The transcript from this week’s MIB: Joel Greenblatt, Gotham Asset Mgmt is below.
You can stream/download the full conversation, including the podcast extras on iTunes, Bloomberg, Overcast, and Soundcloud. Our earlier podcasts can all be found on iTunes, Soundcloud, Overcast and Bloomberg.
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ANNOUNCER: This is Masters in Business with Barry Ritholtz results on Bloomberg Radio.
RITHOLTZ: This week on the podcast, what can I say? Joel Greenblatt, he is Wall Street royalty, he’s a legend in the hedge fund and mutual fund worlds, he ran a fund called Gotham Capital 10 consecutive years compounding it 50 percent a year, those numbers are just off the charts at the end of the decade, he returned money back to investors and said I’m just going to manage my own money for a while, thanks.
14 years later, He opens a mutual fund, Gotham Asset Management, his Index Plus was just rated the number one fund out of 1200 large-cap mutual funds, just astonishing, astonishing number, that fund is only three years old. It acts as a hedge fund alternative. You probably know the name Joel Greenblatt from his books. He tells the story of why “You Too Can Be A Stock Market Genius” was a terrible and accidental title as well as “The Little Book That Beats The Stock Market” “The Magic Formula” I’m going to shut up and say with no further ado, a fascinating conversation with Joel Greenblatt.
I’m Barry Ritholtz, you are listening to Masters in Business on Bloomberg Radio, my extra special guest this week is Joel Greenblatt, he is the managing principal and co-chief investment officer of Gotham Asset Management, the successor to Gotham Capital in a manner of speaking. He is also an adjunct professor at Columbia Business School where he teaches value and special situation investing. He is the author of numerous well-selling books, best-selling books, “You Can Be A Stock Market Genius”, “The Little Book That Beats The Market”, “The Big Secret For The Small Investor”, Joel Greenblatt, welcome to Bloomberg.
GREENBLATT: Thanks.
RITHOLTZ: So I’m excited to speak to you. I very vividly remember when you can be a stock market genius came out in the late 90s and exploded, it was sort of out of left field at least to me and just was suddenly a really, really big book, but let’s go back and start early.
So I have to ask the question from “You Can Be A Stock Market Genius,” what did going to the dog track teach you about investing?
GREENBLATT: Well I wrote up in the book that you know, the only place when I was younger, I kind of like gambling, and the only place that would let us sneak in was the dog track when I was on vacation in Florida and so I used to sneak in with my cousin and we got to place bets and have a good time and you know half the fun was sneaking in.
But we figured we really had the whole dog track thing nailed when we found a dog that had run its last race in 32 seconds and all the other dogs had run it in 44 seconds and we thought wow you know we really have a great dog; we need to bet on this thing.
RITHOLTZ: What where the odds?
GREENBLATT: We had you know very high odds, it was close to 99 to 1, I think, which I think is a size that they let it go and so we thought we to clean up and of course, we lost, you know that dog had been running a shorter race that’s why it only ran 32 seconds and so you sort of really have to know something when you’re betting and then the same thing for investing, you know, if you don’t know what you’re doing, it’s an, you know as they say, an expensive place to find out.
So the dog track, I think, was a nice lesson, losing you know $2 or $4 is a very cheap lesson for us.
RITHOLTZ: So you go to school at Wharton both undergrad and graduate, how did you find your way to Wall Street? What was your first job like?
GREENBLATT: Well I got a summer job on Wall Street first with Kidder Peabody in their research department and to tell you how long ago it was, we were adjusting financial statements for inflation, which doesn’t — probably wouldn’t be a big seller right now.
RITHOLTZ: For the younger listeners, tell us what is this inflation you speak of?
GREENBLATT: Well you know when you hold your dollars and it buys less and less each year, but less and less was like 6 percent or 8 percent, not you know half a percent or 1 percent of what we’ve become used to in the last 10 years or so.
RITHOLTZ: And what led you from research into the art of stock picking?
GREENBLATT: Well, junior year, I read an article actually in Forbes Magazine about Ben Graham’s stock picking formula, and it was really what they used to call net-net or stock selling below their liquidation value and it seems very simple to me because I was at Wharton at the time and they were learning efficient market theory and none of it resonated with me.
I was kind of like I said interested in gambling or at least speculating or figuring things out and then taking a calculated gamble and what they were telling me was don’t try, there were saying that no one can beat the market and the stock prices are efficient and just through simple observation looking at the newspaper and they used to have the 52-week high low prices in the newspaper, it seemed unreasonable that you know the fair price was 51 day and eight months later, it was 120, and that was pretty much every stock had that kind of range every year and it didn’t make sense to me that the fundamentals of the underlying businesses were actually changing that much.
And so when I read Ben Graham, sort of a light bulb went off just this little article and I started reading everything I could about what he had written, both security analysis and the intelligent investor, and eventually led my way to Warren Buffett and you know, sort of the rest is history, it’s a very good age, you know I was younger than 21 at the time you know junior year of college to recognize that this was what I was going to be doing the rest my life.
RITHOLTZ: So let’s talk a little about value investing since you mentioned Graham and Buffett. Value has had a pretty rough go over the past decade, very reminiscent of a similar period of rough performance in the 90s. For those of us with a value tilt in our portfolios, explain why this is a cyclical phenomenon and not the death of value investing.
GREENBLATT: Right, well my definition of value is figure out what the business is worth and pay a lot less. It is not low price-to-book, low price sales investing which if you took a look at MorningStar, you took a look at Russell and they analyze what we do, they don’t put us in value as value investors, they put us in blend.
As Warren Buffett would say, value and growth are tied at the hip, growth is part of value, so the way that it’s traditionally done you know now and categorized is not my definition of value. So what traditionally, when people characterize these things, low price-to-book, low price sales, those are things that have correlated well in the past with the higher return, cyclically, but over time, it tends to work, because let’s say low price book, you know, something selling close to its book value, well that just means people are giving a very high value to the business itself, they’re just sort of valuing it pretty close to the cost of the assets that were placed in the business and not giving much of a premium.
So you would tend to get more than your fair share of companies that are out-of-favor meaning because they are priced low, but if you are a private equity firm, trying to buy a business, you not buying it because it’s trading close to its book value, you’re looking at cash flows and trying to project what they are going to be in the future and what are you paying relative to that and what’s it worth and it has nothing to do with low price-to-book, low price sales, it really has to do with the cash flow generating part of the business.
So, you know, it does not bother me that traditional value as defined by MorningStar, Russell, or whoever else defines it would sort of factor like attributes of individual stocks, has or has not worked.
I mean you know, here’s the big thing, the way I describe this is, look, momentum has worked well for the last 30 to 40 years, not just in this country but across the globe with one or two exceptions. The reason we don’t, we’re not momentum investors, and there is no argument about it, there has, it’s just that if it didn’t work for the next two years, it could be that it is just cyclically out-of-favor like we’re talking about and all we have to do is be patient and it works over the long term, you just have to be a patient investor.
Or it could be that it’s you know not so hard to figure out a stock used to be down here and now it’s up here and there’s plenty of data and computers and ability to crunch numbers and plus plenty of research papers that say that momentum’s worked over a period of 30-40 years and maybe if it doesn’t work over the next two years, the trade has become crowded and it’s degraded. And that’s why didn’t work over the next two years.
And two years from now, I wouldn’t know whether it’s just cyclically out-of-favor or the trades degraded, so that’s why I’m not a momentum investor. The reason I’m a value investor, according to our definition, is stocks are actually ownership shares of business that you value and try to buy at a discount, they’re not pieces of paper the bounce around that you put Sharpe ratios and Sortina ratios and use computer simulations to balance your portfolios or whatever it is.
