GuruFocus Interview with Renowned Investor Joel Greenblatt
His investment philosophy is to find cheap and good companies, usually those in special situations. In his own hedge fund, he employs the principals of the Magic Formula: Look for high ROC and earnings yield, try to figure out what "normalized earnings" will be 3-4 years into the future, and choose only stock that is very cheap based on normalized earnings. He typically has a concentrated portfolio of only 5-8 securities at a time.
GuruFocus readers recently submitted their questions to Mr. Greenblatt, and his answers are below.
Question 1. How do you screen your ideas? It seems to me that doing a magic formula approach, if workable, can be a really good way for a value investor to invest in countries that are out of one's circle of competence for individual stock picking (due to differences in accounting convention, language barrier or level of disclosure).
In your opinion, can the magic formula approach work in emerging markets like India or China despite these limitations? What kind of challenges do you see to using this approach today to these markets?
[Greenblatt:] I think the Magic Formula approach could work in almost all countries. In fact, we have done extensive work in 26 different countries over the last few years. The problem is that internationally, commercially available financial databases are generally of poor quality. We have found that there is a lot of work in taking the financial reporting in different countries and then putting those reports into a uniform context similar to the way we would look at U.S. based companies. So, in theory, the formula should work quite well outside the United States, but I would not be as confident using commercial databases for non-U.S. companies to calculate values. This makes investing, without doing your own work on the original financial statements, more difficult and potentially problematic.
Question 2. When you started Gotham Capital, did you invest in OTC markets or mostly nasdaq stocks? Also, do you go through OTCBB and Pink Sheet stocks? If so is there more of a cheap (dirt cheap) cigar butt approach there?
[Greenblatt:] When I started Gotham Capital, we looked at everything but only on extremely rare occasions did we invest in Pink Sheet listed stocks or illiquid over-the-counter issues. We found plenty of opportunity without having to invest very much in this area. I think investors have to be extra careful and extremely knowledgeable to invest in these markets, but there is nothing inherently wrong with any investment as long as you do your homework. I don't think non-experts should play in these markets, however.
Question 3. Can you give us some thoughts about valuing financial and utility stocks? Your developed "magic formula" is excluding this stocks. You said in an interview that you are working on a formula to value this kind of stocks with a formula too.
[Greenblatt:] We have developed a model and have incorporated financial and utility stocks in our more diversified long only strategies since I wrote the original "Little Book." Financial stocks don't work with EBIT (earnings before interest and taxes), since looking at a bank, for example, "before interest" is a bit meaningless. But we have developed other methods that make sense for both financials and utilities that make adjustments for the differences in these types of companies and seem to work well. So far, we haven't shared them widely, but they are both logical and in line with the way we look at other industries.
Question 4. Would you mind reviewing your investment process for a non-special situation long investment?
[Greenblatt:] My investment process is the same for special situations and normal "value" investing. Our goal in all of our investing is to figure out the "value" of a company or a security and then try to buy it at a big enough discount to that value so that we are left with a large margin-of-safety. However, we can't value most companies. We have to wait until we can find a company or security where we have high enough confidence in our estimates for the business going forward to do reasonable valuation work. Sometimes special situations can provide a catalyst that we can identify ahead of time that may make the gap between price and value close faster or more predictably than it would in a normal situation with no catalyst.
Question 5. Thank you for taking our questions. Like some other notable investors, you choose to teach. Why?
[Greenblatt:] I teach and write because I enjoy it and it is one way I feel that I can give back. Although I was taught certain valuable basics in business school, I really learned how to invest by reading. Graham, Buffett, Dreman, Tobias, Train, Smith and some others were kind enough to share their thoughts, experience and outlook and I always hoped that if I became a successful investor one day that I would do the same for those who came after me. In particular, as far as teaching is concerned, I think the vast majority of business schools still ignore the subject of value investing and I feel lucky to have found a home at Columbia University all these years that values and understands the discipline. I can't think of too many other finance departments where I would be welcome, but in a way I guess that's the good news for future value investors.
Question 6. I am a big fan of your two books and have long been a value devotee. I am also a member of your ValueInvestorsClub.com and am now working at a value-oriented hedge fund in Korea. I have noticed that you teach Value & Special Situations Investing at Columbia Business School. What do you think is the marginal benefit for someone like me to attend Columbia and your value investing classes at Columbia in improving myself as an investor? In other words, what is the general level of skill and experience of your students in the Applied Value Investing Program at Columbia? What should I devote my time on to become a better investor?
