MI381: Joel Greenblatt: Behind the Magic Formula w/ Shawn O’Malley

24:21The catalog was earning around$180 million of revenue per year, and a partnership with Buyer's Club where paid members could get special discounts on Sportsman's Guide's products was really boosting business. Much of the company's value also came from its database of 5.2 million customers, where they knew their customers well because 85 % of sales came from recurring shoppers. On top of that, its competitive advantage lied in offering 25 % to 60 % discounts for items relative to normal retail pricing, which they could offer because their buying agents would comb through vast quantities of discounted or overstocked items from a network of over 1 ,200 suppliers.

24:59All that sounds pretty good. And the most exciting part was that the company could save millions of dollars a year from printing and shipping its catalogs by migrating its offerings to being solely shown online. This was obviously the early days of online retailing, but in five years, Sportsman Guide's online sales went from just$1 million per year to$53 million. Thanks to the internet, a major source of SGDE's operating costs were being phased out. And the catalyst for the stock's price, as it often is, was a recently announced share repurchase program where the company planned to buy back 10 % of its outstanding stock, presumably because management also recognized that the stock's market price didn't reflect its value.

25:40What's not to love about a debt-free, cheaply priced, profitable company phasing out one of its biggest operating expenses, massively buying back stock, and gaining traction with online sales? Even though I know this was a real opportunity that anyone had the chance to read about at the time for free on the VIC forum, it just still sounds too good to be true. However, as Greenblatt frames it, the thesis is pretty straightforward, and it doesn't take a genius to see the opportunity here. Sometimes it's really as simple as just saying that coming out of the dot-com bubble, this was a time when there were a ton of cheap stocks to buy, which means some will slip through the cracks longer than others.

26:19Given it was such a small business with few shares trading publicly and was transitioning to more online sales at a time when markets had been spooked by a bunch of hyped up internet stocks in the 90s going bust, that contributed to the stock price dwindling on a level that seems like a no-brainer in hindsight. From the time it was pitched, SGD stock rose about four times over the next two years, which is a pretty nice return on investment that I'd be more than satisfied with. In reflecting on the three case studies we've gone over so far, Greenblatt tells the students that what matters is in seeing what management is going to do with the earnings they've generated.

26:52From a shareholder perspective, companies can earn as much income as they want, but if management wasted away, then it was all for nothing, at least from a shareholder's perspective. Ongoing profitability combined with share repurchases, where investors could know that at least some of those earnings would be returned to them, is a pretty good start for an investment case, as we saw with SGDE. He says, quote, what your perception of management is and what they're going to be doing with earnings is very important. He goes on to say that with each of these opportunities, any investor with enough practice would have easily been able to recognize how attractive they were.

27:27It's almost a know it when you see it type of thing when it comes to the best types of investment opportunities. What's cool about these examples is that I don't think it takes a ton of experience to see why they worked out. You've seen for yourself now, but there really are instances and markets of hugely winning investments that were not only possible to find, but also reasonably understandable, especially among small and microcap stocks. Here's a little snippet from Greenblatt's lecture to make the point. None of this was taking something to the 37th decimal point. This was all like, this is so cheap, right?

28:01If I'm even close to right, this is so cheap, I'll make money. And if I'm not right, it's going to be hard for me to lose money. So those are all underlying themes to this. And the whole construct of what's been taught generally in business schools over the last 40 years about efficient markets and beta, I know you're in the value investing program, so you've already dismissed that already. But it just seems so ridiculous when you can look for opportunities, and it's the same guy time and time again. And speaking of the same guy, you know, second part of the class where you get to win your Warren Buffett cartoon book is the same guy who time and time again has a certain theme, certain things that he looks for in investment, certain qualities of a business that he's looking for that can make you money.

28:56And the funny thing is, we're going to talk about Buffett, and I'm sure you're all sick of, you know, I mean, you all feel, you know, pretty knowledgeable about Buffett. But I can tell you this, as many times as I read it, I keep saying, oh, yeah, I have to remember that every time I read it. So the more that you pound, and I've been doing this for, you know, unfortunately a long time. Greenblatt continues his lecture by leading students through an exercise where he role plays as Warren Buffett as they throw questions at him related to the case studies on NVR, NII, and SGDE. He discusses the importance of management and how management's actions will speak for themselves.