Basically, they are ownership shares of business that you value and try to buy at a discount so it’s certainly possible that the market does not reward my valuations even if I’m right over the next two years but that doesn’t mean we’re going to stop doing what we’re doing, that’s what stocks are, ownership shares of businesses, and that’s very fundamental to the way we look at everything. And if you actually look at it in that way, you can see all of modern portfolio theory and all the way most academics and many advisers and managers look at the world just seems kind of insane when you really boil it down to ownership shares of businesses that you’re trying to value.
And then you can really sift through all the confusion that the very smart people have tried to put a lot of numbers on the investment business that don’t make a lot of sense.
RITHOLTZ: That’s absolutely fascinating. Let’s talk a little bit about Gotham Capital, you start in 1985 with about $7 million, some of it coming from Michael Milken, how did that relationship began in and why was Milken interested in investing with you?
GREENBLATT: Well the simple story is that I had a friend at Wharton who was one of the first people who was in Michael Milken’s group and I — I had been working at a hedge fund for about three years after graduating from Wharton and I had always wanted to go out on my own and I felt I was ready and I mentioned it to my friend and I said, gee if I could raise you know X dollars, I would go out on my own.
And my good friend gave me a call the next day and said Mike said fine.
RITHOLTZ: Just like that. Done.
GREENBLATT: Yeah so it wasn’t quite as easy as that you know, I had to negotiate my terms in the was actually kind of a funny story because it was my life and he did, you know, I don’t know, at the time 20 to 30 deals a day, I have no idea but it was my life and I’m not a very good negotiator at all. But when I was in the room with him, I wanted the terms that I wanted, to run the money because it was going to be my life and I only had one to give and this was one of 30 deals.
And so I wouldn’t give in and we sat in there for an hour while he kept Ronald Perelman waiting because he was about to buy Revlon, and you know I was just like a little tiny deal and I wouldn’t give in because you know, like I said, I had a bottom line which is pretty rare for me,
RITHOLTZ: And he didn’t let you walk?
GREENBLATT: He negotiated like this was the biggest deal of his life even though I knew it was just, you know, something he did — you know, with dessert at lunch one day or something and he left the room and because I wouldn’t give in and he sent his brother in.
RITHOLTZ: Right.
GREENBLATT: And you know after half hour I got the terms I wanted from his brother and then when Mike got back, he was not very happy but that’s how I got into the business and he was a good partner for me.
RITHOLTZ: That’s a great story so I have to share with our listeners your returns, you compound from 1985 to 1995 at 40 percent annually before fees —
GREENBLATT: 50 percent annually before fees.
RITHOLTZ: 40 percent annually after fees, no, it’s —
GREENBLATT: 50, for those 10 years, it was 50 before fees.
RITHOLTZ: That’s astounding, that’s an incredible run of numbers so the first question is what’s the secret sauce, how you can — we all know the 80s and 90s were a boom time but it wasn’t 50 percent a year, what was the secret sauce for that sort of returns?
GREENBLATT: Well one of the ways to get those kind of returns is not to run a lot of money.
So after five years in business, we returned half for outside capital.
RITHOLTZ: Back to investors.
GREENBLATT: Yes.
RITHOLTZ: They must have been thrilled.
GREENBLATT: Well, not thrilled, but after 10 years, returned all of it, that would make them really not thrilled, because and the other way is to be concentrated, so 6 to 8 ideas were usually 80 plus percent of our portfolio, so that portfolio management theory doesn’t like that strategy very much.
RITHOLTZ: Right, not diversified, high risk, blah, blah, blah.
GREENBLATT: Right, well Warren Buffett has a good response to that as well. You know he says listen let’s say you sold out your business and you got $1 million and you are living in town and you want to figure out something smart to do with it. So you analyze all the businesses in town and let’s say there’s hundreds of business and you stick to — if you find businesses where the managements really good, the prospects for the business are good, it’s run well, they treat shareholders well, and you divide your million dollars between eight businesses that you researched well in town, no one would think that’s imprudent, they would actually think that was pretty prudent.
But when you get to call them stocks and you get stock quotes daily on these pieces of paper that bounce around put people put numbers on it and volatility and all these other things where really it’s not that meaningful, you know from one sense if you’re investing in businesses and you did a lot of research and invested in eight different businesses with the proceeds of your sale, people would think you’re a pretty prudent guy.
All of a sudden if you invested in stocks and did the same type of work, people think you’re insane, and it’s just an interesting analogy that I was think of when people make fun of me that I was that concentrating.
RITHOLTZ: You know the flip side of that is imagine if we got prints minute by minute for the valuation of our homes, people would lose their mind, they wouldn’t be able to manage it. So that understanding —
GREENBLATT: Well, imagine if you had a theory of buying homes, I’m going to buy the ones that went up the most last ready months or six months. I mean it’s a really good analogy. I usually use the house analogy all when people asked me how do we go about in valuing stocks and people understand completely when they’re buying a house, there are certain things you would do and we don’t do any different than owning a business.
RITHOLTZ: That makes a lot of sense. So now let me tack to what you’re doing currently, so whereas you previously returned a bunch of money to investors and hedge funds and saying hey we don’t think there is — this can scale enough that we can keep generating these returns for you. Now you’re going the opposite direction and saying okay, we’re going to look for something that can scale.
So tell us a little bit about the Gotham Index Plus portfolio. We were talking earlier are off-line about passive versus active, this is a little bit of both.
GREENBLATT: Right, so we didn’t run outside money until again after we returned it all in ’94, we ran our — we had been lucky enough to keep our staff and run our internal money but in —
RITHOLTZ: And how long did you do that for?
GREENBLATT: 14 years and then in 2009, we started taking outside money again it was really you know really starts really back when I was in business school and I had read that article about Benjamin Graham and actually did a study with a couple of my classmates, Rich Pzena, who is a famous money manager now and Bruce Newberg who is still a good friend of mine, and we did some work on Ben Graham’s formulas and we ended up doing a research paper and having it published in the Journal portfolio management back in about 1981, and had always been fascinated by that and over the years, we had really evolved more towards the way Warren Buffett invests, not just cheap, but cheap and good.
And I’ve been teaching at Columbia for a number of years, I have been doing that 22 years now, but you know that time in the early 2000s, I’ve been doing it for a bunch years in and we had been making money using the same principles that Buffett uses, you know buying cheap good businesses. And I wanted to prove that together with my partner Rob Goldstein, I wanted to prove that the what I’ve been teaching my students, what we had been using to make money worked very well just like we had shown that Ben Graham’s simple methodology still works back in the 70s and early 80s.
I wanted to show that what we had evolved more into the Warren Buffett way of earning money worked and we want to prove it in the same way that we had written that paper about. So we hired a computer analyst that could help us you know mine through data and we came up with some very simple metrics for good, you know, what’s a good business, and if you read through Buffett’s letters, it’s very clear, he is looking for businesses that earn high returns on tangible capital. And what that means is every business needs working capital, every business needs fixed assets, how well can it convert that working capital and fixed assets into earnings.
And in the book The Little Book That Beats The Market which I really wrote for my kids to understand this, I explained it this way, imagine you’re building a store and you have to buy the land and build the store and set up the displays and stock it with inventory and all that cost of $400,000. And every year if the store earns $200,000, that’s a 50 percent return on tangible capital, maybe I’ll open some more stores.
Then I compared it to another store and I call that store Just Broccoli, it’s not a very good idea just to sell Broccoli in your store, but you still have to buy the land, build the store, set up the display stock with inventory, still going to cost you roughly the $400,000 but because it’s basically a stupid idea just to sell broccoli, maybe you will only earn $10,000, that is 2.5 percent return on tangible capital.
