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!
[b]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