Gotham Asset Management founder Joel Greenblatt (Trades, Portfolio) is no stranger to the investor education business. His well known books, "The Little Book That Beats The Market" and "You Can Be A Stock Market Genius" have both been received very well by investors and are excellent primers for aspiring capital allocators.
In a conversation with Oaktree Capital's Howard Marks (Trades, Portfolio) at the Wharton School of Business, Greenblatt talked about his own development as an investor and about how he went from "risking $10 to make $1" to becoming a deep value investor.
A better way to invest
Greenblatt got his start on Wall Street working for a type of investment vehicle that today would be called a hedge fund (at the time, no such nomenclature existed), which made its money doing merger arbitrage. Merger arbitrage is a strategy where an investor buys a company that is in the process of being bought out by another business, in the expectation that the acquiring side will pay more for it than it is worth.
If company A is trading for $10 a share, company B might offer to acquire it for $16 a share. Typically, shares of company A will rise after such an announcement - say, to $15. The $1 difference results from the uncertainty over whether or not the deal will go through. If it does, the arbitrageur will realize a $1 per share profit. If it falls through, the stock price is likely to fall significantly. This is what Greenblatt referred to as "risking $10 to make $1" - the reward of this process is small relative to the assumed risk (unless you are very good at predicting the results of mergers).
So Greenblatt started to look for opportunities with a better risk-reward ratio:
"I started looking for other ways to invest. I looked for mergers that had interesting securities coming off the way they were paying for the merger. I looked for extraordinary events happening within companies - recapitalizations, spin-offs, or anything where I could get out of the business where I could make a dollar and lose ten or fifteen. So I was just looking for things that were off the beaten path...I started reading everything that Benjamin Graham wrote, and started looking at the world through a different lens."
Instead of trying to earn $1 of value for every $10 of risk, Greenblatt decided to look for special situations were stocks were selling for less than their intrinsic value, at a large enough discount to guarantee a wide margin of safety. He found that this approach yielded far better results - since its creation in 1985, Gotham has grown from $7 million in assets under management to over $3.3 billion.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Warren Buffett Explains the Dangers of Using Options
- Jim Chanos Thinks Commercial Real Estate Is in Trouble​
- The Value Investor's Handbook: 3 More Warning Signs for Investors
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