally do not pay attention to IPO divestitures and carve-outs, but once I
saw that it was a regulatory forced divestiture I knew there could be an opportunity there.

Thesis

45
The public offering of VOYA had been a disappointment for the parent company ING. The parent company
had listed VOYA and priced it $19.50, or just under 10 times earnings and about half of book value. This
had been 15% less than what they wanted to offer it for, but in a forced sell they were not able to wait
for a better pricing period. With the forced sale at less than 50% of book value in mind, I thought it was a
good chance to get in on the ground floor of a “new” company that already had over $100 billion in assets
under management. Plus, the parent company had a number of warrants that were exercisable in the $40
range, telling me that the parent company itself thought VOYA was way undervalued and was poised for
a big jump in price in the next few years. Taking into account all of these factors, I put a two year price
target of $45 on the stock, enough for a 100% return.

Key Figures
Market cap: $5.7 Billion
P/E Ratio: 9.3
Earnings Yield: 18.33%
P/CF Ratio: 5.05
Return on Equity: 18.6%
Net Profit Margin: 21.6%
Other Factors
Management

At the time, Rodney Martin was acting as CEO and Alain Kraroglan was the COO, carry overs from the days
when the business unit was owned by AIG, before being sold to ING. Their ability to handle the separation
from AIG boded well for the future of VOYA. I graded management competent and in good hands going
forward.

Financial Strength

Financial service companies have to be evaluated in different manner than non-financial services, namely
in terms of its balance sheet. Financial services requires a huge balance sheet and in the case of VOYA, it
had a $216 billion balance sheet at the time and a $4.2 billion in debt, a mix of long and short term debt.
With a net profit of $611 million the previous year, none of this really registered as any concern. I graded
financial strength as a B+.

The Last Word

I normally do not like IPO divestitures or carve-outs. In this case it paid to pay attention to the fact that it
was a forced carve-out. For many of reasons that spin-offs do well, including the forced sell off, I knew
this one would perform very well.

46
Example 5
Ebix, Inc. (EBIX)
Bought: $12.74 (July 2014)
1-Year High: $38.04 (June 2015)
Total Return: 199%
Ebix, Inc. provides software and e-commerce solutions to the insurance industry. I first found the company
several years before when it was in negotiations to be bought out by Goldman Sachs – the deal later fell
through. Ebix popped up on my radar again in the spring of 2014 when it started showing up my deep
value screen. I was stunned when I learned it had a high short interest of 37% of all available shares. I was
puzzled as to how a company could one year be a buyout target by one of the smartest firms on Wall
Street and the next year be a battleground stock with a high short interest. That is when I started doing a
deep dive in the company’s fundamentals as well as talking some of the short sellers. Fortunately, one of
the short-sellers, Daniel Yu, was very vocal and was more than happy to share his report with me. As I
studied the company, I wanted to see if I could refute every piece of Mr. Yu’s short thesis. I was able to

47
do that. Shortly after releasing my research report, several activist hedge funds bought substantial stakes
and began helping the company improving its image in the market. Daniel Yu and his band of short sellers
were crushed when the stock went up almost 200% in year, contradicting their thesis that the company
would collapse.

Thesis
Stocks with a short interest of 25% or higher are known in the industry as “battleground stocks”. I have
always that battleground stocks can offer excellent opportunities for deep value investors if after careful
analysis it is determined the short sellers have it wrong. Investors should be very careful because by and
large, short sellers are some of smartest people on Wall Street and often times they are right. In this case,
after looking at the company and who was the vocal short seller (and frankly not being impressed with
him), I decided I liked the company for two reasons – it was a great company and it was dirt cheap.

Ebix’s main business, more than 80% of revenues, is running insurance exchanges, marketplaces for
agencies, companies, and consumers shopping for insurance. Insurance companies pay subscription fees
to this their product on Ebix’s exchanges and transaction fees when consumers buy coverage. This is a
really great business (and one I would love to own in its entirety). Subscription fees are recurring and
renewal rates are very high at 95%+. It has low capital requirements since it is a software based business.
Plus, competition is limited and its scale draws both providers and consumers. The remaining portion of
Ebix’s business consists of back-end software systems for brokers and providers and insurance certificate
tracking.

Despite the best efforts of short-sellers to cloud the picture, the numbers do not lie. The company had
grown at a 5-year compound growth rate of more than 15% a year and operating earnings at 13.9%. The
company is in god financial health with a reasonable amount of debt. Most impressive was that Ebix
generated a lot of free cash flow, averaging 34% of revenues, giving investors a nice dividend yield of 2.1%.
The earnings yield was 15.5% and a free cash flow yield of 9%.

Key Figures
Market cap: $497.7M
P/E Ratio: 9.6
Earnings Yield: 15.5%
P/CF Ratio: 5.12
Return on Equity: 14.69%
Net Profit Margin: 28.17%
Other Factors
Management

Rob Raina has been the CEO since 1990 and has held the chairman role since 2002. He owned 12% stake
in Ebix, clearly his interests were aligned with shareholders. Operationally Ebix has performed very well
under Raina’s leadership, growing at an impressive rate of 29.4% compound rate since 2004. Operating

48
income has grown to over $60 million from $2 million in less than a decade. Ebix started issuing a dividend
in 2011 and has raised it twice, including a special dividend in 2012. Return on invested capital has been
a consistent 20% or more for the last decade. I gave Ebix high marks for having a competent and successful
management team.

