“I’ve been teaching for a long time and I would say that my most successful students are the ones who actually enjoy the process of figuring things out.” — Joel Greenblatt
When I see Joel Greenblatt, for some reason, he reminds me of Benjamin Graham. I don’t really know why, but I guess it’s something in the way he behaves and talks and the wisdom he shares. And I don’t really know how Graham himself much and what he looked like and the way he talked. I associate Greenblatt with Graham, let’s just leave it at that since it doesn’t really matter a lot.
Joel Greenblatt visited Consuelo Mack’s Wealthtrack on November 4, 2016. In this Wealthtrack episode discussions range from what makes a good investment, why the price you pay is crucial, return on invested capital, Warren Buffett and more.
Welcome to our latest issue of ValueWalk’s hedge fund update. Below subscribers can find an excerpt in text and the full issue in PDF format. Please send us your feedback! Featuring Point72 Asset Management losing about 10% in January, Millennium Management on a hiring spree, and hedge fund industry's assets under management swell to nearly Read More
Just to say it, my intention was not to go out and transcribe the whole interview. It just happened to be such a great one that I ended up doing it. Listening to Greenblatt when he discusses the different topics thorughout this Wealthtrack episode truly deserves the attention from every investor out there. So I hope you’ll enjoy it. And also, feel free to share it with anybody you think could learn from it.
The Secret to Investing
Consuelo Mack: Grenblatt has also written several books: You Could Be A Stock Market Genius, The Little Book that Beats the Market, The Little Book that Still Beats the Market, and The Big Secret for the Small Investor. I began the interview by asking Greenblatt to distill a lifetime of being a successful value investor. What is the secret?
Joel Greenblatt: If there is any secret I think there is in understanding what you’re doing. And most people don’t think of stocks, they think of them as pieces of paper that bounce around, and you put ratios on them or figure out difficult math problems with them. To us they’re merely owner-shares of businesses that we’re trying to value and buy at a discount. I think the people who are successful at it a) understand that, and b) really enjoy what they’re doing. I’ve been teaching for a long time and I would say that my most successful students are the ones who actually enjoy the process of figuring things out.
Consuelo Mack: So what does value mean to Joel Greenblatt?
Joel Greenblatt: Value means exactly that, figuring out what a business is worth and only buying it when it’s worth a lot less. Ben Graham said: “Figure out what something’s worth. Buy it at a big discount. Leave a large margin of safety between those two.” And that still the key to it. It’s not more complicated than that.
Consuelo Mack: You and your partner Rob Goldstein have devised a ranking system using just two variables. Is that correct? Return on invested capital and earnings yield.
Joel Greenblatt: Rob and I did a research project, and the very first thing we tested were those two concepts. Is it cheap? Does it earn a lot relative to the price we’re paying? And is it in a good business?In other words, does it deploy its capital well? So cheap was Ben Graham. His best student Warren Buffett made one little twist that made him one of the richest people in the world. He said: “If I could buy a good business cheap, even better.”
Consuelo Mack: So not just cheap? But, a good business cheap?
Joel Greenblatt: A good business cheap. And that was Warren Buffett’s little twist that helped him be so successful over time. And, we started out a project to test the concept that I’d been teaching my students, that Rob and I had been using for many years to make money, to see if we could prove those simple concepts worked very well. And the very first test we did of it ended up, I wrote a book about it called The Little Book That Beats The Market because the tests were so phenomenally good. That’s not exactly what we do now, in other words that was done, I would call that the “Not-Trying-Very-Hard-Method.” We used some crude metrics to simulate cheap and good. And those crude metrics worked so well that we said; “Well listen, we roll up your sleeve investors, we tear apart balance sheets, income statements, cash flow statements.” That’s what we do for a living. We’ve been analysing these for a long time. So, can we take these concepts and really and take them to the next level. The simple concepts work amazingly well. And so we sought out on a long project to improve on that. But, the principles are still the same.
Consuelo Mack: If I started tearing up a balance sheet and income statements and if I were looking for… Is my starting point return on invested capital and earnings yield? Is that… That would be my first kind of cut?