29:35With the homebuilder NVR that we went over, Greenblatt says it was clear that management was thinking with the shareholders' best interests in mind because they were shareholders too, with large stakes in the company, especially after they'd overseen the company's buybacks in the past five years that repurchased more than half of NVR's outstanding stock. I'd add to that just to say that listening to management talk can be a tricky business because to rise to the top of the ranks in corporate America, you probably have to be an unbelievably charismatic person. So any half-decent CEO of a publicly traded company should be able to sell you on their vision for the company because that's their job.

30:12Rather than giving them a chance to bias you, I wouldn't necessarily suggest not to listen to what management has to say on earnings calls or in interviews, but take it with a grain of salt compared to what the numbers are telling you. If a CEO says their company is the best in the business, but you can tell from looking at the numbers that they've lagged their competitors and generating returns in capital, then obviously their claims don't pass the smell test. And if management says they're thinking like shareholders, but they don't actually own any stock in the company they're running or aren't returning capital to shareholders through dividends and buybacks, then you can really just use the numbers again to call their bluff.

30:46Every situation is different, but again, Greenblatt loves to find no-brainer investments where you don't have to debate the merits of an investment ad nauseum because it's sitting in some gray area. With NVR, for example, at least with respect to management, just by looking at the numbers for return on capital and share buybacks, you could have felt pretty confident that they knew what they were doing, which removes one less variable of concern for you as an investor. He continues into a really interesting conversation on how to think about earning back returns, which we've discussed a bit already.

31:15A lot of times people look for specific catalyst to drive returns like buybacks, new product launches, or management changes. But sometimes it can be as simple as a company just delivering the earnings that you expected it to and the market catching up to your outlook. For example, if you expected Walmart's earnings to grow at 15 % per year for the next five years, you might expect its stock to follow the same trajectory and also grow at 15 % per year, which after five years would mean it's going to double from say$10 to$20 per share. Rather than having to wait that entire five-year period though to double your investment, because markets are forward-looking, those higher earnings would eventually get priced in and 30 % to 50 % of the 100 % returns to be earned over five years might come in the first 12 months.

32:00And once you've pulled forward a bunch of those returns, rather than holding for another four years, you might look somewhere else for another opportunity to double your money. The message here, which I think really bears repeating, is not only that markets can correct sharply to price in new information, but that when they do correct, that pulls forward returns from the future, which means anyone buying in after that upward correction would be implicitly accepting a lower rate of expected return. If a stock you expect to go from$10 today to$20 after five years sees a 35 % return in the first year as the market catches up to a higher earnings growth outlook, expected returns fall from 15 % per year initially to 10 % per year.

32:42There's still meat on the bone there, but for investors trying to beat the market, they'd probably lock in that 35 % gain after 12 months and look elsewhere, since 10 % expected returns per year going forward doesn't really offer enough upside. Let's take a quick break and hear from today's sponsors. Hey, it's Sean O'Malley, just popping in with a quick message. If you like this podcast, well, I've got great news for you. We've got a handful of other shows for you to explore, from learning about Bitcoin to embracing a richer, wiser, happier lifestyle. Just go into your podcast app and type in We Study Billionaires to find our collection of shows.

33:18We Study Billionaires is our flagship podcast, and we've made a name for ourselves over the years by interviewing the best investors in the world, including Ray Dalio, Howard Marks, Joel Greenblatt, and many, many more. My colleagues, Stig Brodersen, Clay Fink, Kyle Grieve, Preston Pysh, and William Green each hosts their own We Study Billionaires episodes and bring their own unique perspectives. A whole new world of insights awaits you. Just go ahead and type in We Study Billionaires into your podcast app and see what you've been missing out on. Seriously, go ahead. I promise you'll like what you find.

33:51Bonus points if you show your support for our work by clicking follow. If something piques your interest, just start listening. No hard feelings. I'll be waiting for you back here. Just like everybody else, there was a time when I was a beginner investor, and I have to say, investing is particularly filled with jargon that can just make it so difficult for new investors to understand what is going on. But it's never too late to get smarter about stock investing from the ground up. At The Investors Podcast Network, we've made a habit of studying the world's best investors, and now I'm distilling those learnings into a simple course for you, or for anyone in your life who you might want to share the gift of knowledge with.

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36:20All right, back to the show. This is how legend investors like Greenblatt think through investment opportunities. Not only are they excellent at digging into companies' financials and understanding their situations, but they're also able to think strategically about the expected return going forward and how market fluctuations change those expected returns. Continuing on in his lectures, it's fascinating to see what is effectively an early preview of the so-called magic formula for investing that we talked about at the top of the show, and that which defined Greenblatt's famous book on beating markets.