Financial Strength

Ebix showed solid financial health. It had a manageable cash/debt balance of $58.6 million to $54.4
million. Debt-to-equity was at 13% and the current ratio was 1.8. Ebix generates a lot of free cash flow,
and for the last five years it had been 34% of total revenues. The 2.1% dividend was just 10% of free cash
flow. The company wisely bought back shares when the stock was undervalued to offset the share dilution
from prior acquisitions.

Competitive Advantage

While Ebix is unique in that it offers a wide array of products, it does compete with different companies
on different exchanges. In the life insurance exchange market, it competes with Winflex and Lifespeed,
while in annuities it competes with AnnuityNet. Its closest competitor that offers prodcuts across a
number of exchanges is iPipline. Ebix boasts high customer retention rates (95%+) and a number of other
factors such as high switching costs, product diversity, and limited competition to that give it a unique
economic moat.

The Last Word

Ebix is a perfect example of why it is important to dig in and do your own due diligence. Investors that
listened to the drum-beating short sellers missed out on a 199% one-year return. As I said previously, Ebix
is the company I would love to own in its entirety.

49
 APPENDIX

The Making of a Stock Picker

The Making of a Stock Picker

Many years ago I set a goal of being regarded as a top-notch stock picker. I learned early on that my goal would not
be accomplished without many years hard work and a great deal of reading. Two things that I believe have helped
me get to this point is finding good mentors and reading hundreds of books. I believe that it is impossible to be a
successful value investor without a willingness to do a vast amount of reading – including reading company filings
and business related books. With that in mind, early in my career I committed to reading 300+ pages a day. What I
have found is that over the last decade carrying out that commitment is that I have compounded knowledge. When
I analyze a new company or situation, I usually find reference points to refer back to in my mental library. Decisions
become easier to make because I can refer to earlier situations that I have encountered.

The best way to learn about investing it to read books on the subject and that is what I did. I went to the library and
bookstore and read everything I could find. Over the last 15 years I have read more than 600 books on investing,

50
finance, accounting, economics, and business biographies. I am not suggesting that it is necessary to read 600-plus
books to be a successful investor because it is not. I will emphasize that it is important to be an avid reader. Investing
is in some ways is similar to writing, really only you can teach yourself to do it in the manner that best suits you. Yet
the insights and experiences of others can be a tremendous help.

After getting the basic theories down, it is important to get your hands dirty and totally immerse yourself in the
financial statements (10-Ks, 10-Qs, S-1s, Form 10s, etc.) straight from the companies, EDGAR, Capital IQ, or
Bloomberg. I estimate that I have read the filings of 2,000 companies, including more than 500 spin-offs going back
to 1994, several hundred bankruptcies, and more than thousand mergers.

It is also important to read business newspapers, magazines, and other publications. A few of my favorites are the
Wall Street Journal, the Financial Times, Dealbook (New York Times), Barron’s, Bloomberg Markets, Bloomberg
Businessweek, etc.

Many great investors and analysts give insightful interviews and publish market commentaries. Some sources have
influenced me greatly:

Warren Buffett, Joel Greenblatt, James Chanos, Howard Marks, Mohnish Pabrai, Daniel Loeb, David Einhorn, Bill
Ackman, Paul Singer, Walter Schloss, George Friedman, Jeremy Grantham, Hugh Hendry, John Hussman, Seth
Klarman, John Mauldin, Eric Mindich, John Paulson, John Scully, Richard Rainwater, Michael Pettis, Bill Gross,
Mohammed El-Erian, Robert Prechter, Jim Rogers, Jeff Ubben, Nouriel Roubini, Brad Setser, Victor Shih, George
Soros, and Peter Thiel.

I am often asked for book recommendations on value investing. If I were to teach a year-long class on event-
driven value investing (my primary specialty), these are the books that I would require for class. I would want the
class to cover the basic elements of fundamental analysis, business valuation, value investing, special situation
investing, risk arbitrage, option investments (LEAPS and warrants), risk assessment and portfolio management.
This is a good starting point for anyone that wants to become a better deep value or special situations investor.

Security Analysis and Business Valuation on Wall Street. Jeffrey Hooke. The book is a step-by-step explanation of
how to analyze a stock. Hooke teaches the reader about intrinsic value, relative value, and acquisition value.

How to Read a Financial Report: Wringing Vital Signs Out of the Numbers. John A. Tracy. Offers a plain-English
user’s guide to financial reports.

The Intelligent Investor. Benjamin Graham. This book is the cornerstone of value investing.

Value Investing: From Graham to Buffett. Bruce Greenwald. This is one of the best books on value investing. Bruce
Greenwald is also a professor at Columbia’s Business School and a director of research at First Eagle Funds.

51
The New Finance, 4th Edition. Robert Haugen. Focuses on the evidence, causes, and history of over reactive pricing
in the stock market. The book touches on topics like behavioral finance and provides evidence that the market is
not efficient.