[Greenblatt:] I think business school is a very personal decision. I love Columbia and I think they have a great value investing program but there is nothing that is taught there that you can't learn on your own. Becoming a good investor is about reading, learning and practicing and then practicing some more. There's no magic bullet, but the more experience you can gain the better. Having said that, a good investor is always learning, so however you learn best is what should influence your decision. By the way, I think the valueinvestorsclub.com is still one of the best places on the web to learn about value and special situation investing.
Question 7. Your new funds own hundreds of stocks. But in your book, You Can Be a Stock Market Genius, you wrote that you prefer a concentrated portfolio. How do you invest with your personal portfolio? Concentrated or diversified?
[Greenblatt:] That's a great question. In my new book, I try to address those very issues. If you do in-depth research and really understand the values of the companies you are investing in, a concentrated portfolio can be a great way to invest. I did it that way for many, many years and it was very successful for me and my partners. As a result of the research first started with the "Little Book", we have discovered that we can create much more diversified portfolios and still achieve very satisfactory results. Neither method is better than the other. They both work great. I think a concentrated portfolio can achieve higher absolute returns but a more diversified portfolio has a somewhat smaller range of outcomes, both high and low, over the short term. I have found that both methods are full time jobs if they are done well and we have decided to spend most of our time on our new research covering more diversified portfolios and have invested accordingly. I think this is partially because I have found our recent research new and exciting and I generally enjoy the research and learning process. However, if I could still spend all of my time on concentrated investing, I would be equally happy investing that way. I hope that doesn't confuse you but rather makes it clear that both methods are intelligent ways to approach the investment process.
Question 8. How did magic formula stocks do in the market crash of 2008? Are there any red flags you would look for in eliminating MF stocks from consideration? For example, what if a company's earnings appear highly unstable?
[Greenblatt:] Great question, also. Magic Formula stocks, in general, fell almost as much as the market in 2008. Their rebound, however, was much stronger than the S&P 500 in 2009. I think the best way to look at this strategy, as in all stock market investing, is over the long term, though. This method seems to work because on average we are trying to buy above average quality companies at below average prices. What the market does with these stocks in the interim can be almost anything and in a difficult year like 2008, the best assumption to make is that they will not offer more short term protection than the popular market averages. Over longer periods, this method makes sense and seems to outperform the market averages by a significant margin. We have found that eliminating stocks with certain specific characteristics is problematic. The Magic Formula method in aggregate systematically buys companies where the short term outlook is usually uncertain or negative relative to the recent past. These are precisely the stocks that investors systematically avoid, which is where I believe the potential excess in returns could come from. So, eliminating companies from the strategy where the negative attributes are already well known is not likely to help your results. However, as my father always says, "have an open mind but not a hole in your head," so if you discover anything great, please feel free to email me.
Question 9.Return on invested capital is mean reverting, meaning it will on average decrease over time in the case of high ROIC. Could inclusion of this factor in the MFI therefore actually diminish rather than improve MFI returns?
[Greenblatt:] Including a measure of return on tangible capital has helped our returns over time. Once again, I believe we are buying above average quality companies, but only when they are available at below average prices. Generally, high returns on capital do attract competition and very high returns often fall over time. The question is whether they revert "towards" the mean or "to" the mean. There is a big difference, but in either case, we are trying to pay below average prices, so we should generally be fine in both cases.
Question 10. As I mentioned in your last Q&A session with Gurufocus, in my opinion your two books on investing are the best out there. Can you give details on how your soon to be released book builds on your past writings?
[Greenblatt:] The Big Secret for the Small Investor will be out April 12, and it builds on the writings from both books. But it's a big secret, so I hope you'll enjoy reading this one, too!
Question 11. Obviously you would recommend that the Average Joe should purchase magic formula stocks, but if you yourself had a portfolio worth thousands rather than millions, where would you focus your research efforts? Would you, for example, focus (but not limit yourself to) on nano cap special situations (say<$50 million)? A particular type of special situation?
