“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.
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
[drizzle]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