You Can Be a Stock Market Genius. Joel Greenblatt. Despite the book’s cheesy title, there is a wealth of information
here. The book focuses on special situations including arbitrage, bankruptcies, and spin-offs. This is probably the
best book on special situations.

The Little Books That Still Beats the Market. Joel Greenblatt. A very simple and quick read. The book discusses Joel
Greenblatt’s famous “magic formula”. The formula calls for investing in companies that have high returns on
capital and high earnings yield.

The Essays of Warren Buffett. Lawrence Cunningham. A compilation of Berkshire Hathaway shareholder letters,
all organized by topic. If you want to know about Buffett, this is the best place to start.

What Works on Wall Street. James O’Shaughnessy. The author examines several decades of market data and shows
how 15 of the most common investment tactics have fared over that time horizon.

Contrarian Investment Strategies – The Next Generation. David Dreman. This is one of my top five favorite
investment books. Dreman discusses his contrarian approach to investing while ripping the efficient market along
the way.

For those that want to do more reading and follow a similar path that I have, I have created this list that also covers
a wide range of subjects including financial statement analysis, fixed income, investment banking and real estate.
The bottom line is I like to read extensively and I think it is made me a much better investor because of it. I try to
provide a brief explanation on why each book resonated with me.

The Top Ten

52
The Essays of Warren Buffett: Lessons for Corporate America. Warren Buffett. Edited by Lawrence Cunningham.
Also see the unedited letters: “Chairman’s Letters”www.berkshirehathaway.com
The Intelligent Investor: A Book of Practical Counsel. Benjamin Graham. Margin of safety. The difference between
“investing” and “speculation” – a businessman’s approach. Focus on chapters 8 & 20.
Poor Charlie’s Almanack, 2nd Edition. Charles T. Munger. Munger’s take on the world – his view of extreme
concentration, 5-10 positions, which is what Buffett started doing at Berkshire in the late 1960s, moving beyond
Graham’s diversified pool of special situations.
The General Theory of Employment, Interest, and Money. John M. Keynes. Focus on chapter 12 – one of the best
essays on investing ever written.
Buffett: The Making of an American Capitalist. Roger Lowenstein. The best biography of any financier ever.
Valuation: Measuring and Managing the Value of Companies, 5th Edition. McKinsey & Company Inc. Tim Koller
et al.
Financial Statement Analysis: A Practitioner’s Guide, 3rd Edition. Martin S. Fridson. Learn the ROE breakdown
and accounting nuances.
Business Strategy and Security Analysis: The Key to Long-Term Investment Profits. Raymond K. Suutari.
Advanced qualitative tools for identifying good businesses – the economic value drivers behind the ratios.
A History of Interest Rates, 4th Edition. Sidney Homer and Richard Sylla. The founder of research at Salomon
Brothers offers perspective on interest rates, the lifeblood of finance. This book gives perspective on the most
important external input on valuation.
Make Your Own Luck. Eileen Shapiro et al. A systematic and probabilistic way to make investment and business
decisions.

Valuation and Theory of Investments

Why Stocks Go Up and Down. William Pike and Patrick Gregory. The book you need to understand other
investment books.
Security Analysis and Business Valuation on Wall Street, 2nd Edition. Jeffrey C. Hooke. A good introduction to
security analysis and valuation.
Investment Valuation: Tools and Techniques. Aswath Damoradan. Basics on valuation modeling. See
also http://pages.stern.nyu.edu/~adamodar/
Security Analysis. Benjamin Graham and David Dodd. Learn how to think about capital structure and valuation. I
have read all six editions of this book, skip the 5th one.
Competitive Strategy. Michael Porter. You need to understand the economic forces behind the accounting
numbers.
Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Inevstor. Seth A. Klarman. The book
is out of print, but a bootleg pdf copy circulates on the internet. Also read Klarman’s Baupost letters that are floating
around the internet.
One Up On wall Street: How to Use What You Already Know to Make Money in the Market. Peter Lynch. Practical
knowledge on how to capitalize on your area of knowledge and your strengths in picking stocks.
Beating the Street. Peter Lynch. The two chapters on bank thrift conversions alone are worth the entire book.
John Neff on Investing. John Neff. Bargain investing tips.

53
Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment. David F. Swensen.
The best book about managing a large endowment portfolio and thinking about asset classes, though with some
flaws.
Risk, Uncertainty, and Profit. Frank Knight. A classic on thinking about risk.
Black Monday and Black Swans. Financial Analysts Journal. John C. Bogle
The Theory of Investment Value. John Burr Williams. The first DCF model and how to think about opportunity
costs.
Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street.
William Poundstone. The most important formula for position sizing.