Joel Greenblatt: I think my first cut would be cheap. And that would be the earnings yield portions of what you’re talking about.
Consuelo Mack: Right.
Joel Greenblatt: You know I don’t live in Manhattan, but if I did and I had a three bedroom apartment. If it was available for $250,000, take my word for it, it would be a steal. At $50 million it would be ridiculous. The apartment, the quality of the apartment hasn’t changed. It’s the price that determines whether something’s a good investment. So you can’t invest without price.
Consuelo Mack: And the second part, the return on invested capital, that’s the good, whether it’s good or not. Could you explain how you find return on invested capital?
Joel Greenblatt: Sure. Well, the example I gave in my book, the little book, which I really wrote for my kids to explain it. I gave two examples. I said “Think about you building a store.” Well, you have to buy the land, you have to build the store, you have to set up the displays, you have to stock it with inventory. Let’s say all that cost you $400,000. And every year that store spits out $200,000 in profit. That’s a 50% return on tangible capital. Every business needs working capital, every business needs fixed assets. How well does that business convert the working capital and the fixed assets into earnings? Then I gave another example, and remember it’s for my kids. It’s another store and I call that store Broccoli. It’s a store that just sells broccoli. Not a very good idea. But you still have to buy the land, build the store, set up the display, stock with inventory. It’s still gonna cost you roughly $400,000. But because it’s not a very good idea to just sell broccoli in your store, maybe it earns somehow $10,000 a year. That would be a 2.5% return on tangible capital. So I would simply say: “I would like to own the business that could reinvest its money at 50% returns than 2.5% returns.” And if you read through Warren Buffett’s letters he doesn’t use that term return on tangible capital, but that’s what I called it in the book.
Consuelo Mack: Talk to me about your strategy of choosing stocks, specifically for the diversified long-short hedge funds that you are running now.
Joel Greenblatt: Sure. It’s probably disappointingly simple what I’m gonna tell you. But basically we look at the 2,000 largest companies in the U.S. And we rate them from 1 to 2,000 based on their discount to our assessment of value. Stock number one gets the biggest weight in our portfolio. Stock number two gets the second biggest weight. Same on the short-side. The most expensive stock relative to our assessment of value gets the biggest weight on the short side. And the second gets the second biggest weight. We own roughly a little over 300 stocks on the long side, and 300 stocks on the short side.
Consuelo Mack: So there’s 300 in each extreme?
Joel Greenblatt: Yes, they’re not equally weighted but we own over 300 on each side. And so what we have to do is be right on average. And we’re pretty good at average. We’re not always right, but we’re pretty good on average.
Consuelo Mack: And why couldn’t I just duplicate that?
Joel Greenblatt: I wrote another book it begins, it’s called The Big Secret. And it’s still a secret I say cause nobody bought it. So I’ll just tell you what the secret is.
Consuelo Mack: Yes, please do.
Joel Greenblatt: The secret is really patience is in really short supply. I give a few examples in that book, one of them is really telling. I looked at the top performing managers for the decade of 2000 to 2010. I looked at the top quartile managers, the ones who ended up with the best records.
Consuelo Mack: That’s after the tech crash?
Joel Greenblatt: Yes, 2000 to 2010. Inclusive of the tech crash.
Consuelo Mack: The “lost decade” some people call it.
Joel Greenblatt: Right, the market was actually flat during those period. But the top quartile managers, here are there stats. 97% of those who ended up with the best records spent at least three of those ten years in the bottom half of performance. Not a surprise, but it’s almost everyone.
Consuelo Mack: In the same decade?
Joel Greenblatt: In the same decade. 79% of those who ended up with the best ten-year record spent at least three years in the bottom quartile of performance. And here is the stunning statistic. 47% of those who ended up with the best record spent at least three of the ten years in the bottom decile of performance, meaning they were in the bottom ten percent. So you’re pretty sure that none of their clients actually stuck with them to get the good returns. And to beat the market you have to do something little different than the market. You gotta zig and zag a little differently. But clients are not very patient. I also wrote a study about institutional investors. Two actually academic studies, and both studies concluded the same thing. There is only one metric you need to predict the institutional cash flows. And that metric is “How did the fund do last year?” If it did well it gets all the inflows, if it didn’t do well it gets all the outflows.
