Joel Greenblatt

Biography

Joel Greenblatt (born December 13, 1957) is an American academic, hedge fund manager, investor, and writer. He is a value investor, alumnus of the Wharton School of the University of Pennsylvania, and adjunct professor at the Columbia University Graduate School of Business. He runs Gotham Funds with his partner, Robert Goldstein. He is the former chairman of the board of Alliant Techsystems (1994-1995) and founder of the New York Securities Auction Corporation. He is also a director at Pzena Investment Management, a high-end value firm.

In 1985, Greenblatt started a hedge fund, Gotham Capital, with $7 million, most of which was provided by junk-bond king Michael Milken. Robert Goldstein joined Gotham Capital in 1989. Through his firm Gotham Capital, Greenblatt presided over an annualized return of 50% (“after all expenses” but “before general partner’s incentive allocation” fees) or 30% (net of fees) from 1985 to 1994 by investing in “”special situations” like spinoffs and other corporate restructurings”. In January 1995 Gotham returned all capital of outside partners (approximately $500 million).

From 1995 to 2009 Gotham Capital was closed to outside investors.

In 2000 Gotham Capital, for its first time, helped Michael Burry creating his hedge fund Scion Capital by buying 25% of its capital for one million dollars after taxes. In October 2006, Gotham’s investment in the funds managed by Scion amounted to $100 million. Gotham Capital and other investors wanted their money back but this was prevented by Michael Burry who decided to side pocket (block) between 50 and 55 percent of it, an amount corresponding to his Credit Default Swap short bet which was losing money. Gotham Capital threatened to sue Michael Burry because it was “wildly unconventional to side-pocket an investment for which there was obviously a market”. On “August 31, 2007, Michael Burry lifted the side pocket and began to unload his own credit default swaps” which was now a very profitable bet. The Scion Capital fund was up more than 100 percent. Gotham exited its investments, both in the managed funds by Scion Capital and as a shareholder.

In 2008 Gotham Asset Management, LLC is created as “the successor to the investment advisory business of Gotham Capital”. In 2010, Gotham started four conventional mutual funds raising $360 million. In January 2014, the mutual funds managed $1 billion.  Due to new-money inflows this suddenly increased to $4.8 billion in October 2014 and briefly culminated to $13.1 billion in March 2015. As of November 2019 Gotham Asset Management, LLC manages $5.6 billion.

Investment principles

In the book “The Little Book that Still Beats The Market”, Joel Greenblatt focuses on his magic formula investing strategy that is based on two financial ratios- Return on capital and Earnings Yield. Let’s discuss each of these ratios.

1. Return on capital (ROC)

ROC is the ratio of the pre-tax operating earnings (EBIT) to tangible capital employed (Net working capital + Net fixed capital). It can be calculated by using the following formula: ROC = EBIT/ (Net working capital + Net Fixed capital).

Joel Greenblatt described why he used ROC in place of the commonly used financial ratios like ROE (Return on equity) or ROA (Return on assets). This is because, first of all, EBIT avoids the distortions arising from the differences in tax rates for different companies while comparing. Second, the net working capital plus net fixed capital is used in place of fixed assets as it actually tells how much capital is needed to conduct the working of the company’s business.

Overall, Return on capital tells how efficient the company is in turning your investments into profits.

2. Earnings Yield

Enterprise value is the market value of equity (including preferred shares) + net interest – bearing debt. Earning Yield can be calculated as: Earning yield = EBIT / Enterprise value.

This ratio tells how much money you can expect to make per year for each rupee you invest in the share.

In short, from the above two discussed financial rations, ROC tells how good is the company, and Earning yield tells how good is the price.

Next, here are the three steps suggested by the author Joel Greenblatt in his book ‘The little book that beats the market’ to find companies for investment:

  1. Find the earning yields and return on capitals of the stock to evaluate stocks.
  2. Rank the companies according to the above two factors and combine them to find the best companies for investment.
  3. Have patience and remain invested for the long term. Lack of patience is why people fail to implement the magic formula.

How to use magic formula using the above ratios?

  1. Find the Return on capital (ROC) and Earning yield (EY) for all the companies.
  2. Sort all the companies in ranks by ROC.
  3. Sort all the companies in ranks by EY.
  4. Invest in the top 30 companies based on the combined factors.

Now, we try to find the companies with the lowest combined factor rank.

For example, for company A, although it ranks 1 for the Return on capital. However, its earning yield rank is quite low and that’s why it’s combined rank is quite high. On the other hand, for company E, both ROC and EY rank are decent and hence its combined rank is good for investment.

How to use the Magic Formula Investing Strategy efficiently?

The Magic Formula is based on the simple principle that if you buy good companies at cheap prices you are going to do well. In a note of caution, Greenblatt emphasizes that for the formula to work its magic it must be applied for a period of 5 years. The following are the steps to be followed in order to implement this strategy.

1. The very first step involves deciding the total amount that you want to invest along with the number of stocks. Greenblatt suggests creating a portfolio of 20-30 stocks.

2. The next step includes setting up an investment pattern for the period when you would buy the stocks. Greenblatt expects the investments to be bought in batches spread out through the year. I.e. if you plan on investing in 20 stocks you can plan of buying stocks in batches of 5 every 3 months. Or if you plan on investing in 21 stocks you can plan of buying stocks in batches of 7 every 4 months.

3. The next step is to try and allocate the predetermined total investment amount equally among the number of stocks selected. This means that if you have decided to invest in 20 stocks with a capital of $200,000,  then $10,000 must be spent on each stock.

4. Now we sort the companies in order to only include companies with a market capitalization of over $50 million, $100 million, or $200 million. This will depend on the risk an investor can stomach. On whether he would prefer to invest in stocks that have greater growth prospects in the lower Mcap or ones that are stable with higher Mcap.

5. Determine the company’s earnings yield, which is EBIT/EV.

6. Determine the company’s return on capital, which is EBIT/(net fixed assets + working capital).\

7. Based on the last two steps, rank the stocks according to earnings yield and return on capital. Once ranking them individually is on the 2 parameters is done, rank them based on the combined ranks of the two-parameter. This can be done by adding the ranks of stock in the 2 parameters.

8. Invest in the highest-ranked companies calculated whenever the predetermined dates to invest in the batches arrive.

9. Rebalance the portfolio once per year, selling losers 51 weeks after purchase and selling winners 53 weeks after purchase. This is for tax purposes, as losses can be considered for the same year, and stocks that gain are to be held for longer in order to benefit from the reduced Long term Capital Gain tax rate.

The two parameters used above i.e help us identify stocks that are of high value(earnings yield) and at the same time are below the average price(ROC).

Closing Thoughts

The Magic formula is a relatively simple investment strategy that is easy to understand. Its implementation, however, may take some toll. In order to ensure that it does not cause much of a hindrance, it is best that investors continuously keep recording.

This involves the plan and activity performed along with the appropriate dates. By doing so investors will avoid any confusion. These may arise regarding when they have to buy stocks and when they have to rebalance their portfolios. Happy Investing!

Results

Despite not being a well-known investor, the profitability that Joel Greenblatt (1957) has obtained has been practically unprecedented throughout history.

Over 16 years, it delivered a portfolio return of an exceptional 30.8% per year through its Gotham Funds.

In his book “The little book that beats the market”, he teaches us how to start properly in the stock market, in addition to detailing a magic formula, which consists of the combination of two very simple factors to consistently beat the market and win in the stock market: the EV and the ROC.