Financial Statement Analysis, Accounting, and Modelling

Analysis of Financial Statements, 5th Edition. Leopold A. Bernstein. Hands down the single best book on financial
statement analysis.
Intermediate Accounting. Donald E. Kieso. A great reference work.
Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance. Charles W. Mulford. Dry, but one
of my favorite accounting books. It is the single best book on how to read a cash flow statement. It teaches one how
to assess a company’s sustainable cash flow, which is what a rational investor uses to value a company.
The Interpretation of Financial Statements. Ben Graham.
Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition. Howard
Schilit. Very good tips on reading financial statements, which are marketing documents, skeptically. Learning the
limits of bean-counting is important if you with the really understand accounting.
Quality of Earnings: The Investor’s Guide to How Much Money a Company Is Really Making. Thornton L. O’glove
Fraud Casebook: Lessons from the Bad Side of Business. Joseph T. Wells. The dark side, learn how to avoid it.
Best Practices for Equity Research Analysts: Essentials for Buy-Side and Sell-Side Analysts. James J. Valentine.
How to do better research and modeling.
Financial Modeling*. Simon Benninga. The bible on modeling from Wharton.
Wiley Interpretation and Application of International Reporting Standards. Bruce Mackenzie. Ugly but required.
Wiley GAAP 2015: Interpretation of Application of Generally Accepted Accounting Principles 2015. Joanne M.
Flood. Reference text.
A History of Accountancy in the United States. Gary John Previts. Make sense of some of the historical reasons of
the system.

*I am still working my way through this one. It is a long slow slog

Fixed Income, Leveraged Finance, and Derivatives

54
Inside the Yield Book. Sidney Homer. Great insight from the founder of Salomon Brothers’ bond research
department on how to think about fixed income valuation. Lots of early duration analysis insight.
Handbook of Fixed Income Securities, 9th Edition. Frank Fabozzi et al. The single best and most comprehensive
book on the fixed income markets. A good place to start for intermediate readers.
Bond Portfolio Investing and Risk Management. Vineer Bhansali. A good book on developing an intuitive,
economic understanding about fixed income markets from a PIMCO portfolio manager.
Fixed Income Securities, 2nd Edition. Bruce Tuckman et al. A succinct book on fixed income securities and pricing
written by proprietary traders.
The Strategic Bond Investor. Anthony Crescenzi. All investors need to understand bonds, the money market, and
the yield curve. This is a good introduction for people with no fixed income background.
The Most Important Thing: Uncommon Sense for the Thoughtful Investor. Howard Marks. By the brilliant co-
founder of Oaktree Capital Management – also check out his Oaktree Chairman’s memos online.
Stigum’s Money Market, 4th Edition. Marcia L. Stigum and Anthony Crescenzi. A reference text.
Fundamentals of Corporate Credit Analysis. Blaise Ganguin and John Bilardello. One of my favorite security
analysis books – many of my own analytical checklists were inspired by this book.
Convertible Securities: The Latest Instruments, Portfolio Strategies, and Valuation Analysis. John Calamos
Convertible Arbitrage: Insights and Techniques for Successful Hedging. Nick P. Calamos
Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives. Stephen J.
Antczak et al.
Leveraged Financial Markets: A Comprehensive Guide to High-Yield Bonds, Loans, and other Instruments.
William F. Maxwell et al.
How to Make Money with Junk Bonds. Robert Levine. Introductory primer on junk bonds written in a similar
manner as Joel Greenblatt’s books.
Junk Bonds: How High Yield Securities Restructured Corporate America. Glenn Yago.
Options as a Strategic Investment. Lawrence G. McMillan. I read this after I learned that Gary Cohn credited it for
his successful career as a trader at Goldman Sachs.
Options, Futures, and Other Derivatives. John Hull. The quantitative bible that indoctrinates most MBA students.
With the exception of warrants and LEAPS, I am not a big fan of financial WMD as used by many investors.
Option Volatility and Pricing. Sheldon Natenberg. Covers options in theory and practice.
Credit Derivatives. Geoff Chaplin. An advanced look at all things credit.
Dynamic Hedging: Managing Vanilla and Exotic Options. Nassim Nicholas Taleb. Probably the hardest finance
book I have ever read, but it’s useful.
Collateralized Debt Obligations: Structures and Analysis, 2nd Edition. Douglas J. Lucas. John Paulson and a few
others made billions during the credit crisis by figuring out how to short these.

Distressed Securities

55
The Vulture Investors. Hilary Rosenberg. While not technical in nature, this book gives you a very good
understanding of the qualitative aspects of distressed debt investing. It is a collection of “war stories” from the
eighties and nineties featuring stars like Marty Whitman and Wilbur Ross.
Bankruptcy Investing. Ben Branch and Hugh Ray. This is another good introduction to investing in distressed
companies. It is very basic so possibly a good starting block for those VERY new to the game.
Distressed Investing: Principles and Techniques. Martin J. Whitman. Whitman is one of the pioneers of distressed
debt investing.
Distressed Debt Analysis: Strategies for Speculative Investors. Best detailed book about the distressed world. I wish
all investment books were this thorough.
Distressed M&A: Buying, Selling and Financing Troubled and Insolvent Companies. Peter Nesvold et al. Packed
with lots of useful information.
Corporate Financial Distress and Bankruptcy. Edward Altman. This book is stock full of historical data which gives
the reader interesting context (relative to today). Plus, very head in terms of fundamental credit analysis which
should be the black belt of a distressed debt analyst.
Creating Value Through Corporate Restructuring: Case Studies in bankruptcy, Buyouts, and Breakups. Stuart
Gilson. This is one of my favorite books on bankruptcies. It takes a behind the scenes look at the operations of a
distressed organization and ways that advisers can unlock value. I think it is imperative that investors understand
the difference between a temporary and permanent problem and this book sheds light on how to differentiate
between the two.
Restructuring and Workouts: Strategies for Maximizing Value. Ben Larkin
Last Rights: Liquidating a Company. Ben S. Branch and Hugh Ray
Bankruptcy and Related Law in a Nutshell. David G. Epstein. I refer to this book quite often when some lawyer is
drawing some random bankruptcy provision out of thin air. It is not a “sit down and read for fun” book, but is a
quite handy reference.
Chapter 11: Reorganizing American Business. Elizabeth Warren. Learn the law.
Strategies for Creditors in Bankruptcy Proceedings. Lynn M. Polucki and Christopher Mirick. Learn even more
law.
The Law of Creditors and Debtors: Text, Cases, and Problems. Elizabeth Warren. The blackbelt of bankruptcy law.