Consuelo Mack: Where were you during that decade? I mean, did you meet those statistics? Where you… I don’t know, how many years were you in the bottom decile, or bottom ten percent?
Joel Greenblatt: Sure, we did measure it. We had a year, I would say our worst years were 1998 and ’99 during the Internet Bubble.
Consuelo Mack: Sure.
Joel Greenblatt: The market didn’t agree with the way we were valuing companies. And then the market plummeted in 2000, it wasn’t that we became geniuses all of a sudden. We were doing the same things we were doing in 1998-99 when it wasn’t working. And we got paid of in 2000 when the market became more sane.
Consuelo Mack: What are a couple of the cheapest companies right now that you’re holding?
Joel Greenblatt: Well, there’s one called Towers Watson. It’s a cheap company. It really does all kinds of work for companies, keeping track of their employees and everything else. And it’s a very steady business, and now with the health-care reform I think they’re gonna have continued growth going forward. So that’s a nice business. VeriSign registers most of the domain names in the United States.
Consuelo Mack: So that’s another one that’s again one of the cheapest two by your evaluation?
Joel Greenblatt: Sure, it doesn’t have a lot of growth. It’s still growing about 5% a year, but it’s a very steady income, big cash flow generation. So it’s a, you know, good and cheap.
Consuelo Mack: Right. And what’s the turnover in your portfolios these days?
Joel Greenblatt: Well the way it works is that, you know, if we buy the company at the biggest discount to our assessment of value. Here is value and here is price. Companies on the little cheap… if I’m right in what I tell my students, companies are on a little journey towards fair value over time. And as a company moves towards fair value over time, it’s not as cheap as it used to be. It still could be very cheap, but not as cheap. So we’ll sell some of it down and reinvest that cash in companies that are cheaper. So that’s our process. But if you start at the beginning of the year in our long book, we probably have about 45% of the same names at the end of the year. But their allocation in the portfolio may change.
Consuelo Mack: Right. And I’m gonna ask to the flip side of that. So what are some of the most expensive names in that universe of 2,000 companies that you’re looking at?
Joel Greenblatt: Well Twitter is a company that has a lot of users but not a lot of revenue and a lot of cash flow. And you know it’s losing money, so that’s not usually a good thing. You know growth has slowed down so it’ll be curious to see if they could turn that into a good business model. Zynga is a game company that loses lots of money and probably has seen its heyday. So that’s another short that we have. And generally we’re looking for things that are earning very little or losing money and destroying capital as they do it.
Consuelo Mack: What’s wrong with the old-fashioned way of value investing of just going long, of just buying companies that are really cheap and good?
Joel Greenblatt: Sure, there’s nothing wrong with that and for many years we pursued that.
Consuelo Mack: Right.
Joel Greenblatt: I think perhaps part of your question would be: “Why do most people who go out, especially professional mangers to go out to beat the market, fail?” And I think they have very diversified portfolios of companies, and it’s very hard to know in dozens, or 30, 40, 50, 60 companies very well and know them better than other people. So I think the way to go about it, following that kind of strategy, would be much more… at least one of the ways, would be in a much more concentrated strategy, keeping to what you know very very well and those companies are usually far and few between. So usually a handful of companies, and most managers don’t stick to just a handful of companies. It’s to volatile for their investors. They’ll have to underperform a lot of the time, so people don’t really pursue that strategy. But if you’re goal is to beat the market, that’s a good one.
Consuelo Mack: And speaking of running a concentrated portfolio, Gotham Capital the hedge fund that you co-manage with your business partner from 1985 to 1995. It did have a very heavily concentrated portfolio, I mean six to eight names I read somewhere. Why did you take that approach to begin with? Why be that concentrated?