And so all we said was all things being equal much preferred to own the business that can reinvest its money at 50 percent returns than 2.5 percent returns.
So that was one metric. Good. That’s what we looked at if you read through Buffett’s letters, that’s the first thing he’s looking for.
The other metric we looked at is cheap you know in the analogy I would use as a house you know, it’s $1 million house and one question you might ask is how much rent can I get for that thing?
And if you try to figure out whether that’s a good deal or not and if you get $80,000 a year in rent that’s an 8 percent yield in a two percent or three percent interest rate environment that today might look fairly attractive. So we sort of looked at how much cash is the business generating relative to the cost of buying the business, then we looked at whether it’s a good business, when they have the money, what do they do with it? Okay?
So we came out with two crude metrics for good and cheap and you know Ben Graham said by cheap Warren Buffett said if you could buy a good business cheap, even better, we combine those two, and we used a crude database. You know, a simple database that was publicly available, all for a price that was publicly available, and we went and tested those two simple concepts — good and cheap.
It’s not like we spun the computer thousands of times, this was the very first test we did and it came out so phenomenally well that I wrote a book about it called The Little Book That Beats The Market, that was the very first test we did, that’s what I wrote up.
But my partner Rob Goldstein and I looked at each other and said you know I would call that the not trying very hard method, we actually know how to value businesses, you know couldn’t we — it works so well without trying, could we even improve on this?
And so we built a big research team you know there’s 13 of us now, we have a seven person tech team and what we’re really trying to do is just take advantage of that initial research and actually valuing businesses and what we discovered was that and we were really building it for ourselves you know, hey can we do something with this?
But it turned out that only hundreds of names and being right on average was actually we can make more money because we would have much less volatile returns, we have and — we get what we expect more often by owning hundreds and being right on average and so it was very easy to put together as a long short portfolio, buying our favorite cheaper stock, shorting our most expensive, and because we were doing hundreds and because we’re very good at valuing businesses on average, okay, as opposed to having to be right on every single one when you own six or eight which turned out we made more money because we had spend less time getting negative returns with a diversified portfolio.
When we discovered that, we were willing to take outside money again.
RITHOLTZ: And this was back in March 09 is that —
GREENBLATT: We opened our first fund for institutions in March 09, we opened our first mutual fund in 2012. And we made some decisions back in 2009, number one, we said that most hedge fund managed, because we were long short investing — we’re charging too much, I have sat on Penn’s investment board for 10 years, UJA for 10 years and I saw most of the managers out there and not many justify one and a half in 20 or two in 20.
And the other part that’s wrong with the hedge fund businesses that when people pay those kind of prices, they are not very patient. So it’s the worst of all worlds. You know, you’re charging too much to your clients and they don’t stay very long because they’re either impatient when they’re there paying so much. So we made two decisions, one is to make our fees very reasonable so we didn’t have a performance fee, we just had depending on the strategy you know maybe 2 percent management fee with nothing else on the hedge fund as opposed to two and 20, that was pretty novel at the time.
And the other was that instead of locking people in for a year or two or three we said its monthly liquidity, we don’t want to run money for you if you don’t want to be with us.
RITHOLTZ: 30 days is not a big gate these days at all.
GREENBLATT: Right, well the idea really was is that when you give a gate, every September or October, people have to decide whether they want to lock up for another year or two, when you have monthly liquidity, you’re never forcing them to make a decision maybe the wrong time, they can always have their money and it’s not a signaling device to say you should have a short time horizon, actually for what we do, you need a long time horizon. Well what it is a comfort to know you can always have it, and actually the money is stickier. So we thought those were two things wrong with the hedge fund business, people took out all the wrong times, they’re charging too much, so we would leave our investors with more money and ability to have their money anytime actually turned to be a very sticky business.
And that’s why three years later, we were able to get into the mutual fund business, not dilute our strategy, because we were not charging exorbitant rates, we weren’t charging a performance fee on our hedge funds, and so we were able to turn institutional quality hedge funds into mutual funds without diluting our strategy.
If you’re charging two in 20 to your or one and a half in 20 whatever it is to your investors, you can’t move into the mutual fund space and just charge 1.5 percent or 2 percent because — without diluting your strategy because your institutional investors would get upset. So what ended up happening is that we ended up going to the mutual fund area because we were charging very reasonable fees that would also work in a mutual fund area.
But this is what we discovered and this is my long-winded way of answering your question, your very good question, how did we get into the Gotham Index Plus Strategy which is our new strategy?
Well, it turns out and we know this, but once we were able to come to investment advisers who talk to individual investors much more closely than institutional clients, the problem with active management in general is that to beat the market you have to do something different than the market.
RITHOLTZ: High active share is in the parlance of the industry.
GREENBLATT: Right, to beat the market, you have to do something different. But your returns are going to, as a result zig and zag differently. So I wrote a book called The Big Secret in 2011 and I still say it’s a big secret because no one bought that or read that, so I’ll just tell you about it. In it, I wrote a few studies of remember I wrote in 2011, so I wrote up the decade 2000 to 2010, this was a period where the market was flat but the best-performing mutual fund for that decade was up 18 percent a year, it’s just that the average investor in that fund managed to lose 11 percent a year on a dollar weighted basis by moving in and out at all the wrong times.
And so every time the market went up, people piled into that fund, when market went down, they pile out, when the fund outperformed, they piled in, when the fund underperformed they piled out and they took that 18 percent annual gain when the market was flat so that’s great on an annualized basis over 10 year period to beat the market by 18 points, but for outside investors, they went in and out so badly that the average investor on a dollar weighted basis lost 11 percent a year and —
RITHOLTZ: Astonishing.
GREENBLATT: It’s astonishing and it’s typical even for institutions, I wrote up the study of institutional managers so I took a look at the you know that study which showed the top-performing institutional managers for the same decade, 2000 and 2010, who ended up with the best ten-year record? Quartile? And what — who ended up in the top quartile what did that look like?
And what the study showed was that 97 percent of those who ended up with the best 10-year record spent at least three of those 10 years in the bottom half of performance, not shocking, but everyone, because to beat the market, you have to do something different, you are going to have periods of outperform — underperformance and everyone did.
79 percent of those who ended up with the best ten-year record spent at least three of those 10 years, at least three of the 10 years in the bottom quartile of performance and what I love is that 47 percent half, they ended up with the best 10-year record, but they spent at least three of those 10 years in the bottom decile, the bottom 10 percent of performers.
So you know no one stayed with them but that’s how you end up with the best record.
So here’s a conundrum, there’s a minority of active managers who beat the market.
RITHOLTZ: It’s still over a decade long period —
GREENBLATT: Yes and it’s very hard to find them upfront before they beat the market and if you do, it’s almost impossible to stick with them because to beat the market you have to do something different than the market. So you know picking active managers has been over a loser’s game for a long time even if there are some that win, and it’s a minority, I agree it’s a minority. And so my partner Rob and I took a look at this problem said how can we solve this because part of the reason we’re doing this, we like making money but if we’re not making money for other people which is there really is not a lot of sense and once we got to the mutual fund area we wanted to help individual investors take advantage of the fact that we think we know what we’re doing.
So we develop something called Gotham Index Plus.
RITHOLTZ: So I was going to say Wes Gray of Alpha Architect, I don’t know if you are familiar with his work, has a piece I’m sure I’m mangling the title but it something along the lines that even God would lose clients as an active manager and I just find that hilarious.
So what are you doing so differently with the Index Plus compared to what you are doing previously with special situations and what did your research find about how you can work around this problem of individuals underperforming their own investments?
GREENBLATT: Yeah so it sounds almost like an impossible puzzle, but I’ll tell you how we solved it.