Risk Arbitrage and Event-Driven Investing

Risk Arbitrage. Guy P. Wyser-Pratte. Wyser-Pratte is the dean of the arbitrage community. He is also one of the
most innovative activist investors out there.
You Can Be a Stock Market Genius. Joel Greenblatt. Don’t let the lame title fool you, this is one of the best
investment books ever. It is my personal favorite and behind 80% of what I do – look for opportunities that few
people understand. Dan Loeb once told me read this many years ago because it formed the backbone of his
investment strategy – Dan is now a billionaire.
Fortunes in Special Situations in the Stock Market. Maurece Schiller. Written in 1961, it was one of the first books
written on what would later be called risk arbitrage.
Risk Arbitrage: An Investor’s Guide. Keith M. Moore. A good book with updated case studies and examples.

56
Merger Arbitrage: A Fundamental Approach to Event-Driven Investing. Lionel Melka et al. A good look at merger
arbitrage as it is practiced in Europe.
Merger Mania. Ivan Boesky. It is well known that Boesky was arrested shortly after this book was published. What
is not so well known is that Boesky had plagiarized it from a graduate thesis at NYU.
Merger Arbitrage: How to Profit from Event-Driven Arbitrage. Thomas Kirchner

Speculating and Short-Selling

The Art of Short Selling. Kathryn Staley. Learn how to short well in order to be a better long investor. I once read
this book 12 times in a 6-week period.
Market Neutral Strategies. Bruce Jacobs et al. Some good thoughts on hedging and arbitrage. Daniel Och’s chapter
on risk arbitrage is the best one.
Beat the Market: A Scientific Stock Market System. Edward O. Thor. An out-of print book on hedging, but the pdf
is available for download on Thorp’s personal site. It’s a classic, especially for intelligent long/short work. A silly
title but the book is great.
Reminiscences of a Stock Operator. Edwin Lefevre. A classic. Jesse Livermore is the godfather of today’s trader-
speculator.
Where Are the Customers’ Yachts. Fred Schwed. How Wall Street screws everyone.
The Art of Speculation. Philip L. Caret. A classic book by the man Warren Buffett dubbed the greatest trader ever.
Market Wizards, Updated: Interviews with Top Traders. Jack D. Schwager
The New Market Wizards: Conversations with America’s Top Traders. Jack D. Schwager
Hedge Fund Market Wizards: How Winning Traders Win. Jack D. Schwager
The Education of a Speculator. Victor Niederhoffer
Practical Speculation. Victor Niederhoffer
The Battle for Investment Survival. Gerald M. Loeb. Loeb is hard hitting, he tries to both and invest and speculate.
The line is thin and dangerous.
The Big Short. Michael Lewis. This is porn for speculators and horror for investors.
The Greatest Trader Ever: The Behind the Scenes Story of How John Paulson Defied Wall Street and Made
Financial History. Gregory Zuckerman. The best short trade of all time.
Fooling Some of the People All of the Time, A Long Short (and Now Complete) Story. David Einhorn. Shows the
perils of shorting even when a company is rotten plus the rot at the core of the regulatory system.
Confidence Game: How Hedge Fund Manager Bill Ackman Called Wall Street’s Bluff. Christine S. Richard. It can
take a long time for a short to work and time works against you.
The Mind of Wall Street: A Legendary Financier on the Perils of Greed and the Mysteries of the Market. Leon
Levy et al. A shrewd investor.
No Bull: My Life In and Out of the Markets. Michael Steinhardt. A tough operator.
The Money Masters. John Train
The Money Masters of Our Time. John Train
The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money. Steven Drobny. A look at
the line between speculation and investment.

57
The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds. Maneet Ahuja. The profiles on John
Paulson, Bill Ackman, and Dan Loeb make it worth the read.
Hedge Hunters: Hedge Fund Masters on the Rewards, Risk, and the Reckoning. Katherine Burton. A look at the
greatest hedge fund managers of our time.