36:52He outlines how in compiling studies for the book, over basically any period in any market in any country, you can rank stocks by deciles according to their cheapness, and that directly corresponds to the ranking for their returns over a certain following period. So the top decile of cheapest stocks, sorted by their price-to-earnings ratio, end up with the best returns. The second decile of cheapest stocks have the second best returns, all the way down to the most expensive stocks, which have the worst returns. The question is, why does buying cheap continue to work across time? Greenblatt explains to his students that before he even started as a professional investor in the 1970s, he saw studies on cheap stocks outperforming, and even so, buying them continued to work for him throughout his career.

37:36Although it would seem that as a teacher and author, Greenblatt is giving away his secret sauce, he claims that teaching and writing are immensely valuable to him because they challenge him to think through his investment decisions more meaningfully. He also isn't worried that his strategies will stop working if he shares them with the public. He says the world is a big place and there are plenty of companies to invest in. The bigger reason is that there's a fundamental reason cheap stocks exist. Firstly, cheapness is relative, and there will always be a decile of the cheapest stocks to invest in.

38:08Secondly, cheap stocks exist because there are real reasons to dislike them. If you filter down the US stock market down to the companies with the lowest PE ratios, you get a bunch of unloved names, quite literally companies that nobody wants to own. Maybe they're tobacco or gun companies. Maybe they've gotten a ton of bad press and are laying off staff, or maybe they just have a big headwind that's going to suppress profits for two quarters. Whatever it is, these are companies that investors have decided that, in this moment, they don't want to have them in their portfolio. And while Greenblatt has shown you can do well from simply buying the cheapest deciles of stocks and holding them for a few years, you can do even better by digging into these lists of cheap stocks and determining which companies are facing permanent headwinds and which ones are facing only temporary challenges.

38:52Cheap stocks come from people owning them when they were, well, not cheap stocks, and selling them out of frustration or panic over some turbulence in the company's future, leaving them temporarily discounted enough to attract folks like Greenblatt to check them out further. To make this point even more, in a talk before the CFA Society of Chicago in 2019, Greenblatt explains how he taught the shortcomings of the stock market to a group of teenagers in Harlem. He filled up a jar with jelly beans and asked the students on their own to calculate how many they thought were in the jar, and then submit their answer independently on a note card.

39:25Then he asked the students to go around one by one and say their answers out loud, with the caveat that they could either keep their original answer submission or change their answer based on what others had said. When these students thought critically on their own, their average answer was 1 ,771 jellybeans, which was actually just five away from the correct answer. Yet, when these students gave answers allowed and were biased by what others had said, the average answer fell to 870 jellybeans. As Greenblatt puts it, the stock market is the latter scenario, where investors are hugely biased by what their colleagues have said, what they've read in the newspaper, the headlines they see on TV, and so on.

40:05His approach then is to try and be as independent as possible, covering his ears and blocking out all the noise that can blind him from accurately estimating, as the metaphor goes, the number of jelly beans in the jar. What I love about Greenblatt is that while he acknowledges the nuances and difficulty of investing, he's also open about the fact that it doesn't have to be rocket science. Simple principles like buying the cheapest decile of stocks, filtering them down further by quality, and selling them after a year or two or continuing to hold the truly rare but cheap quality compounders like the HomeBuilder and VR will work pretty well for you.

40:42To some extent, it's a question of having the courage and patience to buy unloved stocks. When everyone is telling you that Intel is imploding and irrelevant in the age of AI, can you really disregard that sentiment and buy the stock? Or will you second guess yourself enough that you wait to see what happens and then the stock bounces back 20 % and the opportunity is mostly gone? I use Intel because it's a timely example of a well-known company that has self destructed this year, but also bounced back from its lows after hitting some truly cheap valuation levels where there's little room for things to get much worse and a lot of upside if the outlook even modestly improves.

41:20After we've followed Greenblatt through three separate case studies, originally pitched by this Charlie479 guy, you might be wondering who he is. That is, the investor who pitched NVR, NII, and SGDE on the Value Investors Club forum. For the sake of simplicity and out of respect for his privacy, I'll continue to refer to this investor as Charlie, but I can tell you a bit more about him if you're curious. After becoming something of a legend on the Value Investors Club forum for his posts, the pseudonymous Charlie479's last post was in early 2009. So unfortunately, he's not still posting winning ideas that we can study or clone.

