After we announced the good news, the response from our users were overwhelming. In the end, we collected a total of 60 questions and passed them all on to Joel. Dear GuruFocus users, thank you all very much for asking the questions!
In our last letter to Joel, we stated that “ Please feel free to skip the questions you do not see appropriate or you simply do not like to answer.” We fully respect his discretion to choose which questions to answer and which one not to.
Today, we received answers back. Joel Greenblatt answered a total 27 questions. Thank you, Professor Joel Greenblatt!
And we also thank company FormulaTrading.com for making this event a success.
Here are the Questions & Answers:
Question 1. While reading your biography or rather from what is available on the internet, I noticed you graduated in 1980 and founded Gotham in 1985. I was wondering what you did during that 5 year interim ? Did you work at a hedge fund or in banking, and if so in what area? (Bertrand)
Professor Joel Greenblatt (JG): After graduating Wharton with an MBA in 1980, I decided to go to Law School to avoid taking a real job. After my first year, I decided that going to law school if you didn’t want to be a lawyer was perhaps not the best idea in the world. I took a job at a start-up hedge fund at the end of 1981 doing mostly risk arbitrage and special situation investing and started Gotham Capital in 1985.
Question 2. Some notable investors such as Benjamin Graham, Philip Fisher and yourself are also well respected teachers. In your view, do good teachers and intelligent investors share any particular qualities? (batbeer2)
JG: I think to be a good teacher you need to understand your subject very well and that enables you to explain things in a simple way. I think the exercise of trying to figure out how to simplify concepts has been incredibly helpful to me over the last 13 years of teaching and I hope my students have benefited from it. I certainly have. I’m guessing that the other investors you mentioned who wrote about and taught investing felt the same way.
Question 3. In my opinion your two books are the best investing books out there. Do you have any plans to write another one? If so when and what will it be about? (djswinney, Bertrand)
JG: I do plan to write another book. It will also be about a basic framework for successful investing written in a way I hope my kids can understand. As for timing, I’ll let you know when I finish it! (I hope before they all grow up!)
Question 4. Besides your own books (which are awesome by the way) and books such as the Intelligent Investor, Security Analysis, what would you recommend reading to get a leg up in investing? Any periodicals that you think are worth perusing? (ConsumerMonopoly, AndreHeggli)
JG: A few of my favorites are: “The Essays of Warren Buffett” edited by Lawrence Cunningham, “Moneyball” by Michael Lewis and “The Invisible Heart” by Russell Roberts.
Question 5. How much of your investing success can be attributed to your uncommon emotional temperament? What are the key attributes of being a successful investor? (bart329, firstname.lastname@example.org)
JG: The answer is: I’m not sure. I like to figure things out and I’ve always liked to gamble. I never bet a lot, however, unless the odds are heavily stacked in my favor. So, I guess that’s what I like about investing. It’s a fascinating “game” if you can figure things out and don’t get in over your head with the size of your bets.
Question 6. How often do you evaluate your portfolio and when do you decide to sell a stock? (email@example.com)
JG: When to sell is always a difficult question. Big picture: I usually try to sell before my investment reaches a conservative estimate of fair value. In other words, I usually sell too early. In addition, I may sell before an investment reaches even that discount to conservative fair value if I find something else a lot cheaper and it makes sense to make the exchange after looking at my overall portfolio.
Question 7. It seems from your portfolio that you weren't very active in the market in the past two years. You had a concentrated portfolio before and recently you came back with a very diversified portfolio in 2008. Then it seemed that you sold almost everything. Was it because you saw the crash coming? Why did you switch funds and can we invest in your new fund? If so, how? What do you see the market and the economy doing in the next few years? (charliet)
JG: Gee, this was lots of questions. Big picture: what gets publicly filed is very limited and does not give very much insight into what we are doing. We have many different funds with different ownership structures and that have different filing obligations. For example, we manage some long/short quantitative strategies where only the long side is subject to filing under certain circumstances. Some of our funds have allocations to sub-managers who occasionally make distributions in kind that are subject to filing (so securities we did not choose directly) and some funds hold investments not subject to filing requirements. So, looking at 13F’s or other public documents only provides a very narrow perspective into what we are doing and may often give very confusing or an incomplete view of the overall picture.
Question 8. Given the recent market declines, do you still believe in a concentrated portfolio? (francomax13)
JG: I still believe that for good business analysts a concentrated portfolio is a good strategy combined with a long term horizon. Actually, last year should give pause to people who think diversification among many stocks in an equity portfolio results in a significant degree of added safety versus owning stakes in a few well-chosen companies.
Question 9. What is the amount of leverage if any used by the fund during it's operation? (Callaquin)
JG: During the 10 years that Gotham Capital managed outside money from 1985-1994 the portfolio was rarely leveraged although small portions of the portfolio were sometimes invested in options.