Corporate Governance, Law,and Activist Investing

How Cartels Endure and How They Fail: Studies of Industrial Collusion. Peter Z. Grossman. Great companies tend
to be natural oligopolies or monopolies.
Antitrust Stories. Eleanor M. Fox and Daniel A. Crane. Case histories on excellent businesses to own.
Corporate Governance. Robert A. Monks and Nell Minow. Governance and ownership is important, something
lazy investors forget. Activists live on it.
Pay Without Performance: The Unfulfilled Promise of Executive Compensation. Lucian Bebchuk.
Bebchuk is a Harvard professor is a thorn in the sides of entrenched, overpaid, and lazy management.
The Law of Corporations in a Nutshell. Robert Hamilton. You have to know the basics.
Corporation Law, 2nd Edition. Franklin Gevurtz. Reference book.
Securities Regulations: The Essentials. Stephen J. Choi. Stay out of jail.
Corporate Governance. Kenneth A. Kim
Shareholder Democracy: A Primer on Shareholder Activism and Partcipation. Lisa M. Fairfax
A Giant Cow-Tipping By Savages: The Boom, Bust, and Boom Culture of M&A. John Weir Close
Extreme Value Hedging: How Activist Hedge Fund Managers are Taking on the World. Ronald D. Orol

Investment Banking, Private Equity, Hedge Funds, and Venture Capital

Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions. Joshua Rosenbaum and Joshua
Pearl
The Practitioner’s Guide to Investment Banking, Mergers & Acquisitions, and Corporate Finance. Jerilyn J.
Castillo
Investment Banks, Hedge Funds, and Private Equity. David Stowell
Applied Mergers and Acquisitions. Robert F. Bruner
Harvard Business Review on Mergers & Acquisitions
Corporate Finance: Principles and Practice. William J. Carney
Mergers and Acquisitions: Case and Materials. William J. Carney
Mergers, Acquisitions, and Corporate Restructurings. Patrick A. Gaughan
Mergers: What Can Go Wrong and How to Prevent It. Patrick A. Gaughan
Maximizing Corporate Value through Mergers and Acquisitions: A Strategic Growth Guide. Patrick A. Gaughan
Corporate Finance in a Nutshell. Jeffrey J. Haas
Mergers and Acquisitions in a Nutshell. Dale A. Oesterle
M&A: A Practical Guide to Doing the Deal. Jeffrey C. Hooke
The Art of M&A: Financing and Refinancing. Alexandra Lajoux and Charles Elson
The Business of Investment Banking: A Comprehensive Overview. Thomas K. Liaw

58
Capital Markets. Thomas K. Liaw
Venture Capital and Private Equity: A Casebook. Josh Lerner
Buyout: The Insider’s Guide to Buying Your Own Company. Rick Rickertsen
Financial Modeling & Valuation: A Practical Guide to Investment Banking and Private Equity. Paul Pignataro
Leveraged Buyouts: A Practical Guide to Investment Banking and Private Equity. Paul Pignataro
Mergers, Acquisitions, Divestitures and Other Restructurings: A Practical Guide to Investment Banking and
Private Equity. Paul Pignataro
Takeovers, Restructurings, and Corporate Governance. J. Fred Weston
Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests. Robert T. Slee
Principles of Private Firm Valuation. Stanley J. Feldman
Middle Market M&A: Handbook of Investment Banking and Business Consulting. Kenneth H. Marks and Robert
T. Slee
The Handbook of Financing Growth: Strategies, Capital Structure, and M&A Transactions. Kenneth H. Marks
and Larry E. Robbins
The Fundamentals of Hedge Fund Management. Daniel Strachman
Private Equity: History, Governance, and Operations. Harry Cendrowski. How private equity investors think.
Lessons From Private Equity Any Company Can Use. Orit Gadiesh and Hugh Macarthur. Some great private equity
tips on how to run a business.
Real Estate

The Real Estate Game: The Intelligent Guide to Decision Making and Investment. William J. Poorvu and Jeffrey
L. Cruikshank. The best quick read on how to think about real estate. Poorvu teaches at Harvard Business School
and had Seth Klarman as a student. The book has some great case studies.
Real Estate Finance & Investments: Risks and Opportunities, 3rd Edition. Peter Linneman. The best book on
investing in real estate.
Investing in REITs: Real Estate Investment Trusts. Ralph L. Block. The only decent book on the topic.
The Wall Street Journal Complete Real-Estate Investing Guidebook. David Crook. A good book on the best
practical way to invest in real estate – go buy local properties in a time of distress and own and manage them directly.
Examples & Explanations: Real Estate Transactions, 5th Edition. Barlow Burke. Learn the law.
Principles of Property Law. Herbert Hovenkamp

Psychology – Cycles, Manias, Bubbles, and Panics

Manias, Panics, and Crashes: A History of Financial Crises. Charles P. Kindleberger. A historical perspective on
crashes and downturns. Markets are often fairly efficient, but offer pockets of inefficiency (which is exactly what I
am looking for). The difference is night and day.
Business Cycles: History, Theory, and Investment Reality. Lars Tvede. Cycles never end – see the NBER data at
NBER.org.
Financial Crisis, Contagion, and Containment: From Asia to Argentina. Padma Desai. A nice short read.
Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Biases.
Michael M. Pompian. The best book on behavioral finance.

