Street Capitalist: Event Driven Value Investments

Key notes:

-There are periods of time, could be 2 or 3 years where it underperforms the market. People usually drop the formula if it does that. That prevents it from widely adopted.
-Over the last 5 years the magic formula is up 73% versus 3% for the market.
-Launching an investment fund to do all the work for investors.
-Not a fast trading strategy. Lost a little bit against the market last year. There are periods when it does not do well or can actually lose money.
-Not a great strategy for hedge fund managers. On average these plays do well over time, difficult to hedge out. That’s why it Greenblatt thinks it will continue to work.
-If you look specifically, you’ll pick reasons why you should not buy them individually. But if you buy as a basket it generally works out.

With value investors, I’ve always looked up to Joel Greenblatt. His book You Can Be a Stock Market Genius was actually my very first investing book. Since then I’ve tried to read everything I could about him, from transcripts of interviews he gave on television, and his course material from Columbia.

I stumbled across a really interesting paper, penned by Greenblatt and noted value investor Richard Pzena published in the 1981 Summer issue of the Journal of Portfolio Management. Their paper is titled “How the Small Investor Can Beat the Market”.

I think that sometimes as value investors we spend too much time trying to emulate our idols, rather than take advantage of the opportunities that are available to us because of our small size. Greenblatt and Pzena’s article affirms the idea that small investors do have an advantage, mainly in the area of net-nets where most securities are small, under followed, and often mispriced. The authors say:

…Wall Street research houses limit their coverage to fewer than 500 actively traded issues (Merrill Lynch being the exeption with approximately 1100 stocks closely studied). Meanwhile, the NYSE trades 2000 stocks, the Amex trades 1000 companies, and the OTC market trades another 7000 issues that are required to provide relatively full disclosure to the SEC. Under these circumstances, the individual may in fact be able to locate unrecognized values in the nearly 9000-stock second tier not closely followed by “experts.”

Now this was written about 28 years ago, so maybe research has changed. Still, certain companies will always be under followed or receive scarce research coverage. I’ve always noticed that there indeed are bargains in the net-nets area. Finding liquidations for example (often the result of a net-net where management realizes their operations are doomed) requires a little extra leg work on the part of the investor. Some enterprising online communities have sprung up that are dedicated to uncovering these bargains. The extra work required to find such bargains makes them less likely to be uncovered by the rest of the investing universe, allowing you, the small investor, to take advantage.

So Greenblatt and Pzena (G&P from now on) set out a methodology for what they define as Graham’s rough calculation of liqudiation value:

Curent assets (cash, accounts receivable, inventory, etc.).

less

Current Liabilities (short term debt, accounts parable, etc.),

less

Long Term Liabilities (long term debt, capitalized leases, etc.),

less

Preferred Stock (claim on corporate assets before common stock),

divided by

Number of shares outstanding,

equals

Liquidating Value Per Share.

G&P didn’t just test this method during a bull market. They say:

…we selected 15 segments of 4 months each over a six-year period in which the over-the-counter (NASDAQ) averages halved and then doubled. (Approximately 60% of our selected stocks were traded in the OTC market.) The period under study ran from April 1972 to April 1978; it included the great market plunge of 1974 and the subsequent strong recovery. The obvious advantage of such a volatile period is that we were able to observe the performance of our selected stocks during extreme market conditions.

G&P look at three factors when designing their portfolio test.

1. Price to liquidation value
2. Price to earnings ratio
3. Dividend yield.

The authors included in the simulations that a security would be sold after a 100% gain or after 2 years, whichever came first.

Here are the portfolios:

Portfolio 1
Price / liquduation value: <= 1.0;
P/E: floating with bond yields;
Dividends: no dividend requirements
Return (After tax/comm): +11.3%

Portfolio 2
Price / liquidation value: <= 0.85;
P/E: floating with bond yields
Dividends: no dividend requirements.
Return (After tax/comm): +16.5%

Portfolio 3
Price/liquidation value :<= 1.0;
P/E: <= 5.0;
Dividends: no dividend requirements.
Return (After tax/comm): +20.1%

Portfolio 4
Price/liquidation value: <= 0.85
P/E: <= 5.0;
Dividends: no dividend requirements.
Return (After tax/comm): +29.2%

Note the differences in performance that come with the adjustments in the portfolio’s screen factors. The best performing portfolio is #4, which contained not only a requirement that the securities be below liquidation value but also that they trade at a low price to earnings level. This resulted in a wide margin of outperformance for portfolio 4 compared to the others. This helps us see that not all net-nets are alike, and that employing the usual methods of sound stock investing in the net-net area will enhance results. Usually, the universe of net-nets is pretty limited, which I believe helps in making it possibly for investors to deeply examine. Plus, since many of these companies are tiny, the small investor may have more luck getting in contact with management than they would with large companies such as GE.

