Stock Spin-off Or Rip-off Ala Madoff?

A stock spin-off definitely can create a value situation, a bargain as it were.  

Why this is likely to occur with a spin-off stock has been described very well in Joel Greenblatt’s book You Can Be A Stock Market Genius: Uncover The Secret Hiding Places Of Stock Market Profits.  It’s a great little book, a fun read, and with its garish yellow cover and outrageous title you can also have an excuse to start conversations with strangers who are staring at you and your book in coffee shops and on subways, if that is your kind of thing.   If you’d just like a quick summation of his main points without the case examples you can also check what I’ve written here.

 

Secrets

The idea that there are secrets that make success possible and that someone who knows them is (claiming to be?) willing to tell what they are has always fascinated me.  Secrets for the price of a paperback!?!  Wow!  Not very well-kept secrets after the book is published, . . . . or, are they?  Mr. Greenblatt tells us generally where to look and gives us examples of how he has successfully found gems there, but faced with a raw list of companies doing spin-offs the question still is “which one(s)?”  And that, my friends, surely remains a secret.

On the other hand . . . wasn’t the concept of a secret formula whose spoils were available only to the select the very model that Bernie Madoff used to keep his Ponzi scheme running so long?  He wouldn’t tell you the secret.  Heck, apparently if you asked too many questions about it he’d show you the door.  But, he would let you invest with him and he would use the secret to make you lots of money.

OK, so let’s assume that Joel Greenblatt really has given us a gift by showing us that if we are looking for an edge, an increased chance to profit, then what we have to do is look for stocks to buy within certain groups or situations.  We can also assume that unless he is out of his mind, he probably either

• isn’t telling us a secret at all, or
• he isn’t telling us the whole secret, or
• for some reason he’s pretty sure that herds of us won’t use it to ruin his business.

From my experience, the last one is the most likely.  Trading and investing require so much discipline and control of ego issues that most people can’t or won’t do what they have to do to even approach the levels of the really successful practitioners.

Due Diligence: Not Losing What You’ve Got While Trying To Get More

So, how do we get from knowing that there is particular area where there is a higher than average amount of gold to be found, but that you have to pick where you dig carefully because there isn’t gold everywhere there and some places will actually cause you to lose some of what you already have?  What do you do to put the odds in your favor?

 

I recently had the pleasure of being able to talk with someone who knows a lot about doing one’s due diligence in picking the best situations to enter and the ones to run away from, Len Blum of Westwood Capital.   

I was looking for more secrets.  I admit it.  But, this time the question was what the secrets are to picking the “right” spin-off stock and not getting caught as the sucker in someone else’s good deal (for them that is.)

Knowing that Len has given a lot of thought to how and why so many people got taken in by Madoff and company, I figured that looking at that situation might give us some new ways to look at doing due diligence on stock spin-offs.  Right off he warned me that my father could have told me the core idea of his advice which is “if you aren’t greedy, you can’t be defrauded”  and “if it looks too good to be true, it probably is.”   Actually, I think my father took it a step further to something about if you are greedy you deserve to be defrauded, but that’s neither here nor there.

 

Anyway . . . . .  the key points are to keeping risk under control that Len told me included

• understanding the business plan.  What does the company do? sell?  How do they do it?  How will the new structures set up in the stock spin-off make them better able to do this?      If you can’t understand it, don’t buy in.  There are lots of deals coming along all the time.  It is the mark of the huckster to try to get you to believe that you have to buy right now or forever lose the chance.  Don’t do the same thing to yourself.       Remember the old pilot’s saying “It is better to be on the ground wishing you were in the air than to be in the air wishing you were on the ground.”  (Not only is the saying old, but more importantly, the pilots who say it are old, which is a very good thing if you are a pilot.)
• looking at who the accountant is.  Who’s putting their name on the dotted line saying that the books add up?  Apparently, in Madoff’s case the accountant was not one of the big seven or big ten or however many” big” accountants there are these days.  Fortunately, in the case of stock spin-offs we have mountains of SEC documentation telling us what is going on.
• assessing the company’s competiveness.  The classic business school SWOT analysis : strengths, weaknesses, opportunities, threats is his “secret” tool for this.   If you’re thinking that this is not a secret, all I can say is that given how carefully most investors work through this process, you’d think it was.
• assessing why (if) this company is essential to its sector.  Where do they fit into the flow of the industry, the secotr, the economy?  Are they an integral and difficult to replace cog in the machine?
• telling what its sustainable competitive advantage is.  Is their product unique?  Are their people smarter?  Do they own all the best locations from which to do business?  What?
• comparing them to the competition.  What do others in their industry think of them?  How do they rank comparatively on the above criteria?