Joel Greenblatt: Right. That’s a great question. And it really goes to the answer I just said. We couldn’t know companies very very well if we had to know 50 of them. We might have to go through 50 or 100 companies to find those six or eight that are at the biggest discount to our assessment value. But what comes with such a concentrated portfolio is that every few years and or two of ideas you wake up and they haven’t worked out, and you might loose 20 or 30 percent of your net worth in those few days. And if you have outside investors they are not too pleased about that. If you’re working with a partner like a have, Rob Goldstein, we understand what we own, we understand that’s it’s just at a bigger discount if we haven’t changed our opinion, and so we’re willing to stick with it. But not many people would. The problem with, I think, giving money to idiosyncratic stock pickers is that I think investors don’t know the logic that really leant behind each investment. All they really have are the numbers, the results.
Consuelo Mack: Right.
Joel Greenblatt: And unfortunately returns in the last 1, 3, or 5 years have very little to do with the next 1, 3, and 5 years. But that’s all people look at, so that they’re giving money to the people who have just performed the best, then they’re taking money from the people who have performed the worst. That’s actually not what’s going on. What you wanna look at is process. Are they evaluating and valuing businesses in a disciplined and effective way?
Consuelo Mack: Is there some Greenblatt golden rule or approach that enables you to invest in this, again it’s a very focused portfolio that got you these 30 or 40 percent annualised returns when you were running Gotham Capital?
Joel Greenblatt: Well sure. I actually wrote a book of war stories, things you looked at, You Could Be A Stock Market Genius. Probably one of the most poorly worded titles ever. But in it I tried to really explain how we go about doing things. So it was a compilation of war stories. And one of the things I said in there was: “If you don’t loose money, most of the other alternatives are good.” So that’s one thing to think of. But mostly the book was about special situations investing. In other words, looking for things that are a little bit of the beaten path, they’re a little complicated, or just a little different then what other people are looking at. Company going through extraordinary changes. Something little odd, something little complicated, something a little different. So I would not say to get those type of returns we had to be the world’s greatest analysts. We just had to look under a few different rocks where other people weren’t looking at the time. But it still all comes down to being able to value a business and buying it at a discount. It’s just that, why not turn the edge in your favour and look at places that other people aren’t.
Consuelo Mack: Do you have a special situation that you’re investing in now? That would exemplify your approach?
Joel Greenblatt: Well frankly, what we’re doing now in a very diversified approach is valuing businesses. And so about six years ago Rob and I my partner, we looked at each other and said… picking, doing an intensive work on just a handful of companies is a full-time job. Covering a whole universe of research universe of stocks, a few thousands of stocks, even with a nice analyst team and a very talented analyst team, is also a full-time job. And we couldn’t do both, and so we decided to go all-in here. And part of it was that it was a little bit different than what we had been doing for several decades. The other part was that there’s a number of ways to make money. One is to be very concentrated in something you know well. And that’s what we had done for a long time. And the other is to be right on average. The benefits of what we’re doing now is that, as I told you before, if… when we owned a stock portfolio of 6 to 8 stocks and two of our investments weren’t going our way, we might wake up and loose 20 or 30 percent of our net worth. Today with a more diversified portfolio our bad days are 20 or 30 basis points of underperformance. And so for most investors, the reason we decided to take outside money in again is our other approach was probably not appropriate for most investors really can’t take the kind of volatility that of that concentrated approach. And the best strategy for most people is the one they can stick with.
Consuelo Mack: Tell me why you and your business partner decided to close the Gotham, the heavily concentrated Gotham Capital fund, and give the money back to investors–the outside investors.
Joel Greenblatt: Sure. We had a great record for 10 years. So we opened up in 1985 and at the end of ’94 we had built up a great ten-year record. And we had done well enough to keep our staff and continued to run our money while returning outside money. Part of it is that we didn’t wanna peg the principle our way of what we know how to do well. So we as your assets rise, Warren Buffett said; “The fat wallet is the enemy of high investment returns.” And so as you raise more and more money it becomes more difficult to get high returns.
Consuelo Mack: Especially in a very focused portfolio, or?
