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Insights from a Meeting with Mr. Greenblatt

February 02, 2006

by Shai Dardashti ?

Almost two weeks ago, Jason Bond and I had the opportunity to meet for an hour with Joel Greenblatt of Gotham Capital. As per the notes below, the discussion reinforced the importance of simplicity, common sense, and focus. And, naturally, the key lessons from the meeting were those that are also shared in Greenblatt's monumental Little Book That Beats the Market:

Some highlighted quotes:

  • "Figure out what something is worth and pay a lot less."
  • "Again, it is all about valuing businesses and paying a lot less."
  • "If I plug my estimates into the Magic Formula, and it comes out cheap, that's good."

Notes from the discussion:


I spend a lot of time reading - newspapers, publications. I am always on the look-out for ideas, but I am not looking specifically for ideas. I am also on the look-out for illustrations to use in teaching. Sifting through a couple of ideas, and usually they don't make sense. I never worry about the five that I should have bought. I just want to be sure that the one I do buy is good. I never worry about selling too early. What are the risks? What are the potential rewards? What is my confidence level? A lot of this comes from experience. When I started out, I was much more precise, based upon the few areas that I knew well. I have gravitated towards Buffett over the years. Good things happen to good businesses. I prefer good to cheap. But I do not categorize companies very often. I look at the spinoff area, for instance, but I am mainly looking for good businesses. I am an "equal opportunity money maker." It's all investing. Figure out what something is worth and pay a lot less. I try to figure out what a business is worth. I pay attention not only to price, quality (high ROIC), and growth prospects, but also to my own confidence level in my estimates. Note: The Little Book is for people who cannot value companies. If you can value a company, you can start with the MF list. Then estimate normalized earnings, normalized free cash flow, and expected growth rates. If I plug my estimates into the Magic Formula, and it comes out cheap, that's good. My confidence level in my earnings estimates 3-4 years out is much higher for good businesses. Then again, if a business is just a pile of cash, and not losing money, and it is a special situation ( i.e., there is a catalyst), then I will pay attention. Again, it is all about valuing businesses and paying a lot less. This is not strictly Graham or strictly Buffett.

 

What underlies most of your questions: The process of valuation.

  1. While studying the footnotes is crucial, the big picture is most important: Earnings yield and ROIC are the two most important factors to consider, with the key being figuring out normalized earnings.
  2. High earnings yield, based upon normalized earnings, is important in order to have a margin of safety. High ROIC (again based on normalized earnings) simply tells you how good a business it is.
  3. Independent thinking, in-depth research, and the ability to persevere through near-term underperformance, are three keys to being a successful value investor.
  4. Worrying about near-term volatility has nothing to do with being a successful value investor.
  5. Think of a concentrated portfolio as if you lived in a small town and had $1 million to invest. If you have carefully researched to find the best 5 companies, the risk is minimal (As Charlie Munger says, "The way to minimize risk is to think.")
  6. Special situations are just value investing with a catalyst.
  7. International investing may offer the best opportunity, at least in terms of cheapness.
  8. Finding complicated situations that no one else wants to do the work to figure out is a way to gain an advantage. (You have discussed and given examples of many such situations in your book, You Can Be a Stock Market Genius.)
  9. Looking at the numbers best way to learn about management. What have they done with the cash? What are the incentives? Is the salary too high? Is there heavy insider selling? What is their track record?
  10. Focus on understanding and buying good businesses on sale, and don't worry about the macro economy. Everything is cyclical, so value can always be found somewhere.
  11. Focus on situations that are not of interest to big players (usually small- and mid-cap, although currently large caps are cheap; spin-offs may be such opportunities, but the key is to figure out the interests of insiders; bankruptcies, restructurings, and recapitalizations may also be such opportunities).
  12. Trust no one over 30, and no one under 30; must do your own work, rather than simply ride coat-tails.
  13. Risk is permanent loss of invested capital, and not any measurement of volatility developed by statisticians or academicians.
  14. All investing is value investing and to make a distinction between value and growth is meaningless.)
Thus, you understand the context of value investing. The most important step, which you have already completed, is to understand the market in context. If your investments go down, but you have done your homework, then understanding this broader context means that the short-term under-performance should not bother you. Again, understanding this context is crucial when things don't go your way. Buffett on the two things you need:
  1. How to Value a Business. (Practice, practice, practice. If Buffett taught a course, he says he would just do case study after case study.)
  2. How to Think about Market Prices.
If you have the ability to analyze international businesses, that is great, but you can make a good living as a value investor in the United States, as evidenced by the Magic Formula, or even in one sector in the United States, as evidenced by my sister Linda who has done quite well by focusing on retail stocks, her specialty.

________________

Shai Dardashti is the executive editor of Shai Dardashti on Grahamian Value, a media outlet reporting news, commentary, and analysis to the value investing community. Shai is currently a senior undergraduate student at The University of Maryland, with plans to graduate in May 2006 and pursue a career in money management. He can be reached at ShaiDardashti@gmail.com


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