Question 10. Could you share your thinking about the relationship among long-term earnings stability, long-term ROE/ROIC and valuation levels (PE, PS)? How do you think about the dynamics of these three variables when valuating a company? (grol1971)
JG: When doing in depth analysis of companies, I care very much about long term earnings power, not necessarily so much about the volatility of that earnings power but about my certainty of “normal” earnings power over time. My goal is to buy a company at a low multiple to normal earnings power several years out and that the company earns good returns on capital at that level of normal earnings.
Question 11. What type of things would you look for in an annual report that your typical investor might not pick up on? Do you feel there is a need to do a DCF analysis of a company? (cyrano)
JG: I look for obvious things when looking for bargains, not something terribly obscure. So, if a company has two divisions, one that earns money and one that loses, I might speculate on what the company might be worth without the money losing division, but that wouldn’t involve higher mathematics or special sleuthing talents. A DCF analysis is potentially a useful reality check to see what kind of growth rate, earnings and discount rate would justify the current price. However, I usually just look at a simple multiple to normalized earnings. If I can buy something at a very low multiple and I have confidence in the earnings stream, I don’t have to calculate a DCF to know whether I want to buy it.
Question 12. In the magic formula investing you suggest a simple scheme of buying the cheapest stocks and sell them every year after a year. A few questions:
- How do you ensure that beyond the statistics there is nothing else that is going on about the company which will cause its value to remain depressed or worse go down?
- Do you actually use the magic formula for any of your investing? If yes what are the additional criteria you use once the magic formula has identified the first set of stocks? (firstname.lastname@example.org)
JG: The Magic Formula works on average. It can either be used as a screening device to find companies to do more work on to determine whether earnings are sustainable and predictable or as a way to accumulate a basket of 20 or 30 companies that on average are cheap and good. If you don’t plan on doing additional research, buying individual companies without further research would obviously be imprudent.
Question 13. In your magic formula, you use return on capital and earning yield to rank the companies. It seems that we will get a lot of cyclicals at their earnings peak, when the earning yield is high and return on capital is high, too. However, that is the worst time to invest in cyclicals. How to avoid this with the magic formula? (valueradar)
JG: The Formula works on average and it is very difficult to predict which particular companies will work. Logic doesn’t always work but I like using it anyway.
Question 14. I suspect that Magic Formula investing has not done well from about Oct. 2007 to Apr. 2009, simply because pretty much all stocks got beaten down. Of course it isn't intended to work well for such short periods of time. What if a conservative investor followed the Magic Formula through this period, but was short the major market indices (S&P, Russell, or others)? How would he have done? In other words, in this current bad time as well as other bad times for the market, did the Magic Formula continue to beat the market averages? (buffetteer17)
JG: The way I would like to answer this question is that the Magic Formula as described in the book is 100% net long. If the market has a huge drop, you cannot expect the formula to make money, you would only hope that it outperforms the market averages. It certainly has outperformed significantly over the long term and that is the proper perspective in which to think about it. If index funds beat most active managers and the Magic Formula can beat the index funds by a wide margin, this may be a very good option for individual investors.
Question 15. I have been experimenting with the Magic Formula method of investing since 2006. I have noticed relative outperformance when compared to the indices (DJIA, S&P), but in the downturn last year, the MF method went down with everything else. I set up a new MF portfolio at the beginning of the year and it's once again outperforming the market indices. My question: if we are in a long-term bear market of the 1966-1982 variety, how do you feel the Magic Formula will perform and would an investor be better off on the sidelines until we see a clear sign of a new long-term bull market? (jeffm30)
JG: A new updated study should be posted on FormulaInvesting.com in the near future and the results appear to be quite good relative to a flattish market over the last 10 years or so. Also, since the market has not performed well over the last decade or so, that may turn out to be a good time to invest, not a bad time.
Question 16. What were the results for the Magic Formula in 2005, 2006, 2007 and 2008? (htcoleman)
JG: A new updated study should be posted to the FormulaInvesting.com site soon.
Question 17. Because free cash flow growth requires not only high returns on capital but also a reinvestment opportunity, have you explored adding a criterion to the screen that would indicate the presence of a significant opportunity for reinvestment? (jdt)
JG: I think this is a great question. The big picture is: the main thing you should be concerned about in the future are incremental returns on capital going forward. As it turns out, past history of a good return on capital is a good proxy for this but obviously not foolproof. I think this is an area where thoughtful analysis can add value to any simple ranking/screening strategy such as the magic formula. But keep in mind, buying a diversified portfolio of companies who have achieved high returns on capital in the past and that can be purchased at bargain prices has worked quite powerfully, buying an individual company without further analysis of this issue is another story.
