Joel Greenblatt is no magician, but the founder of New York-based Gotham Asset Management does have a magic formula for investing. In 2005, Greenblatt, who also has been teaching at Columbia Business School for the past 17 years, published The Little Book that Beats the Market, which explains how investors can outperform market averages by following a simple process of investing in good companies at bargain prices. The ‘Magic Formula,’ as Greenblatt termed it, was about seeking out companies with high return on invested capital, and which could be purchased at a low price. The strategy produced back-tested returns of 30.8% per year from 1988 through 2004, more than double the S&P 500’s 12.4% return over the same period. What better proof than eating your own cooking, Greenblatt’s private investment partnership has logged a 40% annualised return since its inception in 1985.
How did your career in investing come about and which phases were particularly insightful?
It was during my college days in the late 1970s that I first got interested in investing when I read an article on Benjamin Graham. The article outlined how he had this formula to beat the market, provided an explanation of his thought process, and described “Mr Market” a little bit. I read that article and thought: “Boy, this finally makes some sense to me.” That’s when I started reading all I could about Graham and also read about Buffett and his letters. What struck a chord with me was the logic of figuring out you were buying a piece of business and paying a lot less than its actual worth. What they taught in the business school for fundamentals was that this [paying a price less than its actual worth] couldn’t be done and that it’s not worth the time trying to beat the market. I am glad I listened to my reading. It made much more sense to me, given what I had observed about how emotional the market is over the short term. Just sitting around and hanging around for three months, it was pretty obvious that the market wasn’t quite as efficient as my professors were telling me. I think I have pursued a career following that philosophy since then. On the personal side, I have been enjoying teaching in Columbia for the past 17 years. Having the opportunity to think about how it is that I went about investing, and explaining it in a very simple way is very valuable to me, and hopefully to my students as well. I learnt from reading other people’s books, particularly Benjamin Graham, who said that I have always enjoyed writing and always wanted to give back in some way. So, writing and teaching are the ones that I can think of.
You have demonstrated pretty clearly that the Magic Formula, that is, buying good quality stocks in the manner you define, really works. What are the exceptions to this rule?
That’s a great question, but if I knew the answer to that it would be wonderful. If you got a list of companies that appear to be cheap and are able to filter out the ones that are going to work and that won’t, that would be helpful. I don’t have any Magic Formula for deciding which ones will do better than the others. Most companies that end up being very cheap are controversial and face a lot of uncertainty. There are many ways to make money. There is a deep-dive, which is what I did for many years, essentially, owning six to eight names that I had studied very well.
The Magic Formula is a different type of philosophy where you end up buying things that are statistically cheap with very nice quality attributes but are facing some uncertainty. If some things are inherently uncertain we can sit here all day and try to figure out what’s going to happen. So, it’s not worth your time. It is a strategy that works, on average, and it is very hard to pick and choose which ones will work out. What you can make sure is that the numbers are accurate, there is a trustworthy management in place that is incentivised correctly and things of that nature. But, in general, you are buying a bucket of opportunities.
Right now some thing that is very cheap would be Apple. I always ask my students what do you do of a company where the technology is always changing and it is not clear what the competition will look like in a few years. The answer to that would be: always skip that one and try to find out the ones that you can figure out. I don’t know what is going to happen with Apple, but if I own a bucket of Apples then, on average, that is a really good bet. You are buying good businesses with a great franchise at six times cashflow, have great market share and good management, strong balance sheets and so forth. So, if I own a bucket of Apples rather than just Apple, I am pretty sure it is going to work out very well.
How much attention does one need to pay to future earnings, because the Magic Formula is all about the past?
We have all learned that a value of a business comes from the discounted value of its future stream of earnings. The Magic Formula looks backward and may actually seem like making money from reading a history book. It doesn’t make sense that you are making money by reading a history book because everyone else can do that. In other words, any simple formula that has worked over the past 20-30 years will degrade over time. But in reality, that hasn’t happened. The reason is because the Magic Formula deals with out-of-favour stocks and that is why you are getting them cheap. The market has become much more institutional and what that means is that professional managers, who are active stock managers, try to make money over the next two years. If they don’t, their clients leave irrespective of their investing timeframe. Companies not expected to do quite as well in the next year or two are systematically avoided by institutions and that behaviour has become even stronger. That’s why this type of strategy hasn’t weakened over time.
If one were to bracket uncertainties as to which are less difficult to cope with and which aren’t, how would you rank those?
I would steer wary of companies that are subject to government regulation and those that don’t necessarily follow necessarily capitalist incentives or a business where some outside force is responsible for their revenues. Companies that are susceptible are heavily regulated companies such as utilities where the government has a lot of influence and the decisions can be political rather than capitalist.