Aug 2, 2008
Joel Greenblatt on The Little Book That Beats the Market
I’ve been trying to do more reading on Joel Greenblatt, especially about the magic formula he describes in his book .
Here is an interview I found from CNBC which aired January 22, 2006:
BARTIROMO: Let’s talk about your strategy. The first thing you look for in a company, a high return on investment, right?
Mr. GREENBLATT: Yes. Well, we–actually we–I broke down what we–we have done for 20 years at Gotham Capital, the firm I run, into two really important things. One is what kind of business are you buying? Are you buying a good business and then how cheap are you buying it. So the first thing to decide what’s a good business is to look at return on capital. So we–you can think about return on capital. It sounds complicated, but it’s really kind of easy. If you think of it as–in the book, I described a store called Jason’s Gum Store.
BARTIROMO: Imaginary businesses.
Mr. GREENBLATT: Exactly right. And so let’s say it costs $400,000 to open one of these stores. And those stores actually earn $200,000 a year. That’s a 50 percent return on capital. Now take another store. Let’s call it Just Broccoli.
BARTIROMO: OK.
Mr. GREENBLATT: Not a particularly successful store. Costs about $400,000 to build, but let’s say that store only makes $10,000 a year. That’s a 2.5 percent return on capital. We simply said that 50 percent’s better than 2.5 percent.
BARTIROMO: Yeah.
Mr. GREENBLATT: And we ranked all companies based on return on capital from highest to lowest.
BARTIROMO: And–and the other criteria is they have to be cheap.
Mr. GREENBLATT: Exactly right. So the ow–how do we measure cheap? We said the more money a store earns relative to the–the price you pay for it, the cheaper it is. So we–we ranked all stocks based on cheapness. It’s really like the inverse–we–we called it earnings yield, but it’s really the inverse of the PE ratio. Instead of looking at price to earnings, we looked at earnings to price. The higher the earnings you get for the price you pay, the cheaper it is. And we ranked all companies based on cheapness in that way.
BARTIROMO: Um–hmm.
Mr. GREENBLATT: Then we just combined the ranks.
BARTIROMO: And–and used a computer screen to–to look for the companies that fit the bill. You say that people should pick 20 to 30 stocks a year.
Mr. GREENBLATT: Right, well, this is–we just said, let’s try this–the not-trying-very-hard method.
BARTIROMO: Ah-hah.
Mr. GREENBLATT: The not-trying-ve–very-hard method was to pick the stocks that were the cheapest, best combined rankings of cheapness and also with the highest returns on capital. And if you combine those two and just pick the top 20 or 30 stocks, it turned out that you made over 30 percent a year over the last 17 years, and even if you looked at even the largest stocks, the top 1,000 stocks, and just picked out of those, you made more than double the market’s return, about 22.9 percent.
BARTIROMO: So use that strategy for us today and tell us the companies that you came up with that look good to you.
Mr. GREENBLATT: Oh, well, it’s–it’s pretty funny right now. It’s the first time in 25 years that I’ve been doing this that large caps are actually the cheapest and–and a lot of companies coming up on the screen are large caps. Some of them…
BARTIROMO: Large cap technology, you were talking Microsoft, companies like Dell, right? Real quality names.
Mr. GREENBLATT: Right. Well, Microsoft is not a difficult technology. In other words, they have a pretty dominant share of their business, and even though their growth rate might not be as–as large as it has been in the past, it’s–it’s selling in a very low multiple. Maybe after subtracting cash, maybe 15 times next year’s earnings. Tough to get a business of that quality at that low price. Dell is…
BARTIROMO: Because–because the S&P 500 is trading at like above–above 19 times earnings. Right? So when you compare that S&P 500 to companies like Microsoft at 15 times earnings, that’s pretty good.
Mr. GREENBLATT: The whole idea of the magic formula, as we called it in the book, good companies at cheap prices, is that when you buy 20 or 30 of them, on average, what you’re doing is buying above average companies at below average prices. It’s pretty simple.
BARTIROMO: And–and you mentioned Microsoft and Dell. AutoZone is another one. Americal–American Eagle Outfitters was another one you liked.
Mr. GREENBLATT: Right. AutoZone, for instance, if you look out a year or two is g–it’s trading about 10 times earnings. They have close to 4,000 stores, but they could probably still open another 3,000. So there’s a lot of room for growth. So that’s another cheap one. And–and we ow–we actually own some of that.
BARTIROMO: And you’re providing screens free, right?
Mr. GREENBLATT: Right. We set up Web site. We just want to make this as easy as possible…
BARTIROMO: Yeah.
Mr. GREENBLATT: …for people to do. So we set up a Web site called magicformulainvesting.com, and you just put in what size companies you’re looking for, and it will give you the top 25 or 50 companies that rank that way, and you get to choose out of those. And all those companies do incredibly well, based on the screens.
BARTIROMO: Doesn’t–doesn’t work every year though, right?
Mr. GREENBLATT: Well, that’s the great thing about the magic formula is it’s not that great. There are one, two and even sometimes three-year periods where the magic formula doesn’t work. If it always worked, everyone would follow it, and it would kind of ruin everything.
BARTIROMO: Right.
Mr. GREENBLATT: And–and, you know, I’d really be a kind of a blabbermouth telling everyone about this. But the big picture is it doesn’t work every year, and unless you understand what you’re doing, which is buying above average companies at below average prices, you won’t stick with it. So I spend a lot of time in the book explaining to people what you’re actually doing so that when it doesn’t work for a year or two, you still stick with it because what you’re doing is smart.
BARTIROMO: Really, really great strategy and–and so well done. Thanks so much, Joel.
Mr. GREENBLATT: Thanks for having me, Maria.
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