[Greenblatt:] This is an important question. I do not recommend buying stocks with market caps below $50 million using the Magic Formula method. I did not study these but there are potentially big problems in trading such illiquid stocks. There are also a higher percentage of frauds in this area and many of these companies are of low quality. These stocks may be a land of opportunity but I think they require more in-depth research on an individual basis. I also do not believe that commercial databases do as good a job covering these companies well and the data may not be of high quality. The studies discussed in the Little Book only covered companies with market caps above $50 million.
Question 12. Obviously the basic principles in "You Can be a Stock Market Genius" have not changed but if you were to rewrite it today, would you change anything? Would you highlight any other type of special situations? Are spin-offs as rewarding and as prevalent as they were in the 80s and 90s?
[Greenblatt:] I probably wouldn't change anything (though I'm a little lazy and that could have factored into my answer).
Question 13. Do you still invest in special situations, or have your funds grown so significant you have decided to focus purely on quantitative investing techniques, such as investing in magic formula stocks?
[Greenblatt:] There's plenty of room in the special situation area.
Question 14. Considering that many investors have 401k or other tax deferred accounts (and considering that via places like folioinvesting.com, trading costs are close to 0% for portfolios over $100k), have you looked into backtest where the holding period was less than one year? I know Haugen traded on a monthly basis, and his returns were better when he rebalanced monthly as opposed to annually).
[Greenblatt:] I chose one year in the book for simplicity and tax reasons. There is nothing magical in the one year holding period. However, holding winning stocks for a bit more than a year may result in long term gains. Holding losing stocks for slightly less than a year can achieve short term tax losses which are more valuable to investors in most cases. As a result, I chose one year to take advantage of this opportunity. The strategy may work after one month, six months, one year, two years, etc. Trading every month is not practical for most investors but having new information like price changes and new quarterly results factored in could be helpful, depending upon trading costs, which include market impact and bid/ask spreads that are exclusive of trading commissions.
Question 15. Do you feel that an IRA should be even more diversified or less based on the fact that you can't write off losses?
[Greenblatt:] I don't think this should make a difference in choosing your investment strategy.
Question 16. However, when the magic formula is used for selecting a portfolio of stocks in a mutual fund, investors may decide to pull their money out of that fund during periods of under-performance or market crashes/panics. This may, in turn, lead to further losses as the fund manager is forced to sell his/her holdings in order to accommodate the redemptions and not have enough cash to invest when the market is especially attractive (based on more stocks with lower PE ratios).
Do you envision this to be a problem in managing mutual funds employing quantitative techniques where back tested results may not have accounted for investor redemptions? As a fund manager, how would you mitigate the effect of investor redemptions on the performance of a fund, assuming that for the fund to yield the benefits of the magic formula investing method, it needs to be fully invested for one-year periods and hold very small amounts of cash?
[Greenblatt:] This shouldn't affect the mutual fund unless it gets very, very large. We plan to limit the size of the fund to a very manageable level. Also, our experience as long term investors is that stock prices may bounce back to pretty much where they would have been after short term liquidity driven selling. Therefore, patient investors in the mutual fund may not be affected over the long term by short term money flows. The fund does not follow a one year holding period but manages its portfolio based upon the optimum value opportunities available at any given time.
Question 17. Are you planning ETFs based on the magic formula? or funds for non-U.S. domiciled investors?
[Greenblatt:] We are not planning ETFs. ETFs must disclose their positions on a daily basis and this is not something we are willing to do. I like ETFs for various types of other investments which I discuss in the new book.
Question 18. Recently, the small and micro cap MF screens have been churning up multitudes of Chinese RTO stocks. Many, if not most, of these are blatant frauds. I realize that you may not focus much on the microcap area (due to your portfolio size), but have you thought about any techniques, quantitative or otherwise, to eliminate these and other potentially fraudulent companies where you can't trust the numbers?
[Greenblatt:] We do not buy companies with very low market caps for any of our strategies. We also avoid certain suspicious companies including most Chinese companies that have been involved with reverse mergers. My suggestion is that investors choose stocks from a multitude of market caps and that they not invest in stocks with market caps below $50 million. If you have done work on a company and there is something suspicious about their financials then I would suggest that you choose another company on the list.
Question 19. Are you mindful of the market's overall expense level? If so, do you subscribe to Buffett's methodology, Shiller's P/E, any of Graham's pioneering thoughts, your own proprietary method, or something else? Could you please explain your process, as I find your writing to be even more concise and illuminating than that of Graham's and Buffett's indelible oeuvres.