Over the same period, the Value Line index had a return of -0.3% and the OTC index had a +1.3% return. The liquidation value portfolios had huge levels of outperformance versus the respective indexes. G&P give a few reasons for why this might be: 1. large institutional investors can usually only invest in the top 1000 to 1500 high-capitalization stocks. 2. There are less research dollars in the area of such small stocks, resulting in a second tier of stocks that are unrecognized and thus may be inefficiently valued by the market.

G&P end with a comment on the future:

Unless the structure and focus of the securities industry changes dramatically towards more coverage of secondary issues,a route made unlikely by basic economic realities, the individual may not have to worry about the prospect of a completely efficient second tier. On the other hand, in the more computerized future, it is likely that “bargain” stocks will become harder to find and will provide lower excess returns than the “bargain” stocks currently available. Even under these circumstances, the small investor should retain a significant advantage over the large institutional equity funds.

As Ben Graham noted in his classic, The Intelligent Investor, “It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone — after deducted all prior claims, and counting as zero the fixed and other assets — the results should be quite satisfactory.” Apparently, in today’s world of efficient markets, investors can still profit from Ben Graham’s advice.

What’s really quite interesting is that much of this remains relevant today. The economics of the business right now prohibit many funds from stalking net-nets. Even though now it’s easier to find net-nets on screens, the universe is sufficiently large enough to satisfy the appetites of smaller investors and continue to provide opportunities that most larger players are unable to touch. In Greenblatt’s other book, he provides examples like spinoffs and other special situations which are not securities selling below liquidation but are undervalued and untouched by other market players because of institutional constraints. This is what I believe he is getting at when he says that a small investor should retain a significant advantage over the large institutional equity funds.

Some readers may be skeptical of this 30 year old advice. But remember that Graham was able to thrive with net nets 50 years before that. More recently, James Montier the strategist at Societe Generale penned a piece in September that said if an investor invested in a basket of net-nets over a 20 year period, their average annual return would be around 35%. My guess is that net-nets will always remain an area for small investors to profit from, as long as we actually start looking there and embrace the advantages that come with being a small investor.

In my previous post I put up a transcript of an interview with Joel Greenblatt on his magic formula book. Here’s another interview (May 15, 1997) I found on CNBC about his older book You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits. This is by far my favorite investing book and is worth taking a look at for its material on special situations/ balance sheet event driven investments.

DAVID: Your book says you can be a stock market genius, even if you’re not too smart. What are some of the tricks here that–that–that allow you these kind of astronomical returns?

Mr. GREENBLATT: Well, I think to do it the way everyone else does it every year, 80 percent of the mutual fund managers who do a lot of work, can’t seem to beat the market, you have to take maybe a little different angle. And the way I look at things is if you’re looking in places that other people aren’t, you have a much better chance of beating the market.

DAVID: And these are what you call pockets of opportunity’?

Mr. GREENBLATT: Right. There are some areas of the market where, on average, those areas beat the market just randomly selecting those areas.

DAVID: Let’s talk about spin-off securities, which is one of these pockets. T–tell us about spin-offs–I–the one I talked to you about before we went on the air, that I thought of, was Lucent Technologies–is that an example, wh–when it was spun off by AT&T?

Mr. GREENBLATT: Sure. AT&T actually had two spin-offs last year: One was Lucent Technologies and one was NCR. The one that I purchased was NCR. What happens is, is that–NCR’s a computer company, was a division of AT&T, a telephone company. And to separate itself–this small division from the company–they would distribute shares–AT&T distributed shares to its shareholders in NCR. They weren’t purchased. Just if you owned AT&T shares, you would get a distribution of NCR shares. What happens to these shares is that people who get them sell them off.