41:56But we do know that he was and probably still is close friends with Joel Greenblatt and reportedly earned returns of 38 % per year from 1994 through 2003 as a money manager. And with Greenblatt's help, Charlie started an investment fund called Punch Card Capital with around$100 million in assets under management that, at least through 2011, was outperforming the S &P 500 by 12 percentage points per year. If you're really curious to learn more about Charlie479 and his firm Punch Card Capital, in the show notes, I'll link to his only public interview ever from 2011 for you to check out. The name Punch Card Capital is inspired by Warren Buffett's punch card analogy.

42:36Quoting Buffett, the analogy goes as follows. I always tell students in business school they'd be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision, they used up one of their punches because they aren't going to get 20 great ideas in their lifetime. They're going to get five or three or seven, and you can get rich off five or three or seven. But what you can't get rich doing is trying to get one every day. As of earlier this year, disclosures from Punchcard Capital revealed at least four of its holdings, which unsurprisingly included Berkshire Hathaway, but also Ally Financial, Winnebago Industries, and Smith & Wesson.

43:15Because Charlie479 has already contributed so much to this episode and obviously thinks about investing similar to Greenblatt, I want to share a passage from another of his posts addressing the tension between buying cheap stocks and buying high-quality compounders, which is something I've covered at length in last week's episode and in the week before. He's referencing his 2001 pitch on windmill and company ticker WNMLA, where the company had more net cash per share than the stock's current price, meaning the company could be simply liquidated and shareholders would immediately roughly double their money.

43:48There was effectively zero downside, not reduced downside, but again, essentially none. These types of opportunities are known as cigar butt stocks because they're usually dying companies where you can get one last puff of profit out of them since they're just ludicrously cheap, and they're exactly the types of opportunities that both Warren Buffett and Joel Greenblatt made a living on, especially in their early days. Charlie 479 writes, quote, It is always amazing to me how many people will turn down the chance to buy$1 of cash for 40 because they say you'll never see the full value of it. The main reason these types of companies sell at those prices is because most folks won't touch them until they think they have the scoop that the company is about to be sold.

44:29There is a shortage of investors that are willing to be patient and wait for the 45 cents to be liquidated into a dollar. This creates the opportunity. He adds, quote, I'm happy to buy dollar bills for 45 cents and wait for payday to come around as long as there is no cash burn and there are signs that management is headed in the right direction. As long as I know that I have more than$2 of net cash behind each$1 I put up, and that there are certain clues as to a potential payoff, it's not a terrible proposition. Charlie continues by saying, WNMLA is a cigar butt. Cigar butts are inferior to great operating companies with defensible market positions, generating 25 % returns on invested capital and selling at 8XPE like NVR.

45:11However, there are extremely few of these high quality companies that are trading for such low values. Coke is a great company, but fully priced. Ditto from Moody's, American Express, etc. The companies that don't have high multiples are usually average businesses that will produce average long-term rates of return on capital. Look at the Value Investors Club board. It is littered with low PEE stocks with either unexciting returns on equity or very high leverage. I'd say that the WNMLA cigar butt types of stocks have better risk reward than both of these two types of low PE average businesses.

45:47I'd prefer to let cash sit in these asset rich situations until some of the great operating companies fall back down to 10 times price to earnings ratios. Charlie's comments here shed light on how he thought about the balance between cheap cigar butt stocks like WNMLA, which he saw as a substitute for cash with some upside potential versus investments that compound intrinsic value over time like NVR, which are what he prefers most. For instance, take a look at the chart of NVR and WNMLA, which you can see if you're watching this podcast on YouTube. To summarize it briefly, it is up and to the right for NVR, outpacing the S &P 500, while the cigar-bought stock WNMLA offered periods of upside, but otherwise mostly preserved value with flat returns.

46:32The stock prices correspond to intrinsic value over time, and over time, NVR has compounded intrinsic value while WNMLA has not. But that doesn't mean that at 45 cents on the dollar, which is effectively what an investor in WNMLA in 2001 would have gotten, was a bad investment. Basically, Charlie479 says he likes great businesses at low prices, but those are hard to find. So in the meantime, if he can invest in a money market fund, a cigar butt stock with a possible 100 % upside, he's more than happy to do it. While many of the investors on the Value Investors Club are quite savvy, and Charlie479 is probably one of the best to ever post there.

