Joel Greenblatt (Trades, Portfolio) is a legendary value investor who is famous for his Magic Formula, which first appeared in “The Little Book Which Beats the Market." The Investor developed a simple but systematic method which beat the market consistently for over a decade based on his calculations.
In a rare interview in 2022 on The Investor's Podcast, Greenblatt discussed past investing mistakes and his magic formula and revealed his tips for investment success this year. Here are my top takeaways and commentary from the interview, let’s dive in.
The Magic Formula
For some background, Greenblatt pioneered the Magic Formula, which is a systematic way to find “good” and “cheap” stocks. From Warren Buffett (Trades, Portfolio)’s letters, he discovered that companies with high returns on tangible capital were considered to be “good” companies. The focus on “tangible” capital is very important as the intangibles are usually accounting placeholders such as goodwill after an acquisition, which aren’t really part of intrinsic value.
Greenblatt then combined this metric with companies trading at a low price-earnings ratios and several other factors. Greenblatt backtested the full formula in the year 2000, going back to 1987, and it turned out it generated great returns of ~20% per year, which is fantastic and beat the market return of ~9.8%.
How does Greenblatt invest his own money?
In the podcast, Greenblatt said he uses his quantitative approach, which focuses on growth and value, but also takes things one step further with a long/short approach. This involves buying a basket of stocks that you think will increase in value in addition to short selling stocks which are overvalued with deteriorating fundamentals.
Interestingly, Greenblatt also revealed he has a few “highly concentrated positions” in big name companies like “Google (GOOG, Financial)(GOOGL, Financial), Amazon (AMZN, Financial), Microsoft (MSFT, Financial),” which he believes are all a "long term buy and hold” as they are “incredible companies which aren’t fully priced."
Stock market predictions
Using his analysis, Greenblatt believes the S&P 500 will only return mid-single-digit returns moving forward. But he believes a growth and value method of buying stocks is likely to earn 30% to 40% annual returns, which would be incredible.
Greenblatt started his career focusing on spin-offs, mergers and acquisitions. This is a very lucrative field of investing, but it is also challenging as it requires a timely catalyst. When investing, mistakes are commonplace, and even Greenblatt openly admits to making many mistakes in the past and taking a lot of risks. He states candidly, “If I worked for someone else, they would have fired me."
An example of one such mistake was an investment into Florida Cypress Gardens. This seemed like a great investment on paper, but a rare “black swan” event took Greenblatt by surprise. The entire pavilion “fell into a sinkhole” according to Greenblatt, which is a large cavity that appears in the ground as a result of erosion beneath the surface. This taught Greenblatt that “things can happen which you don’t expect” when investing, and he believes “experience is what you get when you didn’t get what you wanted." In order to handicap tail risk events such as this, Greenblatt suggests not putting all your eggs in one basket and diversifying. The goal is to survive and “be able to play another day... In the investment business it’s not about how many hours you showed up, it’s the quality of your thought."
Is a focused portfolio too risky?
Greenblatt believes a one-stock portfolio is “too risky”, but paraphrasing a statement by Warren Buffett (Trades, Portfolio). Let’s say you sold your business for $1 million and then looked around town for new investments. You identified 6 to 8 quality businesses with great management and they could be bought at a good price. Then really that “isn’t risky”, as you have divided your “$1 million into these 6 to 8 businesses”. This may seem risky to some people if you think of them as “stocks” which are these “pieces of paper which bounce around and give you daily quotes”. But instead, if you think of them as real “businesses” and you are a businessman with a 3 to 5-year time horizon, then “nobody would think you are crazy, they would think you are pretty prudent” according to Greenblatt.
Thus the goal with diversification is to balance multiple investments, which businesses you can track easily and have knowledge of. For example, if you have a 100 stock portfolio it would be very difficult to track each business even for a full time investor.
Greenblatt believes it also makes sense to invest more into stocks, where you have a better risk/reward profile and a larger “margin of safety”. A “margin of safety” is an engineering term commonly used by Warren Buffett (Trades, Portfolio) when investing. Basically, this means only buying a stock that is significantly cheaper than its intrinsic value, in order to account for errors and unforseen circumstances.