DAVID: Mm-hmm.

Mr. GREENBLATT: They bought AT&T–they bought a telephone company. They’re not interested in a computer company that AT&T lost $ 7 billion in in the last six years.

DAVID: Well, they sell them off, though, doesn’t the price go down?

Mr. GREENBLATT: The price–that’s exactly why there’s an opportunity. The people who get the stock don’t want it…

DAVID: Mm-hmm.

Mr. GREENBLATT: …they sell it. You get an initial low price, and w–on average–there was a 30-year study that showed that spin-offs beat the market by 10 percent a year just on average.

DAVID: Got a minute, so we’ll have to split it up. But the other pockets of opportunity–merger securities is another one. Give me an example.

Mr. GREENBLATT: Well, when Viacom purchased Paramount, they purchased it with cash, they purchased it with stock and they purchased it with four other securities–warrants, convertible debentures, things of that nature. If you own stock in Paramount and–and Viacom bought it, you would get stock, you’d get cash and maybe you’d keep those things. But if you get all these securities that you’ve never even heard of, you just sell them off. And there’s an–another opportunity to have extraordinary gains in that area.

DAVID: How do I turn somebody else’s misfortune into my fortune with bankruptcies?

Mr. GREENBLATT: Well, what’s interesting is, in bankruptcies, you don’t really invest in stocks after they go bankrupt, but what you can do is–the way stocks come out of bankruptcy is that they give their creditors, like a bank or a–a–a supplier, stock in the company…

DAVID: Mm-hmm.

Mr. GREENBLATT: …so that they can come out–because they can’t pay off the debt…

DAVID: Right.

Mr. GREENBLATT: …because they don’t have the cash. So these suppliers and banks get stock in a company that they had no interest in getting.

DAVID: Right.

Mr. GREENBLATT: They sell it right off. It’s the same exact opportunity as in spin-offs and merger securities.

DAVID: It’s all in here, “You Can Be a Stock Market Genius, Even If You’re Not So Smart.” Our thanks to Joel Greenblatt, author of “You Can Be a Stock Market Genius.”

While doing some digging I found another interview with Greenblatt about special situations. This interview aired April 24, 1997 on CNNfn:

THIERRY: Some would say you wrote the book on-well, “You Can be a Stock Market Genius Even if You’re Not Too Smart.” It happens to be the title of your book. Is that really true that you can be a stock market genius even if you’re not to smart? Why is that?

GREENBLATT: Well, I mean, if you look at the professionals, 80 percent of them don’t beat the market every year. So, that’s really not the place that you should look, going into work every day, picking stocks. It doesn’t seem to work. So, I think the trick that I put in my book is looking in the right places. There are certain areas of the stock market where, just if you randomly select within those areas, you can beat the market. One of the easiest things for most people to check out for themselves is the area called spin-offs. And studies have shown that spin-offs-companies that were once subsidiaries or divisions of a larger company that get spun off to the shareholders of the larger company-do quite well. In fact, they do twice as well as the market on average.

THIERRY: But you want to know about them while they’re takeover targets.

GREENBLATT: No, these aren’t takeover targets.

THIERRY: Really?

GREENBLATT: What happens is these are small divisions of a company.

THIERRY: Of a company.

GREENBLATT: So, let’s say an insurance company owns a steel company. They could possibly say, listen, people don’t want to own both an insurance company and a steel company in one stock, so what they’ll do is spin off the steel company to their own shareholders. So now, everyone will own shares in a steel company and own shares in an insurance company. And what turns-seems to happen is that the shares that are just distributed-in other words, they’re not sold by brokers or anything else, you just get these shares- seem to perform very well, mainly because they’re priced very low in the beginning. No one wanted these shares. They’re sold off. They trade at low prices, and over the subsequent three years, they beat the market by 10 percent a year. So, in other words, if the market over a long term averages 10 percent a year, these will do 20 percent a year.

METAXAS: So, what opportunities are there right now in the market, and do you think it’s a good time to be looking at some of these situations?