We said, number one, most people judge how they’re doing for better or worse by seeing if they beat the S&P 500, that’s in this country and so we started there.
We said most people are going to stick with things if it’s beating the S&P 500 and lose if it’s losing by too much to the S&P 500, so we started with that base for Gotham Index Plus and we said you give us a dollar, we are going to buy the underlying stocks in the S&P 500, we are going to put a dollar into that in the weights of the S&P 500, so you give us a dollar, this is a mutual fund form, you give us a dollar, we re-create the S&P 500 bottoms up, and put a dollar into the S&P 500. Okay?
That doesn’t sound so hard to do and don’t think of ourselves as charging for that portion, that’s pretty easy to do.
RITHOLTZ: And you doing this not with indices but with actual —
GREENBLATT: Yes, we bought the individual stocks because as you’ll hear in a moment, we’re very, very tax efficient so it helps us to own the individual stocks.
Then we go out and we buy $0.90 more of our favorite S&P stocks within the mutual fund and —
RITHOLTZ: And how many are that is that second the plus part?
GREENBLATT: What happens is we to the 250 out of the 500 stocks in the S&P 500 that we like the best, we add $0.90 more of those in the order in which we like them. So the more we like something, the more we will add to it. And then we will short or we will sell $0.90 worth of the stocks we like the least, so we have a 90 long, 90 short, long short overlay on top of the dollar in the S&P, but we do some things to mitigate because obviously if we are going to zig and zag too much, we want to have tracking error but positive tracking error.
People don’t mind winning all the time, it’s the losing part that they don’t like.
RITHOLTZ: Of course.
GREENBLATT: So we’re trying to mitigate the losing part, so what we do with buying the cheapest socks we can find putting $0.90 into them in addition to the index, the dollar already in the index and we are shorting $0.90 of our least favorite, but we want to balance that 90-90 so we have zero beta on that 90-90 because we’re already long a dollar in the market, we don’t want to keep the same beta as the market.
Number two we don’t want to drive tracking error, so we don’t want small stocks to drive returns, so some things let’s say 0.01 percent of the S&P 500, we don’t want that driving our returns but we may really like that stock, we may think it’s really cheap so we will buy more of it and we may even buy five or eight times more of it but that’s only 0.05 or 0.08 percent, not really going to drive returns, we will buy as much as we can subject to the constraints that we don’t want to drive too much tracking error.
The third thing we do is we balance fundamentals. In other words the stocks were short at stock trading at 40, 50, 100 times earnings, these are hope stocks, people really think and they’re buying them now not on current earnings but in 2022, they think it’s going to be really great. So they’re buying these, these are hope stocks based on the future, they are training at 40, 50, 100 times earnings and but there are other reasons why people like them, maybe sales are growing really quickly your other aspects of the fundamentals are going well so we balance those fundamental.
So if you took a look at our long portfolio, we have just as good sales growth in the cheap stocks were buying the expensive stocks we’re shorting, so it’s they’re not unbalanced that way.
In other words, we’re just getting them cheaper, they’re cheaper, we’re making — we are buying the cheapest stocks we can find, we are shorting the most expensive subject to constraints that keep us in line. One is there’s a zero beta, two is that small stocks won’t drive returns, three is that we balance fundamentals so all we’re doing is buying companies that are doing really well and we are just getting them cheaper. And as a result, we have been — we just passed a three-year anniversary in this fund, we got five stars from MorningStar, but more importantly, we beat all 1,200 funds in our category which a large cap blend where the S&P is.
And the most important parties is that we didn’t do nearly as well as I hope to do in the next three years, this was a very tough period for us. Even though we did very well relative to the other funds, we didn’t do very well relative to our expectations and the reason for that is because the market with you know, excluding the last two months, went straight up during those three years with no corrections.
RITHOLTZ: You have a big leverage short.
GREENBLATT: We are short hope stocks, the $0.90 we’re short are hope stocks, when you take risk and hope stocks and you get paid then you take more risk and you take more risk in and there’s no correction so that’s a very tough period for our short book.
Luckily our long book were not low as I said before, we are not low price-to-book low-price sales investors, we’re cash flow oriented investors and people get very optimistic about our cash flows and our businesses when things are going well so our longs were able to keep pace with our shorts and even add three points a year to the — to that and we sort of —
RITHOLTZ: So the plus long did better than the plus short and you still have the underlying S&P?
GREENBLATT: Correct so as index plus, but the great news is, is that spread that 90 by 90 long short spread actually does better in bad markets.
RITHOLTZ: Well, that was my next question, you took the words out of my mouth, if we were to see forget even another 2000 to 2002 or 08, 09 but I’m trying to think of a comparable — I was going to say 73, 74 but that’s not all that different from 08 09, but if we see a run-of-the-mill 20 percent to 30 percent correction that last eight months, how would you expect this to perform?
GREENBLATT: Well those are our best markets for our spread so obviously the index portion would do all that well. But you would want, we viewed as an index and your own protection, in other words, for that portion your portfolio, you want to be 40 percent 50 percent, 60 percent net long, if that’s where your risk tolerance is, what’s the smartest way to take that 100 percent long allocation to the market of that 40 or 50, 60?
And so what we like about Index Plus is really like owning the index with protection attached because you take high-priced caching companies out or company selling at 100 times pretax free cash flow or 50 times, they are going to take those guys out and shoot them in bad markets. these are hope stocks. Those are to get crushed —
RITHOLTZ: Tesla, Netflix, going on the whole —
GREENBLATT: All those guys are going to get crushed you know it turns out, you know, through all our research and everybody else is that buying things that 100 times earnings or things that are losing money is pretty much the world’s worst strategy over time.
RITHOLTZ: Shocker.
GREENBLATT: And so in bad markets, even worse than that. Those stocks would get crushed, we’re buying stocks that are have huge cash flows, people have low expectations for them that’s why we’re getting them so cheap and so we know pay for high expectations in the long book, so when the low — bad news comes in, we didn’t pay for high expectations so our longs tend to hold up better, our shorts are getting killed, great spreads and bad markets.
And let me just tell you where I think the market is. We value — we have a big research team and we value all the companies in the S&P 500, we also value the top roughly 3000 companies, but we value the stocks in the S&P 500 every day for the last 28 years, bottoms up, so I can contextualize where do we stand today relative to those 28 years and right now we stand in the 16th percentile towards expensive over those 28 years. Meaning the market’s been cheaper 84 percent of the time for the S&P, and cheaper 16 percent of the time.
Then I can go back and look at what’s happening —
RITHOLTZ: You mean more expensive 16 percent of the time.
GREENBLATT: It’s more expensive 16 percent of the time, cheaper 84 percent of the time, my apologies, so it’s expensive. And we can go back in time and look at what’s happened to the market over the next few years are from this valuation level in the past. It’s not a prediction, it’s just saying what’s happened from this valuation level in the past and the answer to that is your forward returns have averaged three percent to five percent, two year forwards, eight to ten, not negative because the market averaged nine percent to ten percent returns during those 28 years and that’s something we’ve come to get used to, not necessarily will continue in the future, but that’s what we’ve come to get used to. We’re more expensive than that.
So from the 16th percentile, expected returns about three percent to give percent, eight to ten over the next two years. So if we get close to what we’re thinking over the next year, three to five and we tested this over 17 years before we went live, we were able to add about seven points to that so we can anywhere close to that and the markets only earning three to five, people really are going to enjoy those extra returns at that time.
Our best returns are actually in not up three percent to five percent which is very good returns, above average returns, but negative returns, we had double-digit spreads in all the four years that we looked at that the market in our tests that the market was down and that will be very precious to have, not lose money.
