Joel Greenblatt is no magician, but the founder of New York-based Gotham Asset Management does have a magic formula for investing. In 2005, Greenblatt, who also has been teaching at Columbia Business School for the past 17 years, published The Little Book that Beats the Market, which explains how investors can outperform market averages by following a simple process of investing in good companies at bargain prices. The ‘Magic Formula,’ as Greenblatt termed it, was about seeking out companies with high return on invested capital, and which could be purchased at a low price. The strategy produced back-tested returns of 30.8% per year from 1988 through 2004, more than double the S&P 500’s 12.4% return over the same period. What better proof than eating your own cooking, Greenblatt’s private investment partnership has logged a 40% annualised return since its inception in 1985.
How did your career in investing come about and which phases were particularly insightful?
It was during my college days in the late 1970s that I first got interested in investing when I read an article on Benjamin Graham. The article outlined how he had this formula to beat the market, provided an explanation of his thought process, and described “Mr Market” a little bit. I read that article and thought: “Boy, this finally makes some sense to me.” That’s when I started reading all I could about Graham and also read about Buffett and his letters. What struck a chord with me was the logic of figuring out you were buying a piece of business and paying a lot less than its actual worth. What they taught in the business school for fundamentals was that this [paying a price less than its actual worth] couldn’t be done and that it’s not worth the time trying to beat the market. I am glad I listened to my reading. It made much more sense to me, given what I had observed about how emotional the market is over the short term.
Just sitting around and hanging around for three months, it was pretty obvious that the market wasn’t quite as efficient as my professors were telling me. I think I have pursued a career following that philosophy since then. On the personal side, I have been enjoying teaching in Columbia for the past 17 years. Having the opportunity to think about how it is that I went about investing, and explaining it in a very simple way is very valuable to me, and hopefully to my students as well. I learnt from reading other people’s books, particularly Benjamin Graham, who said that I have always enjoyed writing and always wanted to give back in some way. So, writing and teaching are the ones that I can think of.
You have demonstrated pretty clearly that the Magic Formula, that is, buying good quality stocks in the manner you define, really works. What are the exceptions to this rule?
That’s a great question, but if I knew the answer to that it would be wonderful. If you got a list of companies that appear to be cheap and are able to filter out the ones that are going to work and that won’t, that would be helpful. I don’t have any Magic Formula for deciding which ones will do better than the others. Most companies that end up being very cheap are controversial and face a lot of uncertainty. There are many ways to make money. There is a deep-dive, which is what I did for many years, essentially, owning six to eight names that I had studied very well.
The Magic Formula is a different type of philosophy where you end up buying things that are statistically cheap with very nice quality attributes but are facing some uncertainty. If some things are inherently uncertain we can sit here all day and try to figure out what’s going to happen. So, it’s not worth your time. It is a strategy that works, on average, and it is very hard to pick and choose which ones will work out. What you can make sure is that the numbers are accurate, there is a trustworthy management in place that is incentivised correctly and things of that nature. But, in general, you are buying a bucket of opportunities.
Right now some thing that is very cheap would be Apple. I always ask my students what do you do of a company where the technology is always changing and it is not clear what the competition will look like in a few years. The answer to that would be: always skip that one and try to find out the ones that you can figure out. I don’t know what is going to happen with Apple, but if I own a bucket of Apples then, on average, that is a really good bet. You are buying good businesses with a great franchise at six times cashflow, have great market share and good management, strong balance sheets and so forth. So, if I own a bucket of Apples rather than just Apple, I am pretty sure it is going to work out very well.
How much attention does one need to pay to future earnings, because the Magic Formula is all about the past?