GREENBLATT: Well, you know, I don’t predict the market, really, or where it might go. And I really pick stocks in special situations. And what’s interesting about spin-offs in particular as one area would be they’re always happening. And the reason why they’re cheap has nothing to do with where the market is as the current time. What it has to do with is the fact that people are getting shares that they don’t want, and they sell them.

So, there’s a few coming up right now. In the next few months, Westinghouse (Company: Westinghouse Electric Corporation ; Ticker: WX ; URL: http://www.westinghouse.com) is spinning off their industrial businesses. They’re going to keep TBS and they’re going to change their name to CBS, and there’s going to be a company called Westinghouse Electric which has their industrial business which includes Thermo-King which makes refrigerated trucks. It includes power plant manufacturing and energy manufacturing.

THIERRY: So, you would like the Westinghouse portion of it more than you would like the CBS portion?

GREENBLATT: You know, the funny thing is they both work out. The parent companies do quite well. They beat the market by about 7 percent a year, whereas the spin-offs themselves beat the market by about 10 percent a year.

THIERRY: All right, then take something a little bit more complicated: Pepsi (Company: PepsiCo Incorporated ; Ticker: PEP ; URL: http://www.pepsico.com/). All right, they’re going to spin off, I guess, in three ways or something.

GREENBLATT: Well, actually, Pepsi right now is going to spin off in two ways, except one of their divisions-Pepsi’s going to separate their restaurant business which is Kentucky Fried Chicken, which is Pizza Hut, which is Taco Bell-into a separate company. And Pepsi is going to keep Pepsi and Frito-Lay as one company, and the other company will be those three fast food restaurants. And together they’ll have about 29,000 restaurants. But it will be distributed to Pepsi shareholders who generally were buying because Pepsi’s a good business, just like Coke (Company: The Coca-Cola Company ; Ticker: KO ; URL: http://www.cocacola.com/). It’s-they sell concentrate, and it’s a nice growth business, where the restaurant business has stagnated to some degree. It’s kind of mature business that’s not growing. And that will be appropriate for certain people, and the faster growing soda business will be better for others.

METAXAS: What other themes do you like?

GREENBLATT: Well, another theme that I discuss in the book is buying companies that are coming out of bankruptcy-not going into bankruptcy, and not stocks of companies that just filed for bankruptcy. But what happens in a bankruptcy is that creditors of a bankrupt company-usually a bankrupt company doesn’t have a lot of money. So, they can’t pay off in cash their debts. So, what they give out is stock in the company and the new shares in the new company, the newly recapitalized company, after it comes out of bankruptcy. And a lot of times those share-a bank who gets shares in stock don’t want it. They sell that off, too. So, there’s another opportunity there.

METAXAS: What about insider buying? That’s another one of your themes.

GREENBLATT: Well, in anything that I do, I care that management’s on my side. So, while I said that, for instance, in the spin-off area, that you can double the market just by randomly selecting, I say you can do even better than that.

Let’s-let’s find things that are actually-will do better than the average spin-off which is already doing twice as well. And how do you find those? There are certain things you look at. One of them is insiders want it. That’s the easiest way. If the-I look at how much the insiders are getting paid in common stock and options, and how much they’re getting paid in salary to see how much they’re on my team.

If they’re getting big salaries and they don’t own much stock, I figure their interests aren’t aligned with mine. So, I try to stick to situations where management has a very big incentive to get the stock up. And, even just selecting that one area which is the most important to me, and selecting spin-offs, then you could do incredibly well.

CALLER: Oh good morning everyone. I’m thinking of selling my AT&T (Company: AT&T; Ticker: T; URL http://www.att.com/)and buying Westinghouse?

METAXAS: What do you think?

GREENBLATT: Well, that’s pretty interesting. Westinghouse (Company: Westinghouse Electric Corporation ; Ticker: WX ; URL: http://www.westinghouse.com) is actually going to be spinning off some of their divisions and separating CBS the faster growing and more attractive business from some of their slower growing and industrial businesses. Their core business from the pass. So, it’s a very interesting situation.

I think if you have a long term view of the market, which I think you have to have at this point, stocks are – especially the larger capitalization stocks are pretty high priced at this point, I think some of these will work out and you pick two somewhat depressed stocks; the AT&T and Westinghouse.

METAXAS: AT&T has already gone through that process of spinning off its division.