So you own the Index Plus protection, it’s all more painless way to be long 100 percent long the market and we think people will stick with us because it’s the underperformance periods would be way mitigated based on the way we’re doing it and we are already long a dollar in the market.
RITHOLTZ: And you’re only owning companies that are within the S&P 500, so my assumption is you can scale this pretty easily?
GREENBLATT: Right, well not only that but we also don’t buy big positions and small pieces of the S&P 500, so we’re not worried about our capacity here, we’re just worried about getting high returns for investors .
RITHOLTZ: That is quite fascinating.
I very vividly remember this book coming out in 97, 98 something like that and exploding like it came out of left field, I don’t think a lot of the investing public necessarily knew who you were and suddenly this book was everywhere. What motivated you to write this 20 years ago? 20 plus years ago?
GREENBLATT: I can’t even explain why but I love investing and I always wanted to write and teach and investing is what I know about so I teach investing, I have been doing that at Columbia for 22 years and always wanted to write about it, and so You Can Be Stock Market Genius, see I can’t even think of the name because — it was such a bad name but..
RITHOLTZ: It was a great marketing name, you may not love the name because it doesn’t really describe the contents of the book that well, but it certainly caught people’s attention.
GREENBLATT: Well it was really supposed to be Any Fool Can Be A Stock Market Genius, but the Motley Fools came out with a book and so I had about 24 hours to change the name and I was canvassing my family and my father said something like, how about You Can Be Stock Market Genius and then in parentheses Even If You’re Not Too Smart and I kind of giggled about it and we put that in, and it turned out to be one of the worst titles ever —
RITHOLTZ: On the hardcover, the parentheses, Even If You’re Not Too Smart is part of that.
GREENBLATT: Yes, so — but I just really it was really a collection of war stories from you know we had talked about we had run outside money for 10 years doing 50 percent before fees for that period and how did we do that and you know how can you do that, and what is — what’s the way you’d go about attacking that?
And I just had a fun time writing about the war stories and having a good time with it.
RITHOLTZ: So let’s talk a little but about some of those war stories. First, how well does the book hold up 20 years later?
GREENBLATT: Well I have five kids and made all my kids read it, number one, and so I still think it’s everything in there is very valid you know many hedge fund managers, I did not write it for hedge fund managers, that’s really who took to it the most, which is —
RITHOLTZ: How to be an interesting surprise.
GREENBLATT: Yeah I really wrote it to be friendly and funny and you know just have a good time doing it and I thought I was writing to an audience of average people, but you know, I hadn’t started teaching at Columbia yet and I realized as soon as I taught my first class back in 96 that, I think I really wrote this at an MBA level because it was about at their level and that wasn’t my goal.
But you know now lots of these big hedge funds hand it out first day when someone walks in and says “go read this.”
RITHOLTZ: So let’s talk a little about spinoffs which was such an important part in the first let’s call it, a third of the book, 90 — the 20 years or more that proceeded this, a lot of M&A, a lot of conglomerates being formed, it would make sense that the next era that follows it sees a lot of spinoffs but since the book came out, we’ve seen certainly in the past decade or so, less and less spinoffs, do you think that part of the analysis still holds true or is this just like everything else?
GREENBLATT: No, no, there are plenty of spinoffs and it’s inherent now and people have done studies up through last year that show that they did much better than the market as a whole. But that wasn’t really my point, my point is is that the nature of spinoffs is they are not underwritten securities, they’re usually given to people who don’t want them.
RITHOLTZ: There is an interesting behavioral element that you describe and 97 is long before behavioral finance was everywhere which is I expect people to get this and say this is not why I bought XYZ, I certainly didn’t buy it for the ABC spinoff, so the tendency for a lot of people to not even analyze it sell it and suddenly there’s a good cheap property there.
GREENBLATT: Right so maybe cheap, it may not be cheap, they’re not usually well followed, so they are, I would call it mispriced it’s right for mispricing, it doesn’t really, all the studies that show the average spinoff does this or outperforms or doesn’t outperform doesn’t matter, what I was really trying to show people is places to look where things may be mispriced. And here, where people have never followed this company before, it’s not being sold by an investment firm, given to people who don’t really want it, it’s right for mispricing, it could be underpriced, it could be overpriced, it doesn’t matter which one, it’s you know, I described in the book that it’s you don’t, no fun to take a shovel and dig holes, but if you’re digging for buried treasure, it gets more interesting.
And so this is an area where it has a big red X on it where there could be a nice treasure underneath if you dig here, so it’s worth doing the work in these areas. So right for mispricing is what I’d say, it doesn’t really matter how the average spinoff does. However, they have done very well, there are some things as you mentioned, built into the system that make people get rid of them and then there a lot of other areas in the market that does that.
But the idea behind the whole book was sort of look where I started off with the my in-laws the first chapter was about my in-laws who used to shop in Connecticut for antiques and yard sales and country auctions and things like that.
RITHOLTZ: Artwork, you mentioned —
GREENBLATT: Yes, artwork and sculptures and all these things and they are looking off the beaten path and they are not looking in Manhattan on Madison Avenue, or you know, Fifth Avenue, they are really looking off the beaten path trying to find things that are undiscovered. But I made the point of saying they’re not looking for the next Picasso, they are not finding a painting in some yard sale saying this guy is going to be the next Picasso, that’s really hard to do.
What they’re really looking for is a painting that they found the same artist had had done a painting that’s of the similar idea that just went up for auction for three times the price it’s being offered for over at Sotheby’s so they recognize that right now, a similar pain just went for three times as much, that’s a lot easier to do than to project or predict the next Picasso and so that’s what they were doing, that’s what you’re doing in the spinoff area.
You are looking in — your bargain comes because you’re looking a little harder than other people, you’re looking at things that are a little harder to do, a little harder to find, probably smaller than most people are willing to look, not the main idea, usually these are discarded things and these are all things that are right for mispricing.
RITHOLTZ: That makes a lot of sense. In the book, there is something that cracked me up, you write never trust anyone over 30 and never trust anyone 30 and under. Essentially, never trust anyone.
Tell us a little bit about your thought process with that.
GREENBLATT: Well, when both of us were growing up, that was a saying never trust anyone over 30, I think anyone who is younger than we are probably doesn’t even know that expression —
RITHOLTZ: From the late 60s.
GREENBLATT: Not as funny to them. Yes back in the 60s when we’re going up, that’s what you were so — you know don’t trust a man, you know anyone over 30 and that was just my way of saying that you have to be your own boss, you have to look after caveat emptor in the investment world like everywhere else, most people are trying to sell you things, they have an angle, it is very hard for you to discern who is or who isn’t on your side unless you do the work yourself and know what you’re doing.
And so it’s very important to know that and that’s so, you know I gave a talk at Google a number months back and I started it this way, I said even Warren Buffett says that most people should just index and I started to talk saying I agree with him, then I left. I didn’t actually leave I said but then again Warren Buffett doesn’t index and neither do I, how come?
And I explained the real opportunity set that’s still out there. You know I get — you know is this still any good, does this stuff still work? I get — you know, I get a hand raised in my class at Columbia every year at least for the last five to six years, a student will raise their hand and sort of say, Hey Joel, congratulations on a nice 35 or 37 year career, but isn’t the party over for us? There’s more computers, the ability to crunch numbers, hedge fund, smart people doing the stuff, you know, are we going to have the same chances that that you had?
And so my students are second-year MBAs roughly 27 years old on average so I tell, this is the way I answer I say, I tell you what, why don’t we just go back to when you guys learned how to read, let’s take a look at the most followed market in the world, that would be the United States, let’s look at the most followed stocks within the most followed mark in the world, those would be the S&P 500 stocks, and let’s take a look at what’s happened to the S&P 500 since you guys you know learned how to read.
