Joel Greenblatt on “The Big Secret for Value Investors”

Joel Greenblatt on “The Big Secret for Value Investors”

Note to readers: I am writing all these posts very informally. I have found that readers like this the best, and it enables me to take the most notes possible and get them up in real time. I will be updating the presentations in real time, and tweeting, so make sure to check back frequently or on TwitterFacebook or Feedburner. Also you can check out this website announcement Value Investing Congress Website Announcement.

All notes are the speaker’s own statements, except for the brackets.

Joel Greenblatt is Managing Partner of Gotham Capital, a hedge fund he founded in 1985. Gotham had annualized returns of 40% for 20 years. He has been a professor at Columbia Business School since 1996 where he teaches Value and Special Situation Investing. Mr. Greenblatt is Chairman of the Success Charter Network, a chain of charter schools in New York City. He is the author of You Can Be a Stock Market Genius (despite the cheesy title, this is the best book on special situations ever written) and New York Times bestseller The Little Book That Still Beats the Market (John Wiley & Sons, 2005), and his recent best-seller, The Big Secret for the Small Investor. He is also the co-Founder and Chief Strategist for Formula Investing LLC (, an online money management firm. He serves on the Investment Board at Penn and the UJA Federation. He earned his MBA at The Wharton School.

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First a little bit about the magic formula as I hope you all read in You Can Be a Stock Market Genius.

First looked like Benjamin Graham at cheap, which is EBIT/EV=earnings yield. Then he looked at Warren Buffett for quality stocks-EBIT/(Net working capital+net fixed assets).

We used database back to 1988, no survivorship bias or anything. We looked at 2500 largest companies, and ranked from 1 to 2500 on cheapness and quality. We just used these simple metrics. The results from 1988-2009 are stunning. All the portfolios were run with a one year holding period. Buying each month and holding for a year. Decile one returned 15.2% and Decile ten produced 0.2% annually.

In my latest book The Big Secret for the Small Investor , realized that the best money managers of the past five ten years and they don’t outperform the market.

We wanted to improve on the index fund which is market cap weighted. We believe as Ben Graham and Warren Buffett believe that the S&P500 is overweighed with the largest stocks. Mr. Market sometimes overweighed big stocks and underweighted small stocks. So we looked at S&P500 equally weighted.

But there are two problems 1. You need a lot of rebalancing 2. The small stocks are less liquid.  There are trillions of dollars indexed so you would have more turn-over.

So Rob Arnott decided to weigh companies based on sales, and other quality features. However price was never one of the metrics looked at. The returns still beat the market by 2% by what I call “random errors”. However I do not consider this investing.

The good news is that part of the value effect is that it adds value.

I worked with Rob and put value in the mix. And value outperformed by a massive amount.

We asked should you invest at all in stocks?

We look right now and have a FCF yield of 13.7% which is in the 93% over the past twenty years. The year forward return should be 30-35% vs 10-15% for the market. So not only is the market cheap but the index which you can construct is also cheap.

This also works for a long short portfolio where you short the stocks that are the most expensive and have the lowest earnings yield.

Some say that operating margins are inflated and therefore the market is not so cheap. However, over the last 20 years margins have grown and over the last ten years they are about flat. So I am not sure where margins would revert.Additionally the businesses today, are a completely different type then the ones that existed 20 years ago. Google did not exist 20 years ago as an example.

There is nothing about margins that said that they should revert to the mean. ROC should revert to the mean but ROC should because competition will come in.

Some companies that come up on our screen are GameStop, BestBuy, Aeropostale, HPQ, Dell, MSFT, GD, WFC, Merck. All these companies have problems but that is why they work. But they have 15% FCF yield, so clearly the market thinks that these future FCF yields will not last.

In 1988 I was running Gotham Capital, and I had a fund of funds come and ask to invest. They asked for monthly returns and we were up 1% for the month. The PM of the fund of funds said we had a lot of funds up 1.2% for the month, why did you underperform?

I sit on a lot of investment boards, and we get weekly, monthly, quarterly updates. The world has become much more institutionalized and you have to perform over the short term. This causes people to avoid companies that have underperformed. We end up with a company that has very low expectations built in.  This is “the big secret for the value investor”, you would think these turns would be degraded over time, but the world has become institutionalized.

I have no worries that this will continue and am optimistic about the coming year.


Dividends dont come into our analysis. We dont care if we get the return in dividends or capital gains. If you do really good work on figuring out what the company is worth, the market will agree with you in 2-3 years. If a company is not using its company well, someone will come along that will try to improve it.

Sometimes it is better to re-invest then pay out dividends.

The business which have the largest market caps are more tech and services. Even companies that look like manufacturers such as Aaple really dont build all their stuff.

The Little Book That Still Beats the Market, financials were excluded but it seems like you include them now? The index includes financial. In the Little Book we were looking at EBIT. It is hard to look at a bank before EBIT. So we adjusted it a little bit. Basically the cheaper something is the more it is weighted in the index, which is ridiculously simple.

Can you tell us about your experience with Michael Burry and CDSs as described in the The Big Short? I felt a little better about it, when a WSJ editor says Michael Lewis never lets facts get in the way of a good story.

The truth is that we kept all our mortgage CDSs with him. Michael Lewis interviewed me and never mentioned any of this.

I am not a big fan of asset allocation and would actually be raising equity exposure now.

Have you seen farther back then 1988 about operating margins? Did the trends change prior to Q408/Q1/09? We only had data going back until 1988.

We did not indicate the pullback, but our graphs predicted a small to negative return. They are usually pretty accurate over a year but sometimes takes longer. That is the problem with market timing. The market was cheap in October 08 but went down 20%. However a year later you had a very nice return.

We used to be very concentrated and were small. We had 6-8 holdings when we made 40% annual returns. We gave back a lot of the money to keep small. You cannot do this with a large diversified portfolio.

We have experimented with various methods to improve this purely quantitative method? We tried but nothing really has worked.

Value investing is figuring out what something is worth and pay a lot less. Everyone is different in terms of whether diversified or concentrated works better for you.

I think special situations can still work. I have five kids and am starting to teach them about special situations. One approach is not better than the other and they both can work.

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