GREENBLATT: They have. They just spun off NCR which was also an interesting spin off possibility and that’s a stock that I own right now too. AT&T has a difficult challenge. Their business is changing. I don’t know any who really has a handle on how things are going to workout there. I think they should. AT&T should have the biggest advantage. It’s really fixed -costs business where you have everything in place, and if you are the biggest you should have the best costs advantage. So if they get their management act together, AT&T could turnout very well.

METAXAS: But you’d make that trade?

GREENBLATT: Westinghouse – I like playing special situations, when something interesting is happening. I read one report on Westinghouse which suggested that if they could get the ratings up at CBS you could see a $30 stock price near the next two or three years. And I think the industrial businesses could be interesting. It depends really how much debt is put on them, and how the distribution is made. But their both interesting situations. I probably wouldn’t favor one over the other in that stance, and it depends on what your tax situation is. If you can take a short-term tax lost by selling AT&T and swap for a Westinghouse. That might make sense. If you’re going to take a big gain, you know their both fairly attractive.

THIERRY: We’ve got Westinghouse down an 1/8 at 18 and AT&T down at 31. Our next caller is Mike in New Jersey.

CALLER: Hi, how are you doing. Could you tell me your long term on Compaq (Company: Compaq; Ticker: CPQ; URL: http://www.compaq.com/).

GREENBLATT: Well, the way I pick stocks is a know a lot about a few things. And I have a position in a small company that I don’t want to name that sells a lot of Compaq computers, and services . They’ve had a slowdown lately because the changeover in the new chips, and people – company sort of waiting for either the prices of the old stuff to fall, this is the usual game in the computer business or the their new stuff to come out, and sort of in paralysis and then a short term so what they’re going to pick. So, I really don’t have a long term call on Compaq. It’s a technology stock, also out of my

METAXAS: So, you’d just avoid. You think there is plenty else out there for you to be investing in.

GREENBLATT: Well, I think there doesn’t have to be plenty to be investing. I think this is certainly a stock that was market is what they say, in other words I probably wouldn’t buy the S&P 500 here, I think it has had a very nice run. The larger stocks have done very well, and I don’t know how that continues for a long time, and if you look at Warren Buffet’s latest letter, he said most stocks are overvalued at this point, including the ones he own. And what I think he’s talking about because he runs billions of dollars, he talking about the larger stocks. There are bargains in some of the smaller stocks that have gotten beaten up. This has been a large cap rally, and there is still a lot of small stocks that have gotten beaten up already. So that you don’t have to worry about a market fall quite a much. They all fall in a bear market, but if you pick thinks that have been beaten up already, they should rebound maybe sooner.

THIERRY: Well speaking of that, really the rally has been in such narrow for the blue chips you must be concerned about the fact that it has not broaden out,.

GREENBLATT: Number 1 I have no respect for anyone who has an opinion on where the stock markets going.

Having said that, it does scare me a little the big stocks – it’s been a very narrow band of big stocks that have done particularly well and left a small stocks in the dust. The other side of that coin, there may be opportunities in some of the smaller stocks that already been beaten up, and maybe that’s where I’d look if I were going to invest in the market, because I don’t feel like taunting it and I’m just trying to pick my spots a few things that I know well, that I want to buy is the way to play.

CALLER: Yes, I’d like to know how do you find out the information on the executives that have big holdings in companies which you’ve mentioned?

GREENBLATT: That’s a very good question, and it’s-there’s an interesting answer to that. It used to be much harder. You’d have to either write to a company or go down to the SEC and actually get filings or pay a service for–$20, $30-for each filing. Now, you can really get all this stuff for free over the Internet for the price of a phone call.

SEC requires all companies to file under the EDGAR system, and these are all posted on the Internet in a number of different sources, many of which are free. And you can just look it up, usually in the proxy statement it tells you exactly. When you’re talking about a spin-off, they have to file special filing called a form 10 approximately two months before they actually spin off the company.

So, it’s not even trading yet, and you’ll have two months to study up on a company. You don’t really have to have a quote machine or something like that tracking these things. You’ll have a couple of months to do your research. And, since there were about 100 spin-offs last year, and you probably only need five or six different securities in your stock portfolio, there’s plenty to choose from just in that area. So, those are available in the form 10, also available over the Internet for free.