Question 18. Do you ever use the inverse of the magic formula (low EY and low ROC) as a base for further screening when you look to short stocks, if ever? (Bertrand)
JG: This is a good question also. On page 64 of the Little Book I list the decile returns showing that the first decile of Magic Formula returns beats the tenth decile by over 15 points. So, often the question is asked, so why not buy the 250 stocks in the first decile and short the 250 stocks in the tenth decile and make a risk-free 15 percent. The answer is that the magic formula doesn’t work in every period. Even with high out-performance over long periods of time of Decile 1 vs. Decile 10, there are a few periods where the results might reverse causing large losses and volatility for those periods.
Question 19. What are your thoughts on the European website version of MagicFormulainvesting.eu, operated by two Belgian private bankers? (Bertrand)
JG: I have nothing to do with this site and have in no way approved their use of the name and/or methodology on the site despite the fact that this is left very unclear by the operators of the site you mentioned.
Question 20. In the FAQ section of the Magic Formula Investing web site, you mention that you "have made some common sense adjustements to simple measures of earnings yield and return on capital." Would you please let us know what these adjustments are? (htcoleman)
JG: These adjustments appear on pages 138-144 of the Little Book.
Question 21. Do you anticipate that the formation and operation of Formula Trading will have a negative impact on the investment results of individual investors following the Magic Formula? Why or why not? (htcoleman)
JG: I have no concerns that FormulaTrading.com (soon to be renamed FormulaInvesting.com) will have an impact on future results of the Magic Formula. The formula appears to be very robust at all market cap levels including the largest market caps. Once again, the secret to success in following the formula strategy is patience, a quality in short supply for both professionals and individual investors alike.
Question 22. Why hold each security for only 1 year if it can take a few years to recognize the value of a business? Why not hold for 2-3 years or more? Did you figure the returns on the MagicFormula based on a holding period of longer than 1 year and if yes, what are the results? If no, can you do the calculations and give the results? (hgoldhagen)
JG: A holding period of more than one year also works quite well as the factors are persistent in years 2 and 3. One year was selected because of the relative simplicity and tax purposes.
Question 23. The MagicFormula screener spits out stocks ranked against each other. So, if the market as a whole is overvalued, the best ranked stock may just be the least overvalued and may not be cheap compared to its intrinsic value. Is there another screener that can be added to determine if the stock is actually priced at discount to intrinsic value without having to know how to value a company? Is it better to hold more cash when the market as a whole is overvalued until a correction occurs rather than continuing to invest in MagicFormula securities? (hgoldhagen)
JG: I think the Magic Formula should be thought of as an alternative to other investments in the stock market not for making timing decisions.
Question 24. In your book The Little Book that Beats the Market, you alluded to the dramatic under-performance of a certain investor's 2 strategies in the few years after he published a book on those strategies. Do you think it's a coincidence that the few years following the publishing of your book have been difficult times for adherents of the Magic Formula as well? Is it possible that, by the time someone decides to write a book on an investment strategy, that strategy is typically due for a period of underperformance? (DaveinHackensack)
JG: A new updated study should be published at FormulaInvesting.com soon.
Question 25. Do you think the macro economics important in value investing? 2008 seems to prove that micro economics is extremely important. (valueradar)
JG: I think investors should have a large portion of their assets in equities over time. I don’t know too many people that are good at timing the market relative to macro-economic events. I think time horizon (which will be partially affected by a person’s age) should affect your allocation to equities. Over the last 10 years, while the market index has not performed well, the magic formula has continued to perform well on an absolute and relative basis.
Question 26. 2008 was a bad year for value managers. A lot of very respectable value managers lost around 50% or even more, and had permanent losses. What do you think went wrong with value investing? (valueradar)
JG: Warren Buffett always said that investors should be prepared to lose 50% on their investments in the stock market at any particular time, last year was apparently such a time. So, investors should probably keep this in mind along with their expected time horizon when making allocations to equities. On the other hand, after a year like 2008, there are probably many more opportunities in the equities markets than before.
Question 27. Is your involvement in Formula Trading an attempt to bring your Magic Formula Investing methodology to the mass? (guruek)
JG: Over the past 4 years, I have been approached many times by people asking me for a simple and cheap way to implement the Magic Formula strategy. So after I met Blake Darcy, the founder of DLJdirect, I thought we had a chance to create such a way. The result was FormulaInvesting.com and I do hope it helps individual investors pursue the Magic Formula strategy. The firm allows investors to choose from a list of Magic Formula stocks and to buy them all at once with one click or to have the firm just do the whole process for them.
About the author:
Sascha Seiler is a Finance student in Stuttgart, Germany besides working for a major german bank. Simply trying to buy fractions of wonderful businesses that are run by able people - at fair prices - and then holding on to them forever. This practically means cloning Mr. Buffetts framework. Investment blog (in german): www.intelligentinvestieren.blogspot.com