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Edited by Foxit Reader Copyright(C) by Foxit Software Company,2005-2007 For Evaluation Only. Dec 9, 2005 Issue 051209
Enlightened Investor Digest
BEST IDEAS, BEST PRACTICES AND BEST JOKES FROM THE WORLD’S BEST INVESTORS
Joel Greenblatt’s Lecture at NYSSA by Brian Zen and Garret Hamai
In the freezing cold evening of December 7th, 2005, Joel Greenblatt of Gotham Capital, armed with delightful jokes and a magic formula, warmed the hearts and souls of about 200 security analysts in a seminar organized by New York Society of Security Analysts (NYSSA.org). We are pleased to bring you the financial enlightenments captured from that event: Crunching Data, Searching Magic Formula ♦ During his years at Wharton, Joel Greenblatt manually entered stock data based on 9 years worth of S&P Stock Guides and created their own database for research. ♦ Cleaned up the data by eliminating certain things. Now they use Compustat database. ♦ Richard Pzena figured out how to enter those data into the mainframe computers at Wharton Business School. At that time, the computers were about the size of two conference rooms. ♦ Sometimes, the market throws off bargains because it is unreasonable about the prospects of certain companies. Buffettized: Buying “Cheap” and “Good” ♦ Starting out as a die-hard value investor, Greenblatt became "Buffettized" in early 90's. Why not look for the good ones amongst the cheap companies?! ♦ Greenblatt says that he didn't realize that trying to find cheap and good companies, rather than just the cheap ones, was so important until the 1990s. While Graham was looking for starkly cheap companies, Buffett wants only the good ones. ♦ Greenblatt’s friend, Richard Pzena, remains committed to buying troubled companies at dirt cheap prices, the cigar butt approach. You see this saggy cigar butt on a dirty corner of Wall Street. You pick it up and get one last puff out of it. The puff not very tasty. The act is not very elegant. But it’s free (Laugh). The Magic Formula Was Born ♦ By combining Graham and Buffett, Joel Greenblatt’s magic formula is a computerized system to invest in good companies whose stocks are cheap. ♦ Good companies = High return on capital (ROC defined as operating profit divided by net working capital plus net fixed assets.) ♦ Cheap stocks = High earnings yield (Earnings yield defined as pre-tax operating earnings divided by enterprise value.) ♦ ROC = EBIT/(Net working capital + Net fixed assets) ♦ Earnings yield = EBIT/(Enterprise Value) ♦ If net working capital is negative, use zero. ♦ Here, EBIT is last 12-month’s earnings before interests and taxes (EBIT). ♦ Two key issues addressed by his magic formulas: (1) What is the return on the price you paid? (2) What is the return on the capital the company is investing? Ranking the “Cheapness” and “Goodness” ♦ Greenblatt turned to his computers to rank companies by two factors, good (high ROC) and cheap (high earnings yield). ♦ Ranking Method: If company XYZ ranked 10 out of 3,500 companies in terms return on capital, and it ranked 20 in terms of earnings yield, the combined ranking of XYZ would be 10 + 20 = 30.
Joel Greenblatt speaking at NYSSA
Buying Cheap Stocks Works Over Time ♦ In the 70's, they tested Benjamin Graham's Net-net Formula and found that picking stocks below liquidation value worked well. (Liquidation value = Current Assets – All Liabilities.) ♦ Not every cheap stock performed well individually, but as a basket they did well. ♦ However, these types of opportunities are practically extinct in today's market. ♦ Many other studies have shown the strategy of buying cheap companies works over time.