59
“A Survey of Behavioral Finance” in Handbook of the Economics of Finance. Nicholas Barberis and Richard
Thaler. Read all works by Thaler, Kahneman, and Tversky.
The Intuitive Investor: A Radical Guide for Manifesting Wealth. Jason Apollo Voss. An important book because it
goes into the emotions about investing – emotional or right-brain/ creative reasoning often hurts investing but
should be harnessed to help.
Predictably Irrational, Revised and Expanded Edition: The Hidden Forces That Shape Our Decisions. Dan Ariely.
All humans, even the most rational ones, are mostly irrational.
Why Smart People Make Big Money Mistakes. Gary Belsky and Thomas Gilovich
Influence: The Psychology of Persuasion. Robert B. Cialdini
The Nature of Explanation. Kenneth Craik
Confusion of Confusions. Joseph de la Vega
Myth of the Rational Market. Justin Fox
Heuristics and Biases: The Psychology of Intuitive Judgement. Thomas Gilovich, Dale Griffin, and Daniel
Kahneman
Mental Models. Philip N. Johnson-Laird
Judgement Under Certainty: Heuristics and Biases. Daniel Kahneman, Paul Slovic, Amos Tversky
The Crowd. Gustave Le Bon
Extraordinary Popular Delusions and the Madness of Crowds. Charles Mackay
If You’re So Smart: The Narrative of Economic Expertise. Donald n. McCloskey
Winning Decisions: Getting it Right the First Time. Edward J. Russo and Paul J.H. Schoemaker
Beyond Fear and Greed. Hersh Shefrin
The Fortune Sellers. William Sherden
Why People Believe Weird Things. Michael Shermer
How We Believe. Michael Shermer
The Believing Brain. Michael Shermer
Market Volatility. Robert J. Schiller
Irrational Exuberance. Robert J. Schiller
Inefficient Market: An Introduction to Behavioral Finance. Andrew Shleifer
The Winner’s Curse: Paradoxes and Anomalies of Economic Life. Richard H. Thaler
Minding the Markets: An Emotional Finance View of Financial Stability. David Tucket
The Psychology of Finance. Lars Tvede
Theory of Games and Economic Behavior. John Von Neumann and Oskar Morgenstern

Decision Making

Academically Adrift: Limited Learning on College Campuses. Richard Arum

Hedge Hogging. Barton Briggs
The Shallows: What the Internet Is Doing to Our Brains. Nicholas Carr
Models Behaving Badly. Emanuel Derman. The King of Quants on how common sense, intuition, and good
assumptions about reality matter in building models.
Future Babble: Why Expert Predictions Fail – and Why We Believe Them Anyway. Dan Gardner

60
The Checklist Manifesto: How to Get Things Right. Atul Gwande
The Hedgehog, the Fox, and Magister’s Pox: Mending the Gap Between Science and the Humanities. Stephen Jay
Gould
Thinking Fast and Slow. Daniel Kahneman. Discusses two modes of thinking and how to use each mode to make
better decisions – from the father of prospect theory and cognitive bias/behavioral economics theory.
Education’s End: Why Our Colleges and Universities Have Given Up on the Meaning of Life. Anthony T.
Kronman
More Thank You Know: Finding Financial Wisdom in Unconventional Places. Michael J. Mauboussin
Think Twice: Harnessing the Power of Counterintuition. Michael J. Mauboussin
The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing. Michael J. Mauboussin
The Checklist Manifesto: How to Get Things Right. Atul Gawande
Filter Bubble: What the Internet Is Hiding From You. Eli Pariser
Decision Traps: The Ten Barriers to Brilliant Decision-Making & How to Overcome Them. Edward J. Russo
Super Crunchers. Ian Ayres
Why Zebras Don’t Get Ulcers. Robert M. Sapolsky
Expert Political Judgement: How Good Is It? How can We Know? Philip E. Tetlock
Everything Is Obvious: Once You Know the Answer. Duncan J. Watts
Psychology of Intelligence Analysis. Richards J. Heuer Jr. A CIA instructor on how to analyze data.
Thinking in Time: The Uses of History for Decision-Makers. Richard E. Neustadt and Ernest R. May. Two Harvard
professors from the Kennedy School of Government give useful policy analysis tips by using history – this also
applies to investing.
The Art of Strategy: A Game Theorist’s Guide to Success in Business and Life. Avinash K. Dixit. Game Theory 101.
Investigative Reporter’s Handbook. Brant Houston. Tricks reporters use to dig up information.
In an Uncertain World; Tough Choices from Wall Street to Washington. Robert E. Rubin. Rubin mentored some
of todays best hedge fund investors: Edward Lampert, Erich Mindich, Dinkar Singh, Daniel Och, Richard Perry, etc.
Read the first third of this book to learn Rubin’s probabilistic thinking.
Common Stocks and Uncommon Profits and Other Writings. Philip A. Fisher. Basic qualitative tools for
identifying good businesses. A good investor is both a skeptic and an investigative journalist.
Thinking and Deciding, 4th Edition. Jonathon Baron. Modes of thinking and how to be “more rational”.
The Theory That Would Not Die: How Bayes’ Rule Cracked the Enigma Code, Hunted Down Russian Submarines,
and Emerged Triumphant from Two Centuries of Controversy. Sharon Bertsch. The most important formula in
investing along with the Kelly Criterion – all investing is Bayesian decision-making.
The Billion Dollar Mistake: Learning the Art of Investing Through the Missteps of Legendary Investors. Stephen
L. Weiss. Learn from others’ mistakes and make fewer of your own – this book is just a start.
In Retrospect. Robert McNamara. A smart man recounts his dumb mistakes.
The Fog War (film documentary). A documentary about Robert McNamara and his dumb mistakes.
Models of Man: Social and Rational. Herbert Simon. The creator of bounded rationality reflects on on bounded
reason and human incompleteness.
How to Solve It. George Polya. A good math book.