This stuff is very important to you if you enter the decision making process with a bias, such as the assumption that spin-off stocks are going to outperform.  It has been said that the purpose of thinking is to be able to stop thinking.  Working through a checklist of criteria is one way not to stop thinking too soon.

Lessons From The Madoff Rip-off

That all sounds good and doable with spin-off stocks and their parent companies, but what about Madoff?  It was really off topic, but since I was talking with Len Blum, clearly a guy who has probably forgotten more about mergers, acquisitions, and investing in general than most of us ever knew, I had to ask . . . . how did investing with Madoff stack up on these criteria?  Were the tests he’s suggesting robust enough to keep me out of big trouble from a master con artist?  (Let’s face it, not every spin-off is undertaken in ways that benefit the investor. )

The answer was a resounding “absolutely”.  OK, so what were the Madoff red flags?  Lots it turns out, but just a few of the ones he told me were enough to make the point – -

• The returns were spectacular for an investment that never showed a loss, returns clearly too good to be true.
• Madoff used a complex strategy that many investors did not understand – don’t ever buy something you don’t understand!
• Madoff created a mystique.  He would not meet investors directly.  He turned down money (that’s pretty bizarre for a fund manager).
• The accountants were not well known, respected providers.
• There was not a third party holding and accounting for the money.
• Madoff’s fees of four cents a share were too low for a “genius” (if a heart surgeon would operate on you for $10/hour, would you go under his knife?).

 

What Could They Possibly Have Been Thinking?

 So, why did people go into it?  Especially why did people and institutions put all of their money into it?  To this question Len allowed as how no one knows why other people do what they do for sure, but that is seems that there were three groups

1. people who simply did not know better,
2. people who were capable of  knowing better, but did not analyze the offer carefully enough,
3. people who did know better, were perfectly aware of the red flags,  and went into it anyway.

Groups 1. and 2. I can understand, having done at least my share of dumb things for both of those reasons, . . . . but #3? 

People Who Knew Better

 Whatever the reasons that that third group  (the ones who had to know better)  invested with Madoff, it has to be one of the great cosmic jokes of the decade if not the century that they ended up being the dupes right along with the poor souls who trusted, who wanted to be in the right group, who were too shy to ask questions.

What were those professionals thinking?  If they could be fooled by this, then I certainly can’t expect to be able to avoid this kind of thing,  but there is no doubt in Len Blum’s voice when he says that it was all there for the prudent individual to find.  So what’s going on? 

It baffles me, but it brings to mind one of the basic strategies of cognitive psychotherapy.  Most often if you directly ask someone why they did something stupid or wrong they will tell you either that they don’t know or they will give an answer that doesn’t go anywhere in terms of untangling the mess and making it less likely to happen again.   It can even be posited that at some level they don’t want to know what they are thinking.

So, the therapist can ask “What might a person who in this situation took this action believe?  What might their process have been?” 

What might logically be between the stimulus (in this case the offer to put your money with a guy who is reporting bigger returns than his system would be expected to generate) and the response (buy or stay out) that would explain their choice of what to do.  If you were a knowledgeable professional who believed that being greedy put you at risk of being defrauded, you probably would have stayed out.  If you believed that you might make a lot of money with little chance of being accused of doing something wrong and that this was just the way business is done, or some similar version of assumption or belief, then you might have invested in it.

The recently released tape of Madoff coaching a witness on sidestepping the SEC investigators aired on WBUR radio in Boston recently makes me think that maybe this is a question that someone with more knowledge and experience than I should be asking.   It was chilling to me to hear Madoff tell the person on the other end of the phone call over and over what to say and what not to say to limit the chance that the SEC would accuse them of front running.  He clearly did not want the investigators to even start thinking about that or any other potential violation.  You can hear the whole tape by clicking here.  

So, trying to think like the aforementioned therapist, I asked Len what beliefs or thoughts could have led a professional who was fully capable of smelling a rat to put money with Madoff.  

He responded by saying,  “Some bright investors are dishonest.  What if  using common sense, an investor knows that Madoff’s purported strategy is a sham?  Yet the investor knows that Madoff’s legitimate trading operations trade 10% of the volume on the New York Stock Exchange.  And what if, the investor assumes that Madoff is “front running” – using information about pending securities trades to profit (buy before buy orders are processed and visa versa) – and this is how Madoff is making such extraordinary returns (frankly, besides for a Ponzi scheme, this is the only other logical explanation).  Then, since nobody can prove that the investor suspected front running, the investor invests with Madoff to earn illegal returns without fear of retribution.”

That certainly does fill in that previously mentioned gap between stimulus and response better than anything I came up with.

Tags: due diligence, Madoff, stock spin-off