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construct a portfolio of 20 to 30 stocks. My mantra is to keep things simple. The other day. higher deciles consistently outperformed those below them from top to bottom. Invest 1/3 or 1/5 of your money into 5 to 7 top-ranked companies every 2 to 3 months. ♦ In his own hedge fund. © 2005 Zenway. Reinvest the proceeds into new top-ranked companies. rather than two-year periods. 4. and sell winners right after 12 months for tax benefits. the annual return was 22. ♦ “We never mastered the art of selling. ♦ The cheap portfolio tends to have less volatility also. research could take months.Page 2 Enlightened Investor Digest ♦ The magic formula beats the market 96% of the time. Maybe the time window that a value stock stays undiscovered is being shortened towards one year as more and more people start searching for values. ♦ Sell losers right before a year is up. Greenblatt’s Personal Investment Process ♦ Looks for value with a catalyst. Stick to this simple and mechanical system for at lease 3 to 5 years to give the magic formula a chance to work.9%. Hold them for one year. ♦ Turnover the portfolio at year end to buy a new list of 30 highest ranked stocks based on one-year’s worth of new financial data. Joel Greenblatt also discussed in detail the operating steps of the magic formula investing: 1. ♦ Having a concentrated portfolio works well for lazy people. 6.) 5. Usually spend one month or so to do research. We are semi-bubbling idiots at it. sell winners a few days after the one-year holding period.com Inc. trading cost is cheap now.8%. Go to magicformulainvesting. “I call it the Not-Trying-Very-Hard Model (Laugh). Sell each stock after holding it for one year. 7. They are simply different places to find cheap stocks. Greenblatt uses the basic principals in the magic formula: Look for high ROC and high earnings yield. 3. after one year. ♦ Sell if something even cheaper is found. you get a complete set of new earnings data.” confessed Joel. ♦ Thinks about how much he could lose if he's disastrously wrong. ♦ Makes sure the stock is very cheap based on normalized earnings. Redistribution or reproduction is prohibited without written permission. In difficult situations for which he and his partners have time. Specify your criteria for minimum company size. . ♦ Besides.” said Greenblatt. ♦ 5 to 8 securities can make up 80% of his portfolio. Magic Formula Investing: The Operating Steps In his new bestseller: “The little Book that Beats the Market”. ♦ When ranked by 10 deciles (250 stocks in each.com (Nice plug!) 2. ♦ Tries to figure out what “normalized earnings” will be 3-4 years into the future. The Magic 30. (Dollar-cost-average into the “good and cheap”. in their opinion.8% Per Year for 17 Years ♦ Magic formula works! Using stocks of all sizes. it produced a 17 year annual return of 30. Get a list top-ranked companies based on high return on capital and high earnings yield.000 stocks. ♦ If there is a great opportunity which. ♦ No formal process or time frame for purchase decisions. won't last. For tax purposes. Greenblatt and his partners went on and on talking about the stocks that made a huge move after they sold at intrinsic value. ♦ Selling has always been difficult. After 9 to 10 months. One position could be up to 30%. It would be a good time to run the rankings again. Not that many stocks to track. Sell losers a few days before the one-year holding period. Joel Greenblatt (left) and Christopher Kehoe Sell Rules ♦ Sell close to intrinsic value. Why the One-Year Holding Period? ♦ It is interesting to note that more stocks worked out over one-year rolling periods. so nice things happen sooner. Special situations are just value investing with a catalyst. and if they feel they Greenblatt’s “Not-Trying-Very-Hard” Model ♦ Buy the top 30 of the highest ranked companies. Using only the largest 1. To remove the uncertainties and difficulties of selling. ♦ Besides. a one-year holding period was picked.
Values can always be found somewhere. ♦ He does acknowledge that you could probably find cheaper companies internationally and it is a good idea if it is within your area of expertise. © 2005 Zenway. . not well understood. and requires too much work. People don't want to do the work. you would make another mistake. but it can be difficult to calculate.’ (Laugh) In the end. We have no macro view. ♦ He thinks that “EBITDA – Maintenance Capital Expenditure” would be a better measure of earnings power. ♦ Don’t know if or when this trend will reverse. Greenblatt said. you would have made a big mistake.” said Greenblatt. cheap company for the long run. If you could value companies. ♦ Things such as volatility have nothing to do with buying a good.Enlightened Investor Digest understand it. the longer time horizon I look at. “It is kind of ironic that. No Edge in Foreign Markets ♦ Greenblatt prefers to invest domestically because it's within his circle of competence and he hasn't run out of opportunities. “Pick and choose.” Fair Bet Yet Unfair Investing ♦ Look for a big mess that seems too complicated.” The Vogue of Return on Capital ♦ There seems to be a movement towards high return on capital. the housing bubble could drag everybody down… We ignore those. I feel meeting CEO is not very important because I am not good at reading people. ♦ The low P/B stocks haven’t work very well in the past 10 years.” (Laugh) ♦ The Efficient Market Theory is a crazy way to look at the market.’ Next day I meet another CEO and say to myself: ‘This guy is smart. “I used to meet a CEO and say to myself: ‘This guy is smart. “Fortunately. we ignore the macro picture. It is worth the work. ♦ “Now the value is in big caps. he may do more with international investing. ♦ Everything is cyclical. they sometimes use the approach of "Ready. there were plenty of noninternet values out there. the consumers could drop dead.” said Greenblatt. you should ignore the noises from volatility and stock prices. Fire.” said Greenblatt. ♦ If he was younger. Ignore Volatility and Stock Prices ♦ Taking your clue from the stock prices is crazy. you will be at an advantage. Numbers Are More Important than People ♦ First look at the numbers as they don't lie. ♦ In 2002 and 2003. Redistribution or reproduction is prohibited without written permission. the older I get. But if you look at the macro picture. You can learn a lot about the management by looking at what they've done though the numbers. ♦ Meeting the management in person and determining their abilities is not easy. ♦ What is more important is: (1) What the management has done with the cash? (2) What are the incentives? (3) Is the salary too high? Page 3 (4) Is there heavy insider selling? (5) What is their trackrecord? ♦ Compare “what they do” with “what they say”. You can beat the market. there were plenty opportunities in small caps. The long-short guys blow up every eight years. Joel Greenblatt (left) and Brian Zen The Macro Picture Is a Distraction ♦ In 1999 and 2000. On Long-Short Strategies ♦ Q: “How about long the top deciles of cheap stocks and short the bottom deciles of expensive stocks?” ♦ A: “I am not a fan of shorting. Aim!" ♦ Has financials and utilities in the portfolio. not well followed. ♦ Look for semi-complicated situations. EBITDA Minus Maintenance CapEx ♦ For his own investment practice. If you were worried that the burst of the internet bubble would have dragged those values further down. The key is to identify what cuts to the core. If you were concerned that the bear market could go on further. I call it the ‘I got it! I got it! I ain’t got it!’ Strategy. but once you do the research.com Inc. Greenblatt uses a different input for earnings. too. ♦ Bad signs: high salaries and insider sellings.
and individuals who receive them often dispose them in the market immediately. If they have a large stake in the spin-off. as the companies tend to be small in size. ♦ Greenblatt's secret to success in the stock market lies in identifying situations (mainly involving corporate changes) which are not of interest to the big players. ♦ The time horizon for judging performance is relatively short (between a few months to maximum—a year). January 26.com/9y7vt How Joel Greenblatt Reads 10-K’s This is a featured premium content in the paid deluxe version of EID. The credentials of the parent company are also very important in evaluating spin-offs. The shareholders typically sell them off without regard to price or fundamental value as their primary interest is in the parent company. Institutions typically shun these securities. 4) Great documentation on the to-be-spun-off company is filed with the SEC in a form-10. ♦ Big players could not buy small companies. ♦ Institutional investors are often uninterested in spin-offs.com/eid The Advantages of Small Investors ♦ Investment managers' performances are judged on the basis of how well their portfolio performs vis-à-vis the stock market index. please visit: http://www. but which offer a high upside potential. we look at after-tax numbers. (Blank stare…pause. ♦ Risk arbitrages are subject to too many uncertainties (the merger may not even go through). They have not engaged investment banks to sell the equity and therefore there is no market buzz or generally any advertising what so ever.a great bargain. i. When we have losses. New York Society of Security Analysts http://nyssa. buying stock of a company that is subject to an announced merger or takeover.) That was trying to be funny. The initial price after the spin-off. tends to be depressed .zenway. in mergers. making them attractive investments. Details: http://tinyurl. Merged Securities ♦ While Greenblatt warns against merger risk arbitrages. Small investors can afford to ignore the index. 2006. Bankruptcies One More Trick ♦ Greenblatt disclosed: “We have one more trick. .. When a company hives off a part of its business into a separate company. To subscribe. preferred stock. Why Spin-off Opportunities Are Exciting 1) The spin-off of an S&P 500 company usually causes a large sell off of the spun-off company by S&P 500 index funds as the spin-off is usually not added to the index. ♦ However. he is very much in favour of merged securities. How to uncover the secret hiding places of stock market profits? Joel Greenblatt provided the following list: Spin-offs ♦ Spin-offs are Greenblatt's favourite. warrants or rights. Price at Mutual Series of Funds. Redistribution or reproduction is prohibited without written permission. so the chances of burning one's fingers are high. that is the spun-off company isn't very exciting and may not even be such a good company.Page 4 Enlightened Investor Digest not sold. 2) The "parent" company of the spin-off has no incentive to advertise or talk up the spin-off. The price is thus driven down. When we have gains.e. but distributed among the parent company's shareholders. Greenblatt quotes a study that found that a very large number of such spin-offs outperformed their industry peers by a whopping 10% per year in the first three years after the spin-off.org will host another great value investing seminar by David Winter. it means that there is a high level of commitment to making the spin-off a success. ♦ Greenblatt strongly emphasises that in every corporate change it is important to determine where the interests of the insiders (directors of the company) lie. Investment managers therefore tend to skip those opportunities where the pay-off is likely to come only after a long time. 3) The spun-off company is generally some kind of drag on the parent company's valuation. former partner of Michael F. we look at beforetax numbers.com Inc. the acquirer sometimes pays for the acquisition in terms of securities other than stock—bonds. The parents of the spin-offs also outperformed their industry peers by 6% during the same three-year period. therefore. (Laugh)” On Thursday. The shares of the spin-off are generally © 2005 Zenway. it may do so for several reasons.
