In 1998 and 1999, Joel Greenblatt’s approach to value investing – find inexpensive stocks that represent a good value – was encountering its worst market environment in history. In the run-up to the 2000 tech crash, Joel Greenblatt, author of several investing books and chief executive and founder of the Gotham Funds, was exhibiting what he says is the key to proper investing: patience. He knew his value investing formula worked, it was just that the market didn’t appreciate value at that moment in time.

Then the 2000 tech crash and earnings relative to a stock price – “sanity” – came back into the market and Joel Greenblatt was rewarded.

“We didn’t become geniuses during those years, we were doing the same things, the market just didn’t agree with the way we were valuing companies,” he said in a recent Wealthtrack interview.  “We got paid off in 2000 when the market became saner.”

Gotham's Joel Greenblatt Discusses His Value Investing Formula

Joel Greenblatt on investing approach

Joel Greenblatt notes that fund investors are not typically patient, moving their assets to the “hot fund” that generated the top performance the previous year.  But this is the wrong approach to fund investing, he says.

To prove his point, Joel Greenblatt and his staff conducted a study of fund manager performance from 2000 to 2010. Those who were ranked at the top in terms of returns were also at one time ranked at the bottom. Joel Greenblatt notes that 97 percent of those who ended up in the top quartile spent at least three years in the bottom half of performance. What’s more, 79 percent of those with the best ten year record spent at least three years in the bottom quartile, and 47 percent of those who ended with the best ten year record spent at least three years in the bottom decile of performance.

The message is simple: even the best fund managers have down years. A “hot money” approach to fund investing isn’t the way to generate returns.

In fact, many professional investors prefer a strategy on investing in a good fund after it has experienced a difficult market environment.  It is most important to make sure a fund manager has a valid process and understand when it will work and when it shouldn’t work.

Joel Greenblatt’s process for investing

Joel Greenblatt’s process for investing is disciplined, systematic and effective.  After a decade as a hedge fund, Greenblatt launched a family of mutual funds recently. Gotham’s Absolute Return fund, up 7.19 percent year to date, has an 18.96 percent annualized return since inception in 2012.  The Gotham Enhanced Return fund has 25.70 percent annualized return and the Neutral fund has a 10.60 percent annualized return.

Joel Greenblatt’s investment methodology is simple at its core. Investing, he says, is about “ownership shares of businesses we try and buy at a discount. Value is figuring out what a business is worth and only buying it when it is worth a lot less.”

To accomplish this, the fund considers the 2000 largest companies and categorizes them based on a value formula. The first part of the formula determines if the company is inexpensive, that there is potential to have a strong return on investment capital. The second component determines the quality of the stock, its potential for earnings yield. It ranks the 2000 stocks from best value to least, and then the top 300 value stocks get investments, with the best values receiving the highest allocations. The lowest 300 stocks he shorts using the same method. The key is not being absolutely right, but “right on average.”

Joel Greenblatt’s long / short strategy

Joel Greenblatt’s long / short strategy is unique in that it is equally weighted. Many long / short equity fund managers might typically have 70 longs and 30 shorts where Gotham is 50 longs and 50 shorts.

“These are simple concepts but they work amazingly well.” The portfolio typically has 45 percent turnover as stocks move along the value spectrum, increasing or decreasing their portfolio allocation as

Companies he thinks are currently cheap include Towers Watson, which should benefit from the healthcare realignment and Verisign, Inc. (NASDAQ:VRSN), which registers domain names and isn’t much of a growth stock but a consistent performer. Stocks he thinks are expensive, and thus has shorts on, include money losing tech high flyers Twitter Inc (NYSE:TWTR) and Zynga Inc (NASDAQ:ZNGA).

When asked why his initial company closed shop after a strong ten year run, he quoting Warren Buffett, who noted that the more money under management, while generating higher fees, equates to diminished performance, particularly in a concentrated portfolio. While Joel Greenblatt’s initial hedge fund had just a handful of investments, his new mutual fund has as many as 600 positions.