[Greenblatt:] It's hard to answer your question even with the nice compliment attached. Generally, I would choose an amount that I am comfortable being invested in the stock market and stick with the strategy within a narrow range. The market was clearly overvalued in the year 2000 and the zero returns over the next 10 years reflected that reality. However, the Magic Formula strategy actually did quite well during that period because many undervalued stocks could still be found during this period. So, looking at market "averages" can be very misleading about the investment opportunity set. Most institutions like endowments and pensions choose a target allocation size to stocks and then adjust within a narrow range around that number. Then again, most of these organizations don't do so well, but I don't have a better idea. I guarantee "winging it" based upon perceived market "cheapness" or economic conditions will give most investors even worse results.
Question 20. I was wondering if you felt that the U.S. financial dominance over the rest of the world could come to an end or at least slow down. Over the next 20 years, what do you expect U.S. stock investing returns will be compared to international stock investing returns? For example, how do you think your Professionally Managed U.S. account will perform relative to your Tax-Managed International account? Thanks for sharing your time with the community.
[Greenblatt:] That's a good question that I don't have a 20-year answer for. I think the U.S. is still a great country, economy and place to invest. A combination of an established rule of law and a great entrepreneurial spirit should continue to make it possible for businesses to thrive here. We have lots of challenges but so does everyone else. I think having more investment choices is great though and I am very excited about the investment opportunities internationally as well. Since people are human all over the world, the opportunities for value investors should be similar over time in all of these places.
Question 21. In chapter seven of your first book you list an assortment of publications that one can navigate for investment ideas. Several years ago Warren Buffett indicated that if he was limited to one publication, he would opt for the Wall Street Journal. I believe he has since altered his choice to the New York Times. In 2007, Michael Price implied that the Wall Street Journal's quality had diminished in comparison to the past. Given that things change over time, would you please share your present thoughts pertaining to what you expressed in "You Can Be A Stock Market Genius". In 1997 you wrote, "You don't have to read anything other than the Wall Street Journal, though you can find new ideas almost anywhere in the business press. Particularly good newspapers for scouting out new ideas include The New York Times, Barron's, and Investor's Business Daily. There's also a list of well-known business magazines to choose from. I've found Forbes and Smart Money to be the best sources of good ideas. The next source of potential ideas is investment newsletters. My favorite is Outstanding Investor Digest. Another good investment letter is the "Turnaround Letter." In addition, are there any industry specific publications that you read on a regular basis? In your book you mentioned American Banker and Footwear News. Are there any websites you utilize to mine for investment ideas? I believe I read that you were fond of Bloomberg, and I assume that's true of your own sites (Magic Formula and Value Investors Club). Paul Sonkin revealed that he engages in "key word" alerts. Do you employ similar tactics? You also discussed prospecting investment ideas from the masters. Specifically, you mentioned Michael Price, Marty Whitman, and Richard Pzena. Whose 13Fs do you peruse? Whose 13Fs do you deem are of particular relevance to those that have small sums (under a quarter billion - to steal your phrase) to commit? (I've noticed that some of your proteges aren't required to file 13Fs.)
[Greenblatt:] I still love the Wall Street Journal. I also like The New York Times (for its business section). There are now too many opportunities over the Internet to mention, but one of my favorites is a site that I helped found, the valueinvestorsclub.com. This is a great site to learn how many good investors think and I highly recommend it to all of my students.
JOEL GREENBLATT Is the Co-CIO of Gotham Asset Management, LLC, a Professor on the adjunct faculty of Columbia Business School and the former chairman of the board of a Fortune 500 company. He is the author of three books, You Can Be a Stock Market Genius, The Little Book That Beats the Market, and his new book, The Big Secret for the Small Investor. Greenblatt holds a BS and MBA from the Wharton School at the University of Pennsylvania.
Past performance is not indicative of future results. There is no guarantee that the strategies discussed will prove to be profitable. It should not be assumed that the investment recommendations or decisions made in the future will be profitable. Investing in the stock market carries significant risk, including the risk of loss of all or a substantial portion of the amount invested. A copy of Gotham Asset Management, LLC’s Form ADV disclosure document is available upon request. More information about the advisor including its investment strategies and objective can be obtained by visiting www.gothamassetmanagement.com.