We have all learned that a value of a business comes from the discounted value of its future stream of earnings. The Magic Formula looks backward and may actually seem like making money from reading a history book. It doesn’t make sense that you are making money by reading a history book because everyone else can do that. In other words, any simple formula that has worked over the past 20-30 years will degrade over time. But in reality, that hasn’t happened. The reason is because the Magic Formula deals with out-of-favour stocks and that is why you are getting them cheap. The market has become much more institutional and what that means is that professional managers, who are active stock managers, try to make money over the next two years. If they don’t, their clients leave irrespective of their investing timeframe. Companies not expected to do quite as well in the next year or two are systematically avoided by institutions and that behaviour has become even stronger. That’s why this type of strategy hasn’t weakened over time.
If one were to bracket uncertainties as to which are less difficult to cope with and which aren’t, how would you rank those?
I would steer wary of companies that are subject to government regulation and those that don’t necessarily follow necessarily capitalist incentives or a business where some outside force is responsible for their revenues. Companies that are susceptible are heavily regulated companies such as utilities where the government has a lot of influence and the decisions can be political rather than capitalist.
How do you assess the risk to reward when it comes to situations such as drug discovery, regulatory changes, litigation risks or something similar?
Things that everyone knows about are usually reflected in the stock price and those are reasons why you get a stock so cheap. The things that you are mentioning are usually so big and obvious that they are fully reflected and, in fact, are over-reflected. For example, you read the newspaper you will know why to avoid that stock and people will just do that. It’s human nature to avoid things with issues. So, if you buy stocks with very low expectations built in and the low expectations come in, you don’t tend to lose much money. But if a company does a little or a lot better than the low expectations built in, then you have the chance of asymmetric returns on the upside. That is the type of risk-reward you are looking for. It doesn’t work for every company but, on average, it works really well.
How do you build that into a valuation framework?
We just go by the numbers. So, if something is extremely cheap we buy it. At Gotham Asset Management, we do our own analysis without using databases. We ourselves go through balance sheets and income statements of thousands of companies to make sure we have the right numbers. We do our own valuations using various measures of absolute and relative value. We make sure it’s systematic, just like the Magic Formula, so we are not swayed by our own opinions. We want to make sure that the money being earned is real, that there are no accounting tricks, unknown liabilities such as deferred tax assets, off-balance sheet liabilities, pension liabilities and similar such complicated stuff. But the philosophy is very similar: we are trying to figure out value through various measures of absolute and relative value and pay a lot less. It’s not more complicated than that.
Does the Magic Formula apply to cyclicals? Because usually, in commodity companies, earnings are the highest when you are at the peak of a cycle.
It appears to work quite well for commodity companies. Everybody knows that their earnings are at a peak and should be avoided, so you need to buy them at a low enough multiple to peak earnings. There is always a price that you can buy anything at as long as it is not a bad business. If it is earning a lot of cash, there is a value to that business that investors are ignoring.
In a spin-off situation where do you see maximum opportunity? Is it to buy stocks as sum-of-parts and then wait for a demerger or to bet on that part of the business that is likely to be spun off?
Statistics show that both these strategies work. But the point about spin-offs is that something extraordinary is happening in a business. It is either breaking up or there is a new independent business or there might be a new management. Since spin-off stocks are not underwritten by investment bankers or sold to anyone, they are ripe for mispricing. Mispricing could mean either it is over- or under-priced. When I am looking at an opportunity I am just happy about a potential mispricing. Now, that doesn’t mean that they are always underpriced, it just means it is worth digging because you have an interesting situation. On average, they outperform the market, which means, on average, they are mispriced.
Do you look at spin-offs only when the management of the company has made its intention clear or even otherwise?
When I spoke about spin-offs, I was only talking about announced spin-offs. But sometimes I do look at companies that have two different businesses where the bad business is masking the good. When I own such a stock I am actually hoping that the bad business does even worse. The reason is that even with a bad management it becomes very obvious that they have to do something, even if they are slow to do so. Sometimes it works and sometimes it doesn’t. But they are still ripe for activity. I wrote about 100 pages on this in my first book. But when you are doing such in-depth research as opposed to writing a book, it’s more evolved.