Emotions and Investing
Investing is not just about numbers, it is also about self awareness and the ability to manage your emotions.
Controlling your emotions when investing can be a challenge. Greenblatt believes “Portfolio managers get paid for having a strong stomach”. However, he does state that he is “only human” and he does feel bad for a few days after losing money on an investment. But tries to keep perspective, think clear, and focus on buying if the stock market is down.
Conversely, he believes without the volatility of the stock market it would also be difficult to find opportunities. This leads to my favorite quote, which I say regularly on my Youtube Channel (Motivation 2 Invest) and that is “Volatility = Opportunity”. In addition, to the great quote by Peter Lynch “The most important thing in investing is to know what you own”. Joel Greenblatt (Trades, Portfolio) follows on from this, as if you know what you own you are less worried when the stock market gives you a bad price quote, as you understand the business and its true value.
Importance of Thinking Probabilistically
Investing is a game of chance, odds and probabilities. Greenblatt believes great investors are “always calculating the odds”. The goal really is to look for investments with an asymmetric risk/reward profile. For example, if you have a 10% chance of losing money, but can gain 5 times your money if right, that is a great investment.
It also ties back into valuation, as if you are able to value something with conservative estimates, you can identify the potential loss or gain. For example, if a stock is 90% undervalued, the upside is 90%.
Is Bitcoin a good Investment?
Joel Greenblatt (Trades, Portfolio) stated the obvious that Bitcoin or gold has “no earnings” and thus is very difficult to value. “People could make money speculating” but “I have no intelligent way to value it”. Paraphrasing Warren Buffett (Trades, Portfolio) “I would put it on the too hard pile” and he also looks for “one foot hurdles” like Buffett.
The powerful lesson is the discipline to play games where you are equipped to win and have an advantage. This all goes back to the core principles of understanding your circle of competence and the game you can play to win. For bets, that are more speculative such as Bitcoin, Greenblatt suggests; “sizing your bets appropriately” or even having a small speculative portfolio.
Fair to Wonderful Businesses
In a similar manner to Warren Buffett (Trades, Portfolio), Greenblatt went through the process of first focusing on deep value or cheap stocks before transitioning to buying “wonderful businesses”. Greenblatt’s evolved strategy aims to buy both “cheap and good” investments.
He even reverse-engineered Buffett’s purchase of Coca-Cola and used it as justification to pay more for Moody’s stock. Credit rating agency Moody’s is a low capex business with a brand, and franchise and was the first company Joel ever paid over 30 times earnings for. Greenblatt believes “original thinking is overrated” and by thinking like Warren Buffett (Trades, Portfolio), “one of the greatest investors in the world”, he was able to make a great investment.
Importance of Having a Business Partner
Joel Greenblatt (Trades, Portfolio) states the importance of having someone to bounce investing ideas off. For Warren Buffett (Trades, Portfolio), it’s Charlie Munger (Trades, Portfolio), who Buffett jokily calls the “abominable noman” as Munger tends to say “no” to every investment idea. Often we can get trapped in our own thought process and although this is good for independent thinking, it can also cause us to become overly focused on a single method. Whereas multiple perspectives and ideas, can open up new avenues of thinking and help to fill in our blind spots.
Joel knows many people who are successful but less accomplished and don’t have the qualities Buffett has. Greenblatt also admires Buffett’s ability to simplify complex concepts in order to communicate better. From his experience teaching and writing Books, Greenblatt has learned the skill to simplify complex topics to make it accessible to others. Quoting Albert Einstein;
“Everything should be made as simple as possible but not simpler” .
Joel Greenblatt (Trades, Portfolio) is a legendary value investor who looks to be just getting into his stride. His magic formula is simple, yet powerful and he has learned from the master himself Warren Buffett (Trades, Portfolio). Greenblatt has found something he “loves” and suggests others do the same to become great at something and live a happy and fulfilled lifestyle.