So I take them back 20 years when they were seven years old and I say from 1997 to 2000 the S&P 500 doubled from 2000 to 2002, it halved, from 2002 to 2007 it doubled from 2007 to 2009, it halved, and from 2009 today it’s roughly tripled, which is my way of telling the people are still crazy and it’s way understating the case. Because the S&P 500’s an average of 500 companies, if you lift up the covers and look at the dispersion going on between those 500 companies, between which are in favor at any particular time in which are out-of-favor, the price movements are much wilder than what the average of 500 companies doubling and halving, doubling and halving, that doesn’t even begin to tell the story.
So if you drew a horizontal line and call that fair value like Ben Graham said, and then you draw a wavy line around that horizontal line and call that stock prices, the market is pitching us opportunities all the time between stocks that are way below fair value and way above fair value, the reason investors don’t beat the market has nothing to do with the market is not throwing us pitches in that it’s not still emotional, they are behavioral problem, there’s agency problems, there is a lot of other issues going on but it’s not because we’re not getting really great pictures all the time.
People are still emotional. If you’re cold and calculating go back to what we talked about the beginning where stocks are ownership shares of businesses and you’re just cold and calculating about what they’re worth, you can really take advantage of the market, I actually tried to explain this concept a friend of mine who is an orthopedic surgeon asked me to speak to a group of his buddies at a big dinner that he was hosting for orthopedic surgeons said talk about the stock market for half an hour try to explain it and then take Q&A. So I talked for half an hour, I started taking Q&A, and when I was done, the questions were something like, hey oil went up two dollars yesterday should I buy some or market was down one percent yesterday, should I get out?
And my conclusion from that talk was that I had just crashed and burned and I had not really, really gone through these very learned doctors and then.
RITHOLTZ: A notoriously difficult group to teach anything about because they believed themselves experts in everything.
GREENBLATT: Well, I was asked to teach a much easier group, this was a group of ninth graders from Harlem.
RITHOLTZ: Right.
GREENBLATT: This was a couple years ago and just for one day a week, for an hour a week, we come in and teach them about the stock market and this was right after I crashed and burned with the very learned educated doctors and I didn’t want to fail with the kids.
RITHOLTZ: Right.
GREENBLATT: But as you’re saying I had fresh opportunity blue sky with them not know anything about the stock markets, so I really thought long and hard about how I was going to explain the stock market to them.
And so the first day class, I brought in a big — one of those old-time jars filled with jellybeans, you know, a big glass jar filled with jellybeans and I passed out 3 x 5 cards and I passed the jellybean jar around and I told him to count the rows and do whatever they had to do but write down how many jellybeans they thought were in the jar and went around the classroom and collected the 3 x 5 cards.
Then I said I’m going to go around the room one more time and ask you in front of everybody else have a jellybeans you think are in the jar and you can keep your guess from your 3 x 5 card, you can change your guess, that’s completely up to you, and one by one I went around the room and I asked each student how many jellybeans they thought were in the jar and I wrote that answer down.
So let me tell you the results of the experiment the average for the 3 x 5 cards you know the first guess was 1771 jellybeans, that’s what it average to, and there actually 1776, jellybeans in the jar.
RITHOLTZ: Interesting.
GREENBLATT: So that was pretty good and when I went around the room one by one asking each person publicly how many jellybeans they thought, that average gas was 850 jellybeans.
RITHOLTZ: That’s interesting.
GREENBLATT: And I explained to the kids that the second guess was actually the stock market and what I was to teach them to do is be the first guess, be cold and calculating, count the rows, be very disciplined in valuing the businesses not influenced by everyone else around them when the second guess what happened what everyone heard what everyone else was saying and in the stock market, everyone read the newspapers, they talk to their buddies, they see what everyone saying and doing and reading and seeing the results in the news every day and they are influenced by everything around and they’re not being cold and calculating and disciplined.
And so I was going to teach them how to be cold and disciplined and that’s what we try to do. We have a very disciplined process to value businesses and that’s what I was teaching them to do and that’s what stocks are, ownership shares of businesses and all the noise, 99.9 percent of the noise you read the paper every day excluding this podcast is really noise, and so that’s — you know, that lesson really resonated, I think, and I did much better than the doctors.
RITHOLTZ: I would’ve guessed from the beginning you would’ve done better with the kids. I’m a big fan of Sturgeon’s Law which is 90 percent of everything is junk and when you talk about filtering out the noise and trying to get to the signal, hey the same thing is true across all sorts of different venues that that noise in the public is just it’s astonishing and I’m fascinated by that having people do it publicly and how that leads to such a different result especially when they came so close on average when they were private.
Let’s talk a little bit about one of your later books The Magic Formula, how did you make this transition from what looks like special situations investing to really quantitative investing?
GREENBLATT: Sure, well, I’m glad you brought up that way so I wrote a book called The Little Book That Beats The Market and we don’t think of ourselves as quantitative investors although in The Little Book That Beats The Market, we used some simple quantitative methods to show people concepts of Ben Graham said buy it cheap, his best student’s a guy named Warren Buffett who said if I can buy good business cheap even better and that made him one of the richest people in the world and we have used that philosophy, that’s what I teach at Columbia that’s what we’ve used to make money over the last 37 years, buying good and cheap businesses and wanted to share that with everyone else and so we ran a statistical test just to show that just using crude metrics for cheap and crude metrics for good and crude metrics for a and crude database that we could do very well.
And so that’s what we show the magic formula and we said the magic formula only really has two parts, cheap and for cheap, we really rank companies based on a simple metric that was earnings before interest and taxes to enterprise value and I usually describe that as rent, in some other words, you are buying a house and they are asking $1 million and your job is to figure out whether that’s a good deal or not.
So there is fairly simple questions you’d ask if you try to figure that out. One would be if I rented out this house how much could I get for it after my expenses?
RITHOLTZ: What is your return on capital?
GREENBLATT: No, so return on capital would be how the business invests its own money, it’s really as the investor what price do I have to pay for the house and how much is it going to earn me?
So as an investor, it’s my return on capital, but I don’t want to confuse that with how the business itself invests its money which is really how I look at return on capital.
RITHOLTZ: Got it.
GREENBLATT: So there is — to it’s really return on investment.
RITHOLTZ: Okay.
GREENBLATT: I’m laying out $1 million getting $80,000 a year in rent, that might be 8 percent and net of my expenses and interest rates are two or three percent, that may look pretty attractive, there are other questions you probably ask you know if we were really doing this analysis, you would probably say, hey what are the other houses on the block going for the block next door and the town next door, how relatively cheap is this?
And we do the same thing. We say how cheap is this business relative to similar companies, how cheap is it relative to all companies, how cheap is it relative to history, that’s what we do at Gotham but for the purposes of the little book that beats the market, we just did cheap on a free cash flow basis just like how much rent. But and it’s a very simple metric and then we said, you know, I described this a little bit earlier, we talked about it, is I was trying to describe — I wrote this book for my kids and I said how do you describe how good the business is?
And if you read through Buffett’s letters it’s very clear that is looking for businesses that are in high returns on tangible capital and I described that is every business needs working capital, every business needs fixed assets, how well does it convert its working capital and fixed assets into earnings?
So I said if you’re building a store, you have to buy the land, you have to build the store, you have to set up the displays, you have to stock with inventory and if all that cost you $400,000 and the store earns you $200,000 a year, that’s a 50 percent return on tangible capital, and I compared that to a store I called in the book of Just Broccoli and —
RITHOLTZ: Which is not going to return a lot.