2005-2007 Enlightened Investor Digest Only. Global expansion partnering with local government to get the best land ♦ Gannett Inc. ♦ Sharper Image (SHRP) at $9. Page 5 For Evaluation ♦ Another unconventional opportunity that Greenblatt suggests is not the stock. we filter out the 99% of the information out there that is useless or false. one needs to be very careful in choosing the 'right' bankrupt companies to invest in. Recapitalization ♦ Greenblatt sees recapitalization (buyback) transaction as an investment opportunity. Subscribe now! http://zenway. hidden assets in real estate and subsidiaries with the next Warren Buffett extracting cash and liquidating those assets in pieces. low valuation. near tangible book value. with positive cash flow. Inc. ♦ QLT Inc (QLTI) at $6.2.3 and Oriental Financial Group Inc. like Buffet.Edited by Foxit Reader Copyright(C) by Foxit Software Company. below book value. Greenblatt too shuns complex restructuring where one cannot understand what is really going on. thus increases the tax saving which can then be passed on to the shareholder. ♦ Boston Scientific (BSX) at $25. but only after the water is gone. asset values and the historical development of financial structure? Z At zenway. The prime reason that makes buyback companies interesting is that buyback of shares increases the leverage in the balance sheet of the company. (GCI) at $59. bank debt and trade claims of companies that are emerging from bankruptcies. growth could come back with a nice bid on GDT. the test of true success or prosperity of the business? ♦ What can be detected via a study of long term relationships between earning power.5. ♦ Marsh & McLennan (MMC) $28. (OFG) at $13.com/eid Next Issue: Notable Recent Buys and Sells of Enlightened Investors like Buffett and Klarman. learning and research is involved in finding these hiding opportunities. (WHI) at $8. ♦ According to Greenblatt "there is almost no other area of stock market where research and careful analysis can be rewarded as quickly and generously". However. but bonds.com. may retain its leadership in insurance brokerage industry. Major Restructuring by Companies ♦ One can either invest after restructuring has already been announced or when a company is ripe for restructuring. below liquidation value with positive cash flow. many equity analysts tend to drop coverage of companies that are undergoing major corporate changes. ♦ Funnily enough. We bring you only the financial enlightenments. please support our research work by subscribing to EID at: http://zenway.” − Ted Williams ZENWAY STOCK WATCH LIST ♦ Disney (DIS) at $24. ♦ Of course. below book value. ♦ Sears Holdings (SHLD). The Disclaimer Even Greenblatt acknowledges that a lot of reading.2.com Inc. insider buy.com/eid Or call: 646-388-0887 How Benjamin Graham Evaluate Past Earnings Records: To obtain this premium content. Balance Sheet Analysis according to Graham ♦ How capital is invested and how the capital structure is divided between senior bond issues and common stock? ♦ What are the strengths and weaknesses of the working-capital position? ♦ Can reported income be verified by the equity changes over the years? ♦ What are the various sources of income? ♦ What are the return on equity and return on capital. we all know that there is no free lunch! Z Specific Ideas from Joel Greenblatt: (See our paid deluxe version of EID) “Do you have the patience to wait till the mud settles and the water gets clear? Can you sit still till the right action presents itself?” − Lao Tzi "I like to shoot fish in a barrel. ♦ Bargains are created as there are a large number of anxious sellers and the businesses tend to be unpopular. After all. Redistribution or reproduction is prohibited without written permission. ♦ W Holding Co. but earnings still under pressure. © 2005 Zenway.8. two Puerto Rico banks near book value with insider buys." − Warren Buffett “Wait for a good pitch to hit. and the stuff is cool. ♦ American Locker (ALGI) at $4. and bring only the 1% that matters. .
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