Joel Greenblatt, His Magic Formula, and the Bargains Today

Ben Graham: “It is fortunate for Wall Street as an institution, that a small minority of people can trade successfully, and that many others think they can.”

You can learn about the attitude and philosophy of a successful value investor by viewing CNBC’s interview with Joel Greenblatt.

CNBC Interviews Joel Greenblatt on September 28th, 2011

Also, Forbes Interview a few months ago:

Figure it out what it is worth and pay a lot less—Joel Greenblatt

Transcript of Interview:

The hedge fund manager behind the magic formula investing strategy, Joel Greenblatt (JG), has delivered impressive returns. His firm Gotham Capital delivered 50% annual returns for about a decade– late last year he launched a family of four mutual funds called formula investing.

The key here is value investing, buy stocks cheaply, and return on capital. What about the global economic weakness and European debt crisis woes? Did the Magic Formula outperform that situation? Let’s ask Joel Greenblatt. It’s great to see you.

JG: Thank you.

CNBC: Talk about the formula. Is it yield over some sort of return? What’s magic about it?

JG: well,  unfortunately it’s not really magic, but it does work quite well over the long-term. We’re trying to do two things:

  1. Buy something cheap. Ben Graham  said figure out what it is worth and pay a lot less. What we look at is free cash flow to the price we’re paying.
  1. Ben Graham’s best student, Warren Buffett, added a twist to that. He said cheap is nice, but if I can buy a good company (defined for Buffett as high and consistent ROE unlevered) cheap, that is even better. We try to get the best combination of cheap and good.

CNBC: What do you think about this market right here? I would think for a value
investor, there appears to be a lot of value, or is this a value trap?

JG: Well, we have looked at trailing free cash flow yields over the last 20 years. Right now stocks are priced somewhere around the 95 percentile toward cheap—meaning it is one of the cheapest periods both for the market and for our value portfolios that we can put together. If you really look at that, what that said a year ahead of these levels of valuation, the market could be up 15% or 20%; at least that’s what’s happened in the past. The value portfolios could be up in the mid-30s percentage return or so. You know, it’s a very scary time to invest. That’s when you get your best bargains.

Stocks are reflecting a lot of skepticism right now, and usually it doesn’t
look this good unless things look terrible.

CNBC: Some of your top holdings, Game Stop, American Eagle, Best Buy, Microsoft, HP, Wells Fargo, is there. Is there a narrative that runs through them other than the formula itself?

JG: The narrative is that each one of those companies is hated brutally by most people. Hewlett-Packard, I think we know the story, but the prices are cheap. HP is expected to earn $5 EPS and it is trading at about 4x EPS. You pay your money and you take your chances, but we think it is cheap. You can get your money back in four or five years and get the company for free. Because of metrics we used, we actually excluded financials. There was no projection that we would have a financial crisis. Just that one of the metrics we were using was earnings before interests and tax so you can’t look at a bank before interest. So we now include banks in our widely diversified portfolios because of our adjustments to our formula for financial companies.

CNBC: What do you say to those who say historical patterns are meaningless? Where we’re going to go through a looking glass if you assess the situation in Europe?

JG: Every time we’ve had valuations this low, the macro-environment has looked terrible. So at a minimum, you could say that prices reflect that people are skeptical. Prices (ALREADY) reflect that things might not be so great next year.

The magic formula takes out the emotion to buying plunging prices. We make sure the numbers are good in the present—we don’t project.

All I am trying to do is figure out what it is worth and buy it for a whole lot less. The great thing is that the Magic Formula doesn’t always work because if it did, then the formula would cease to work for the long-term.  But in
the long-term (two to three years to five years). This is how the market prices
stocks.  Yes, people are very emotional right now, but we think there are great bargain to be had today.

Editor: Wise words, but hard to put into practice consistently when you are affected by the noise and fear around you. Investing is simple but not easy.

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