GREENBLATT: No, just broccoli selling just broccoli in your stores probably not a good idea, I never tried it but it’s probably not a good idea but you still have to buy the land, build the store, set up the display, stock with inventory, still going to cost you roughly the same $400,000 but because it’s a dumb idea maybe only earns $10,000 a year that’s 2 1/2 percent return on tangible capital and all I said in the book was all things being equal, if I can get the same price, I would much prefer to own the business that can reinvest its money 50 percent returns than 2 1/2 percent returns.
And so what I did for the books purposes is something very crude, I ranked all companies based on how cheap they were and then I took another ranking of how good they were, what kind of returns on tangible capital they were getting, then I combined those two ranks and bought the best combination of cheap and good and I showed how well that works, it worked so well just using these crude metrics that the top 10 percent combined score for cheap and good did better than the second 10 percent, did better than the third 10 percent, in order all the way down to the bottom 10 percent, just showing you the power of how this cheap and good works so well.
RITHOLTZ: And if I’m getting these numbers right, from 1988 to 2004 this portfolio would’ve returned about 30 percent a year while at the same time the market would’ve given you a little over 12 percent, is that about right?
GREENBLATT: Yes so that was with small-cap stocks which unless you’re an individual investor would be hard to take advantage of as a institutional investor but I also did a similar study for the thousand largest companies, you know, the Russell 1000 companies, and you know which are very similar to the S&P 500 and that that was 22 percent versus about 12 percent.
RITHOLTZ: Also pretty good year, I will take that.
GREENBLATT: And possibly little more realistic for large investors.
RITHOLTZ: We have been speaking with Joel Greenblatt, he is the CIO of Gotham Asset Management.
Be sure and check out the podcast extras where we keep the tape rolling and continue discussing all things value and index plus, you can find that at iTunes, Overcast, Soundcloud, Bloomberg, wherever your finer podcasts are sold.
We love your comments, feedback, and suggestions, write to us at MIBPodcast@Bloomberg.net, you can check out my daily column on BloombergView.com follow me on twitter @Ritholtz, I’m Barry Ritholtz, you’re listening to Masters in Business on Bloomberg Radio.
Welcome to the podcast, Joel, thank you so much for doing this and I’ve been looking forward to this for long time, you and I have never met, never really spoken before, but I’ve been very much aware of who you are and what you’ve done over the years and I have tell you some of the numbers that you have put up and I know there’s only so much we can talk about them are just astonishing.
We talked about the 50 percent a year before fees for 10 years, that’s an amazing run, like Renaissance Technology that returned capital to investors, I have to imagine people were not especially happy when after 10 years of the sort of returns, you said here, I have to give you this back. What was motivating, was it strictly scale or was there — were there other factors that said I’m done managing other people’s money at that at that point in time.
GREENBLATT: You know, that’s a great question.
I thought about that a lot, I love investing, never was going to quit, we had gone to a size I suppose after 10 years of having nice returns that we could keep our staff and continue to run our internal money and for me it’s just fun to do.
RITHOLTZ: Did you think that at that size, you couldn’t continue generating those sort of returns.
GREENBLATT: Well, I think, you know, I left out you had asked me how we did 50 percent a year and you know one was I said we stayed small, two, we were concentrated, and three, really we got lucky.
RITHOLTZ: Right.
GREENBLATT: Okay? that you have to have some luck to get those kind of returns during that period of time and so one of the most fortunate people on the planet I have a large family with five kids, I love doing this, I like to do really well so there’s pressure I put on myself when I’m running other people’s money, maybe have a little less so when I’m not running it, so I don’t think it was really a calculated plan other than you know how can I continue to enjoy what I’m doing in the best way and still get to do what I like, and still work with the people I like to do.
And so it seemed like the right thing to do at the time I guess is the best way I can —
RITHOLTZ: That makes sense and it took almost 20 years before you started, that’s really a decade.
GREENBLATT: About 14 years.
RITHOLTZ: 14 years before you said it took that long to forget the stress of running other people’s money?
GREENBLATT: Well you know when you own six or eight names, one of the issues there is that every two or three years, pretty much like clockwork and wake up and lose 20 percent or 30 percent of my net worth in a couple days because one or two things weren’t going our way, either we were wrong or just you know they went the wrong way for a little while, we knew what we owned, we were going to get paid back and that’s a little more stressful.
RITHOLTZ: Sure.
GREENBLATT: And it had to happen, when you are not concentrated, that has to happen, a little more stressful with other people’s money since I know what we owned and A, I’m a big boy so when I make a mistake you know, I just chalk it up to a learning experience and move one.
RITHOLTZ: Right.
GREENBLATT: Let’s just say I think my investors were great but maybe they wouldn’t be so kind that that happened and it did seem to happen every two to three years and I think that’s unavoidable.
So when we developed a strategy to take advantage of our principles meaning buying good cheap businesses and shorting expensive ones that were trading way above what we thought they were worth, when we discovered that we can actually make more money having diversified portfolios and that are bad days would be 20 or 30 basis points of underperformance not 20 percent to 30 percent down, that was A, it wouldn’t degrade our own returns taking other money when we had hundreds of stocks on the long and short side. And B, it wouldn’t hurt our own returns because more diversity helped our returns because when you don’t get what you expect, meaning you get aberrationally bad returns, sometimes it ends up in negative compounding.
So when you have hundreds of stocks more diversity on each side, you get less aberrationally bad returns, that is why insurance companies don’t insure five people because even if you do great underwriting of those five people someone steps off a curb, you can tell I don’t sell insurance but if someone steps off a curb and ruins all your numbers, it didn’t matter what kind of underwriting you did of that say, life insurance.
RITHOLTZ: It’s too small a pool, you need a much bigger pool.
GREENBLATT: Yes, so, if you can be right, you know they want to be right on average, so they want to be right over hundreds or thousands of people and so when we realize that we can make more money being more diversified when you go long short and put on leverage you want at that, it didn’t hurt us to take outside money, because diversity was good for us and you know, to cover so many companies, we need a big research teams would build up our research team and our tech team to help us trade, you know, where — tech team one guy we have you know was a MIT chess champ, another guy was won Google code jam, you know out of 25,000 people, another guy’s you know that as smart as those guys so I get to work with the tech team and they help us trade efficiently, they help us trade tax efficiently.
So we’re very, very tax efficient, help us all put together the systems where our fundamental analysts can cover a broad range, so it’s been fun building a team to do all these different things, so I’d say we’re fundamentally, we fundamentally value businesses but our tech team helps us put together risk-adjusted portfolios very well and trade efficiently and be tax efficient all those things and just building this whole thing as, you know, doing something with the same principles that we’ve always used has been really just fine.
RITHOLTZ: Tell us the most important thing people don’t know about your background?
GREENBLATT: Well I don’t know what they don’t know, I’ve written three books and I always tell personal stories within the book, so I think I’ve included lots of embarrassing things.
I yeah I don’t think I’ve ever written that I enjoy playing tennis, I did write that I enjoy sailing and that I’m not very good at it and I’ve been in a bunch of close calls with that but that’s probably how I spend most of my leisure time as well as along with my family, so there’s nothing really too fascinating.
RITHOLTZ: Tell us about some of your early mentors.
GREENBLATT: Well, you know, one of the reasons I read books is because my mentors really came from reading people who were kind enough to share with me their wisdom over time and that’s you know people like Andrew Tobias and Benjamin Graham and even Buffet in his letters and David Dreman, you know who wrote Contrarian Investment Strategy and John Train who wrote the Money Masters and all these people really were helpful in forming and getting me involved in investing and you know I wanted to share some the things that I learned too because that’s how I learned.
It really wasn’t so much you know some the people were dead and they were still sharing with me and some of the people were just kind to do so and I you know, one of my ways you know besides the fact that I enjoy writing, it was another way that I felt I could give back.