61
 U.S. Financial History and Biography

A History of the American People. Paul Johnson

Major Problems in American Business History: Documents and Essays. Regina Lee Blaszczyk
The Ascent of Money: A Financial History of the World. Niall Ferguson
Against the Gods: The Remarkable Story of Risk. Peter L. Bernstein
Capital Ideas: The Improbable Origins of Wall Street. Peter L. Bernstein
Capital Ideas Evolving. Peter L. Bernstein
A Monetary History of the United States, 1867-1960. Milton Friedman
Money Mischief: Episodes in Monetary History. Milton Friedman
Money: Whence it Came, Where It Went. John Kenneth Galbraith
This Time Is Different: Eight Centuries of Financial Folly. Carmen M. Reinhart Kenneth Rogoff
100 Minds That Made the Market. Kenneth L. Fisher
Jay Cooke: Financier of the Civil War. Ellis Paxson Oberholtzer
Russell Sage: The Money King. Paul Sarnoff
The Life and Legend of Jay Gould. Maury Klein
The Life and Legend of E.H. Harriman. Maury Klein
Carnegie. Peter Krass
The People’s Tycoon: Henry Ford and the American Century. Steven Watts
The Panic of 1907: Lessons Learned from the Market’s Perfect Storm. Robert Bruner
The House of Morgan: An American Banking Dynasty and the Rise of Modern Finance. Ron Chernow
Morgan: American Financier. Jean Strouse
Insull: The Rise and Fall of a Billionaire Utility Tycoon. Forrest McDonald
A History of the Federal Reserve, Volume 1: 1913-1951. Allan H. Meltzer
A History of the Federal Reserve, Volume 2, Book 1, 1951-1969. Allan H. Meltzer
A History of the Federal Reserve, Volume 2, Book 2, 1970-1986. Allan H. Meltzer
Bernard Baruch: Adventures of a Wall Street Legend. James Grant
The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals. Frank Partnoy
The Great Crash of 1929. John Kenneth Galbraith
Capital: The Story of Long-Term Investment Excellence. Charles D. Ellis
The Partnership: The Making of Goldman Sachs. Charles D. Ellis (One of my favorite business books)
Mellon: An American Life. David Cannadine
As I See It: The Autobiography of J. Paul Getty. J. Paul Getty
How to be Rich. J. Paul Getty
The Predator’s Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders. Connie Bruck
Master of the Game: Steve Ross and the Creation of Time Warner. Connie Bruck
Tap Dancing to Work: Warren Buffett on Practically Everything, 1996-2013. Carol J. Loomis
Too Big to Fail. Andrew Ross Sorkin
The Sellout. Charles Gasparino
Once in Golconda: A True Drama of Wall Street 1920-1928. John Brooks
The Go-Go Years: The Drama and Crashing Finale of Wall Street’s Bullish 60s. John Brooks

62
Business Adventures: Twelve Classic Tales from the World of Wall Street. John Brooks
Liar’s Poker. Michael Lewis
King Icahn: The Biography of a Renegade Capitalist. Mark Stevens (One of my favorite business books)
Kerkorian: An American Success Story. Dial Torgerson
How to Be a Billionaire: Prove Strategies From the Titans of Wealth. Martin S. Fridson
The King of Cash: The Inside Story of Laurence Tisch. Christopher Winans
Barbarians at the gate: The Fall of RJR Nabisco. Brian Burroughs and John Helyar (My all-time favorite business
book. I have read it 10 times in the last 15 years)
The Snowball: Warren Buffett and the Business of Life. Warren Buffett
Bailouts or Bail-Ins: Responding to Financial Crises in Emerging Markets. Nouriel Roubini
When Genius Failed: The Rise of Long-Term Capital Management. Roger Lowenstein
The Chastening: Inside the Crisis That Rocked the Global Financial System and Humbled the IMF. Paul Blustein
The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron. Bethany McLean and Peter
Elkind
Cable Cowboy: John Malone and the Rise of the Modern Cable Business. Mark Robichaux (Probably the greatest
capital allocator of all-time)
More Money Than God: Hedge Funds and the Making of the New Elite. Sebastian Mallaby
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone. David Carey
Big Deal: Mergers and Acquisitions in the Digital Age. Bruce Wasserstein. (One of my favorite books. Wasserstein
was a genius and dealmaker ultra ne)
Merchants of Debt: KKR and the Mortgaging of American Business. George Anders. Read for the inside scoop of
private equity.

63
64