METAXAS: Do you think five or six stocks will do it?

GREENBLATT: Yes. I think that one of the problems and one of the reasons why mutual funds don’t really out-perform the market is they can’t just stick to their five or six or seven best ideas. Generally, they’re running hundreds of millions or billions of dollars and they have to for legal
liquidity and compliance reasons invest in 30, 40, 50, 60, 100, 200 stocks. It’s tough to have 200 good ideas at one time, but it’s not so hard to have five or six good ideas. And that’s why, if you include all the expenses and having to pay their management fees, that’s why most of them under-perform most of the time. And even the ones who do better than average for a year or two, usually there’s no correlation between how they’ll do the next year. So, that’s not even going to help you. So, I think the bottom line is to do it yourself. But you have to put in a little bit of time. But it’s not that hard.

THIERRY: So, you really shouldn’t be running with the herds. In fact, it was said this morning that a lot of mutual fund managers are worried about the Jeffrey Vinik syndrome, and therefore, they want to just invest in the same stocks that every other mutual fund manager is going to invest, so that nobody could get fired, really, for being wrong. I mean, if they’re wrong, they’re wrong with everybody else.

GREENBLATT: I think that’s true, and I think the name of the game really in the mutual fund business is not to make money; it’s to do a little better than the market, or at least not worse than the other mutual fund managers. So, when I invest for myself, I’m trying to make money. When a mutual fund manager who is down 10 percent when the market’s down 20 percent is dancing.

THIERRY: He’s trying to keep his job.

METAXAS: Let’s go to David in New York. Hello, David. You’re on the air, David. All right, David was going to ask about Informix (Company: Informix Corporation ; Ticker: IFMX ; URL: http://www.informix.com/).

GREENBLATT: Well, it’s lucky, because I don’t know anything about it.

THIERRY: All right, well, there you go.

METAXAS: All right.

THIERRY: Let me just ask you then, if you are narrowing it down to the five or six, one of the five or six that you like is American Express (Company: American Express ; Ticker: AXP ; URL: http://www.americanexpress.com/), right?

GREENBLATT: Yes, actually I’m at the tail end of that position. That was a spin-off. They spun off Lehman Brothers(Company: Lehman Brothers Holdings Incorporated ; Ticker: LEH ; URL: http://www.lehman.com/) several years back, and the reason why-and in that case American Express was the parent company. I didn’t-I looked at Lehman Brothers, and the insiders didn’t own much stock. So, that’s one of the things I look at. I usually look at three things, but that’s one of the main things I look at. They didn’t own much stock, so I didn’t want to deal with that. But then I started taking a look at American Express which was the parent company of Lehman Brothers.

One of the reasons that most investors didn’t like the stock is because Lehman’s earnings were so volatile it screwed up the growth picture that was really happening in American Express which has two very good businesses; as a charge card business and an investment management business. So, once that was freed it-and if you subtracted the value of what you got for your Lehman stock and just sold it off, then you were able to create American Express at nine times earnings. And this is a real franchise. This is a Warren Buffet franchise. It turned out about nine months after the spin-off took place, Warren Buffet did take a 10 percent position in American Express, and this was really uncovered through the spin-off process, and so American Express at that time was around $30. And it’s had a great run here, when-where people though that, gee, these are great businesses and they’ve had a huge earnings explosion, should earn over $4 this year. And it’s a very high-quality stock. It has had a nice run.

The only reason I’d hang in there now is because they were in talks with Citicorp (Company: Citicorp ; Ticker: CCI ; URL: http://www.citicorp.com/) at the end of last year. And I think once you’ve decided to sell your company, I think that’s the end of the game. It’s very hard to keep your employees motivated and everything else, and I think they’re in a little bit of Limbo now. And I think when they find the right deal-and Citicorp would have been a very good deal. It probably wouldn’t have been, from what I’ve read, a big premium to the stock price. But, what would happen if Citicorp and American Express merged together, there would be a lot of cost-cutting they’d be able to do, because Citicorp has a huge credit card portfolio, and there would be a lot of overlap and Citicorp would love to have American Express’s investment management business. And, I think both stocks would go up significantly, even if it was a merger of equals.