Joel Greenblatt: Yeah, especially in a very focused portfolio. At least that you have many more alternatives, as you run more and more money, and Buffett runs you know probably a $100 billion or so, you can’t look at a number of the smaller situations that you could before. And even if you could, you couldn’t put a lot of you money, a big percentage of your money in those. So I think we should start in the way of keeping our hurdles pretty low. You know, being able to look at more choices is usually better, and so we wanted to. And it was a very concentrated portfolio. So it was a combination of those things. And we really enjoy what we do.
Consuelo Mack: Explain the long-short strategy, and why you think over the long term that’s better than just being long.
Joel Greenblatt: Sure. Well, if you’re able, when you’re a long and short, long you’re picking the cheapest companies you could find. The ones that are at a discount. The ones you think could give you good returns over time.
Consuelo Mack: You are as a value investor?
Joel Greenblatt: Yes. And on the short side you’re gonna pick expensive companies that you think will come down over time, meaning they are overpriced, and the market will realise that they’re overpriced and come down over time. If you’re good at doing both you have two ways of making money. One on the stocks you like the best, and one on the stocks you like the least. So what we’re trying to construct is something that makes it easier to be a contrarian value investor. Buy things people don’t want, short things that people love to death at the moment. And that’s potentially a volatile market. We’re trying to make it as diversified and easy to take as possible. So it’s always tough to be a contrarian, and we’re trying to make it as painless as possible. It’s not always successful, but that’s the goal.
Consuelo Mack: How do you justify, I guess from a value investor perspective, the fact that you are investing in so many companies? They all can’t be the best. Doesn’t that bother you at all, I mean, you’re dealing now with numbers in supposed to individual companies that you know inside and out?
Joel Greenblatt: Sure. No, it’s a great question. The big picture is we’re excellent on average. We’re not right every time, we’re right most of the time however. And that’s all we need to be when we have 300 names. On average we get it right. And some things are inherently uncertain. A lot has to do with what’s gonna happen in the future. It’s been shown that Wall Street analysts aren’t particularly good at doing that. But when we’re using our metrics of valuation, both cheap and good, on average they work quite well over time.
Consuelo Mack: Last question. The one investment for a long-term investment diversified portfolio, I ask each of our guests what that should be. Obviously none of our guests can recommend their own founds. So what would you have us all own some of in a long-term diversified portfolio?
Joel Greenblatt: Well, number one for tax reasons, ETFs are a great structure meaning you don’t pay taxes until you sell them. So if you bought an ETF, a share in an ETF today and held it for twenty years, when you get dividends you’ll pay taxes on that but you won’t pay any taxes, it’s almost like a retirement account. You don’t pay taxes, if they’re well-structured, until the twenty years ahead when you sell them. I wrote a book saying that market-cap weighted indexes aren’t really the smartest way to go about investing
Consuelo Mack: Because?
Joel Greenblatt: Well, because for market-cap weighting, what that means is that you buy more of the bigger companies. The ones with the higher prices. And if a company is overvalued, what you tend to do is buy more of it because you’re being the ones at the highest prices. If a company is bargain-priced your owning less of it. So it’s really a systematic way to do the wrong thing at every stage. And that cost you about 2% a year. So your alternatives would either go to an equally-weighted index, an equally weighted S&P 500 and those work. And you make plenty of errors and you make them randomly so you get the 2% back, that you make the mistakes with a market-cap index. You could buy a fundamentally weighted index or what I would prefer is a well-structured value index but in form of an ETF so you have the tax advantages. And for most people most funds don’t beat the market over time. So the advice to buy an index, despite what I do for a living, is quite good. Just you should buy the right index.
Consuelo Mack: Joel Greenblatt, thank you so much for joining us from the Gotham Funds. It’s been like taking your class at Columbia Business School. We really appreciate it.
Joel Greenblatt: Thanks so much for having me. Appreciate it.
Article by Hurricane Capital, Old School Value
About the Author
The pseudonymous Hurricane Capital was Born in the 80’s, lives in Sweden with a Masters of Science in Business and Economics from Stockholm University. Got interested in value investing and devotes his free time and investing. The main goal through the Hurricane Capital blog is to learn about different investing topics, investors and business cases for investment.