47:09There are a lot of recommendations there for companies that produce mediocre returns on capital, yet sell at modest prices of, say, 12 times earnings. These aren't always bad ideas, but the majority of them will lead to just average results. The real outstanding returns come from identifying the relatively few truly undervalued situations, whether from an average business selling for half of net cash like WNMLA, or an exceptional business selling at a single digit earnings multiple like NDR. So we've spent a lot of time today going through some wonderful investments and match your formulas for investing and all that good stuff.

47:45But for good measure, I want to go over the story of what Joel Greenblatt told his students was his worst investment ever. As so many terrible investments do, everything looks good on paper for what it's worth. The company was growing, had impressive returns in capital, and he was wooed by management after an executive painted a rosy but seemingly realistic picture of the future. In a nutshell, it was a company that hosted trade shows in Las Vegas. At the turn of the 21st century, there were thousands of companies in the computing and internet industries willing to sign up to participate in trade shows and show off their offerings to prospective customers.

48:18And this company was essentially the organizer for those events. They'd pay for a few hundred thousand square feet of space on the Vegas Strip for around$2 per square foot, and then turn around and rent out the space for the trade show at a cost of$60 per square foot. But they didn't own the real estate and they could easily rent more as these shows expanded. Thus, they had massive operating leverage, meaning that they didn't have a ton of costs that scaled up. If they were able to rent out the space for trade shows at more than$60 per square foot, those incremental gains would almost entirely ripple down to their bottom line.

48:51And as more and more computer hardware and software companies arose to take advantage of the internet boom, the trade shows would probably only grow bigger and bigger each year, especially now that the former head of Ticketmaster was taking over the operation that had been managed previously by a Japanese company, which was not really paying attention to it enough as it should have. At least that was the idea for GreenBot's thesis here. It seemed like a no-brainer. The company was an intermediary, seemingly best positioned to benefit from the secular rise in the internet. With the business being immensely profitable and having plenty of space in Las Vegas to expand into more and more bigger trade shows, there was a pretty strong case for the company being able to continue generating excellent returns for shareholders.

49:33Obviously, that's not what happened. And as Greenblatt points out, operating leverage can work both ways, boosting profitability as the business expands and cutting profits quickly if the size of the trade shows contracts or the rates they can charge to rent the space narrow. Operating leverage, if you're not familiar with the term, can come about in a few different ways, but it's similar to the concept of economies of scale. A company with economies of scale advantages can spread out fixed costs and capture a higher percentage of profit with incremental sales, and they correspondingly have high operating leverage.

50:05Put differently, operating leverage refers to how much operating profits change due to changes in sales, and this company had a lot of it, which is normally seen as a good thing. After hype around the internet peaked, interest in trade shows fell off, and they got smaller and smaller until the company finally went bankrupt. As Greenblatt puts it, for every foot the trade shows shrank, $60 subtracted from the bottom line. Strong past returns, attractive unit economics, and a plausible outlook for growth were not enough to save the company. His position in the company fell from$12 per share to$1 per share before Greenblatt was able to get out, which just goes to show even great investors can fall for misleading stories about a company even when everything looks good on paper.

50:49As Greenblatt says, there were many times along the way where we could have gotten out with a profit, yet we compounded our mistakes by waking up too late. To wrap things up today, I'll just say that it's an incredible resource to have Greenblatt's lectures available on YouTube, and I'll link to a playlist of them so you can watch them for free if you're interested. Greenblatt has the rare combination of investing brilliance, interest in sharing his learnings, and an intuitive ability to distill complicated financial information into digestible insights. I would, of course, also recommend his books to learn more about the magic formula, in addition to checking out our interview directly with Greenblatt on our We Study Billionaires and Richer, Wiser, Happier podcast, which I'll also link to below.

51:33If you take anything away from this episode, I hope it's to pick up the habit of frequently reading through the Value Investors Club forum. You'll probably find some wonderful investment ideas, and at worst, you'll learn a lot about how to think through investment opportunities. As a final note, I'd like to, in the spirit of today's theme, in the episode with one last quote from Joel Greenblatt. He tells us the following, quote, choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match. You may live, but you're still an idiot.

52:06Please don't be an idiot running through a dynamite factory with a burning match. Know what you're looking for. And if you don't already know, I've shared some resources today that will more than point you in the right direction. With that, I hope you enjoyed today's episode and I'll see you again next week.

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