METAXAS: All right. We have a quick question on banking now from Diana. Good morning, you’re on the air.

CALLER: Yes, good morning, I’m interested in Chase Manhattan Bank (Company: Chase Manhattan ; Ticker: CMB ; URL: http://www.chase.com/), what you think of it. It’s gotten beaten up kind of the last week or so.

GREENBLATT: Well, actually I used to own Chase Manhattan. I actually sold it before it made its big run-up, right around $90. I guess it ran up way past there. I’m not sure where it is today, but in that area. You know, I was a seller of that, basically because you’re sort of-banks have had a very nice run. I try to look at normalized earnings, in order words, how much Chase should earn in a good environment or in an average environment, actually. And I think now we’re a little better than average.

They have a big credit card portfolio, consumers, and every few years the banks blow up in some area. At one point it was foreign loans. Now, I think the next coming crisis and that’s the issue, whether it will come or won’t it come is they have a big exposure in credit card lending. And consumers are really strapped. And I think with the economy still strong, you’re still having huge amounts of bad debt expense for all these credit card companies, and I think that-I think that we’ve hit the peak in that area, and although I don’t think it’s an expensive stock, there are probably cheaper things out there.

So, I think it ran even further than if it was going to normalize. So, I think it’s a good stock, not a great stock.

THIERRY: And, as opposed to spin-offs, we’re seeing so much consolidation in the banking industry right now.

GREENBLATT: Yes, which is a big move. And, obviously, that was- Chase has more than doubled over the last couple of years, and that was really the merger with Chemical. It was a huge cost- cutting benefit, eliminating a lot of duplicate. And that’s- operations-and that’s been the big story in that stock. And that story’s out. They’ve achieved the benefits, or at least it been
assumed that they will achieve the benefits that they planned in the stock price now, and I don’t think it’s overpriced. I just don’t-and relative to the market, it’s probably a good buy. It’s just I think it’s had its run.

THIERRY: All right, let’s go to Alice in New York.

CALLER: Hi, Joel, I just wanted to say I thought your book was terrific. Could you tell me what your favorite spin-off idea is today?

GREENBLATT: Well, there’s one that we own-I really don’t like to tout stocks in general. I mean, the idea behind my book was to really teach people to fish for themselves and they could eat for a lifetime. And one of the-but, one of the things that we do own that
was-is a big cap stock that I don’t think will move the stock one way or the other was a spin-off from, actually, AT&T (Company: AT&T; Ticker: T; URL http://www.att.com/), and that company is NCR (Company: NCR Corporation ; Ticker: NCR ; URL: http://www.ncr.com/).

Back about six or seven years ago, NCR was purchased by AT&T in a hostile deal, and they paid about $7 billion. Since that time, they’ve sunk in about $3 billion into NCR, so that’s about $10 billion. They spun it off in January. Now, the stock with no debt is priced at $3 billion. And, if you really want to look at it, the stock’s at $30. It’s got $11 a share in cash with no debt. So, really, we’re down to a valuation for the actual business of NCR of $1.9 billion. And NCR has a couple of good businesses. I’m not an expert in technology, but this is the way I look at things. If I feel like if I’m not going to lose money, then the other alternatives are pretty good. So, I’m looking down. I have $11 in cash in NCR; the stock’s at $30.

They have a data warehousing business which should do about $800 million in sales this year, and that’s the business where they provide computers for, let’s say, Wal-Mart (Company: Wal-Mart ; Ticker: WMT ; URL: http://www.wal-mart.com/) and they, at the check-out counter, there’s a huge amount of information that flows through there, there are only very few computers that can do it, and NCR is the leader in that field, data warehousing, even though it’s small relative to their $7 billion in sales, it’s a fast growing business. And, other competitors might trade at two or three times sales. Just give that one times sales. That with the cash covers most of the value of the stock. And there’s still over $6 billion of sales left.

THIERRY: All right, there you go.

METAXAS: All right.

THIERRY: Joel Greenblatt, Managing Partner at Gotham Capital. Thank you so much for joining us this morning.

GREENBLATT: Well, thank you for having me.

I’ve been trying to do more reading on Joel Greenblatt, especially about the magic formula he describes in his book The Little Book That Beats the Market.

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.