RITHOLTZ: So let’s talk about some books. What were some of your favorite books? You have already mentioned the two from Graham Intelligent Investor and Security Analysis, what other books did you find influential? Be they finance not finance fiction and nonfiction, what really stayed with you? You mentioned David Dreman on Contrarian Strategies, that’s an interesting book.
GREENBLATT: Yeah, well there is a book called The Invisible Heart which explains basic economics to most people and most people are today, you know especially young people are kind of more socialists —
RITHOLTZ: Isn’t the old-line socialists in your youth and capitalist in your older age, I know I’m mangling that.
GREENBLATT: Yes, no, I know the reference and that’s partially true, it’s just discouraging to me that the understanding basic economics is kind of necessary and so there’s a book that’s a fiction book, to — Russ Roberts wrote it called The Invisible Heart, not many people have read it but it’s a very short book that I think most people should read, so I would read that, I would have my kids read that.
RITHOLTZ: Russ Roberts also maintains a blog, is he the same one?
GREENBLATT: Yes, yes, yes.
RITHOLTZ: And does he do — actually Econ talker or something like that.
GREENBLATT: He probably does, I haven’t followed that, it is a book about economics, it’s a fictionalized book about a high school economics teacher, but is just a pleasant short book way to learn basic principles are so I’d highly recommend that even if you want to be in the you know, no formulas, just want to be — you want to understand basic economic principles. I think that’s one of the best the people haven’t seen.
I think for investing Moneyball was one of the great if you’re a sports fan at all just understanding how to buy undervalued players is very similar to buying undervalued stocks and so that’s a really helpful book for most people.
I just read a book I’ll call the Power Of Moments which I really enjoyed which says that most of your seminal moments in your life really come between the ages of 15 and 30, because you have a lot of firsts, you know it’s the first time you graduate and leave home, might be your first girlfriend, you graduating college, you getting your first job, you might be getting married, you might have kids, all happens in that kind of compact period for most people and people think back to the rest of your life about those seminal moments and it is really about a book about creating your own moments.
In other words, those happen because those are natural firsts, those happen naturally because of evolution but can you create those kind of important moments in your life and it really comes down to creating doing new things, always creating — you have to be a little more creative when you get older to create those new things but those are the things you think about which I think are quite important.
I’m also reading another book now which I think I’m having a lot of fun with which is — I think it’s called Never Split The Difference is by the ex-chief hostage negotiator for the FBI, you know just negotiating and also thinking of you know how you can apply some of these concepts to business you know to be effective. So enjoyed that. You know everyone has to read Interesting Investing, Intelligent Investor, you know I think it’s chapters 8 and 20, Buffet always points out and agree with that.
I think Buffett wrote a bunch of letters that were compiled by Lawrence Cunningham that get (ph) into topics, and that was laid out and I always assign that in my class which I just think is a great, great book and you mention my three books three times and so you have to read those too.
RITHOLTZ: Tells us about a time you failed and what you learned from the experience?
GREENBLATT: I will talk about my worst investment, not specifically what it was but it but it was an investment in a tradeshow company all that I bought through was really I created through a spin off and shorted one thing and bought another and I actually paid $3 for something that I was immediately going to get $6 for but I fell in love with the business and actually ended up did I paid three dollars for the eventually in short order, went way past the six dollars because I love the business it went to $12 a share which was pretty good but I had a very large position in it at that time and what I loved about the business was A, it ran a computer tradeshow called Comdex in Las Vegas and I loved the business because plenty of space in Las Vegas, if they got more clients to display at their tradeshow they, could just rent more space for $2 and resell it for $62, they didn’t have to commit, it so that was like a $60 contribution for every incremental sale they could make and that’s generally called operating leverage.
And that’s what I loved about the business and I think people are very familiar with financial leverage, right? If you put up a dollar and I borrow $9 and buy something worth $10, you realize that if that $10 thing you bought falls a dollar or two, you are going to go broke and everyone understands that, that’s very straightforward.
So this was my lesson and operating leverage you know unfortunately after 9/11, right before 9/11 the tradeshow bought another tradeshow, they borrowed a lot of money to buy it and then 9/11 happened and people didn’t want to travel.
And so I learned a lesson in operating leverage where when you don’t get that $62 and it only cost you $2, $60 dollars of less earnings drop straight to the bottom line as well and it’s called operating leverage and I just thought I’d describe that to you so that people would realize that on the way up, just like financial leverage is a lot of fun and on the way down operating leverage on the way down is not very much fun. So I got out most of my stock in about a dollar so I will just leave it at that say —
RITHOLTZ: That’s a lesson.
GREENBLATT: That’s right, an investment lesson in operating leverage, at least be aware.
RITHOLTZ: Our last two questions, what sort of advice would you give a millennial or recent college graduate who told you hey, I am interested in going into financials as a career.
GREENBLATT: Well you know I taught at Columbia as I mentioned for the last 22 years and so I tell my students that first day of class actually, I tell them that you know I don’t think there’s a lot of social value in being an investment manager, it’s not that I don’t think investors who do work set help set prices and allocate capital and all those things, but I just think A, they’re not very good at it, and B, it’ll get done without you.
And smart people doing this, too much horsepower rather than go into other fields. I have loved being in this field, I enjoy it and there’s nothing wrong with it. But what I tell my students is I’m even one step removed from doing something I don’t think is that socially valuable because I’m teaching you how to do something that’s you know, so what am I doing here and so what I make my students promise and I think they take to it well is that if I do teach them and I am helpful in learning how to do this and they enjoy it, there’s nothing wrong with it, it’s a great thing but they should think of a way to give back.
They you know, we get way overpaid in this business, we’re successful, and if they’re successful with what I teach them and I I’d say that to any young person, if they are successful in this field, I think they should really think of our different ways, they’re clearly smart people, they are clearly driven people, they’re thoughtful and so they should be able to think of a way to give back and use the skills for that.
And so that’s what I tell young people who want to go to the investment business.
RITHOLTZ: And our final question, what is it that you know about investing today that you wish you knew 37 years ago when you were first starting.
GREENBLATT: I would say probably the secret to being successful is patience. The big secret that no one bought them and will tell everyone is really just having a longer time horizon than most people and understanding what you’re doing, meaning you’re buying businesses, and if you’re good at valuing them, I actually make a promise to my students first day class every year, I promise them if they do good valuation work, the market will agree with them.
I just never tell them when. It could be a couple of weeks, it could be two or three years, but if they do good work, the market will agree with them and to keep that in mind to continue to do good work and have patience. And you know, since you can check your stock price 30 times a minute now, you know, we used to get when I was you know coming to the business, used to get a quarterly statement and throw right in the garbage, you know, and really care that much.
Now minute to minute, you know, even our best investors, you know, $20 billion endowments expect weekly returns from us in our private funds, I have no idea what they do with that information but that’s what they’re asking for and everyone is judged on very short time horizon.
So if you can step back and take a longer time horizon, that is the big secret that I could share and the sooner you learn that and the sooner I learned that, the better off that they and I will be.
RITHOLTZ: We have been speaking with Joel Greenblatt, co-CIO of Gotham Asset Management. If you enjoyed this conversation, be sure to look up an inch or down an inch on Apple iTunes, Bloomberg, Overcast, and you could see any of the other 200 such podcasts we’ve done previously.
We love your comments, feedback, and suggestions, write to us at MIBPodcast@Bloomberg.net. I would be remiss if I did not thank the crack staff that helps us put this podcast together each week.
Caroline is my engineer today Medina Parwana is our producer, Taylor Riggs is our booker Mike Batnick is our head of research. I’m Barry Ritholtz, you have been listening to Masters in Business on Bloomberg Radio.
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