Could you recall some of your own best and worst investments over the years?
There are a couple of good investments. I invested in a business attached to Citibank, which had a strange capital structure, at half its cash value. The best investments are the ones where you are not risking very much and have a good potential to make money. Another good investment was Host Marriott where people didn’t understand that the parent didn’t have much debt on it. So what looked like a very risky investment was actually a very safe one. By doing the homework we figured that out. These would be my two best investments.
The top ten
My worst investment mistake was actually a trade show operator that used to run Comdex, a popular computer trade show. They bought another business three days before 9/11, unfortunately. Then people stopped travelling to trade shows. What I liked about the business was that it had great operating leverage. Meaning that they would rent space in a convention centre at $2 a square foot and they could lease it out at $62 a square foot. They could lease as much as they wanted. Unfortunately, when your business shrinks they say leverage works both ways and operating leverage also works both ways. They lost business. They lost a contribution margin from that business. They would lose $62 in sales and the cost associated with that was only $2. They would lose $60 of pure profit every time the business shrunk, and it did. The lesson learnt was that operating leverage in addition to financial leverage works both ways.
What is your approach when it comes to selling stocks?
I look to own stocks that are still selling at a discount to what I think are conservative valuations. More often than not, I sell something if I have found something much better. When my alternatives get better, I revaluate my portfolio and decide where I want to allocate my money. I tend to end up selling companies at conservative valuations though they are ideally worth much more. I sell them too soon and that is probably a general mistake that I make.
What are the valuation mistakes that people often commit?
Valuation mistakes are usually based on projecting much better results than we have seen in the past. I would say projections of sales led by new products are suspect. Usually, I find cost savings are much more predictable. It is much better to look at the past track record of the management and build that into the future rather than assume they are going to change
In India, investors complain that a portfolio built on a Graham model usually doesn’t result in stocks that have great quality or a moat. In such a case, since closer to its full price there aren’t too many takers, a better approach would be to buy a stock at deep discount and sell it at a narrower discount. Is that something that you have experienced, too?
If you are not managing too much money you can probably adopt such a strategy. Buffet wouldn’t do that any more because he has too much money to invest. What I think I have learnt over the years is, when you buy too many things you are not buying enough things that are quality. You should keep looking till you find quality. There may be a few of them but you don’t need many to make good investments and to do quite well. If I had only bad businesses to choose from, I would still be patient and wait for better businesses that are predictable. But in bad businesses, when things happen, they usually don’t happen in your favour.
You say wait for something that is predictable, but you do hold a lot of technology stocks.
Right. If I find it hard to have a concentrated bet on Apple, I could find 20-30 similar bets to Apple that are as cheap as it is with good franchisees and high returns on capital. But I won’t buy technology companies that are not yet making money. I buy things that are more established and have proven themselves in some way: have revenues, lot of cash flows and are earning good return on capital. So, we are eliminating the ‘hope stocks’, the ones where people are hoping that this new technology will take off. I am not predicting that.
Has your investing strategy changed drastically from when you had started?
Not really. My strategy has really been investing in businesses for which I have to pay less. We have an approach now and have built a diversified portfolio covering many companies. We will follow the approach of my first book as well, which is to concentrate on a few good names. There’s nothing wrong with that. They are both great investment strategies that are slightly different. However, the investment concepts of being able to value businesses and buying only when you can find a good discount are identical. I often tell my students that if they are good at valuing businesses, the market will agree with them sooner or later. It could be anywhere from few weeks to more than two-three years.
The corollary to that is, in case of individual stocks, in over 90% of the cases three years is enough time for the market to agree. But when you put together a group of companies, on average, recognition happens a lot faster. So, investing is about figuring out what somebody is doing right and paying less. Special situation investing is about finding pockets of opportunities where there are bargains. But you still need to go figure out what is its actual worth. The same things happen when you are buying out-of-favour companies based just on the metrics. Value investing is not complicated, but
valuing a business is.