Joel Greenblatt on Special Situations, the Magic Formula, and Paying Up for Quality

Joel Greenblatt

My first full-time job on Wall Street was doing risk arbitrage — merger arbitrage — and basically when a deal goes through you make a dollar or two, but if it doesn't go through you lose ten or twenty dollars. That wasn't a very appealing risk-reward business for me. So I ended up looking around the perimeter of the deal: when different pieces of paper were given out, or there was a company spin-off before a deal could get done — anything that could get me out of risk arbitrage and into something else.

It turned out that when companies are going through extraordinary change, a lot of interesting things happen. Sometimes they're complicated; sometimes little pieces get thrown away. I started looking at all these different areas because the risk-rewards were so much better. These special situations don't happen in their hundreds at once, so if you examine one that is complicated, or obscure, or not on everyone's radar — because the regular analyst who follows that business doesn't care about this little piece — you can almost not invest so much as cheat. You know what something's worth, nobody else is looking at it, and if you can buy it for a lot less it doesn't feel that risky. If you think it's worth ten dollars and you can pay five, and you're wrong and it's only worth seven, that's Ben Graham's margin of safety. And you can take a bigger position in something where you can't lose much money.

Joel Greenblatt

Even in that case I didn't feel I was being bold. I felt I had an opportunity that doesn't come along that often and I had to take advantage of it. In the Host Marriott situation — a spin-off from Marriott that split into two businesses, one bad — the capital structure was set up so that the parent company didn't have effective debt on it. The debt was asset-specific, like a mortgage on a building, not corporate-level debt. I paid four dollars for what I thought was six dollars' worth of unencumbered assets, plus a whole other business in a subsidiary that could be worth a lot of money. I didn't think I was taking much risk; I thought people just didn't see this because it was so complicated.

It's like finding one of the best things you've ever seen and putting one or two per cent of your portfolio into it — that's getting it wrong. That's saying you don't see this very often and you didn't actually take advantage. You really have to take advantage. I'm a little older and wiser now — I've seen crazy things happen and made many mistakes. My partner Rob Goldstein and I have joked many times that if we worked for someone else they would have fired us about six times already.

Joel Greenblatt

Harcourt Brace Jovanovich — a publisher that also owned amusement parks in Florida, believe it or not — went to acquire a small company called Florida Cypress Gardens, which I remembered visiting as a kid. There were water-skiing Santa Clauses at Christmas time, water shows, beautiful gardens.

When I saw it was being taken over, I was literally in the first month of running my own business. I was 27, I had money from a very famous investor, and I wanted to do a good job. There was a nice spread in the deal and I thought it made sense, so I bought Florida Cypress Gardens as one of my first investments. A few weeks before the deal was supposed to close, Florida Cypress Gardens fell into a sinkhole. The main pavilions literally fell into a hole that appeared out of nowhere — and apparently that happens quite a lot in Florida.

The Wall Street Journal wrote a humorous story about it. I was thinking: why is this funny? I'm about to lose my business. It teaches you that things can happen that you don't anticipate and that aren't really your fault. I had never even heard of a sinkhole. They recut the deal at a lower price and I lost money, but not terribly. Howard Marks's line fits perfectly: experience is what you got when you didn't get what you wanted.

Joel Greenblatt

I've been doing this a long time and I had never seen anything like it — never anticipated anything like closing down the world. Besides the terrible human cost, it was a great lesson that you have to be at least diversified enough and aware enough that really bad things can happen. You have to live to play another day. You can come back from big mistakes, but you have to survive first.

Part of what you get paid for in this business is your stomach. What I always enjoyed was that if you think well and try to figure things out, it's not a matter of how many hours you showed up — it's the quality of your thought. But understanding that bad things can still happen regardless of how well you thought is important. The market came back fairly quickly, so it wasn't as painful as it could have been, but we didn't know that at the time.

Joel Greenblatt

I don't consider six to eight names making up 80 per cent of your portfolio particularly concentrated. One name for your whole portfolio — that's concentrated. Think about it as Warren Buffett would: you sell your business and get a million dollars. You look around town at a couple of hundred businesses and pick six or eight that you can buy at a good price, in good businesses, with management you think will do a good job. Nobody would say you're crazy. They'd think you're prudent — you took your windfall and divided it among six or eight businesses.

But put a stock price on it every day and people change the analysis. It's what the finance literature calls myopic loss aversion: people don't like getting a quote that's 30 to 40 per cent down. Meanwhile, big institutions invest in private equity — funds that buy a small handful of businesses, leverage them up — and nobody thinks they're crazy. They just don't mark down their portfolios the way the stock market does; they wait a few months and pick a number. I just get a quote every day and have to contextualise it correctly.

Joel Greenblatt

Not very well, if I'm honest. We did very well in our first fifteen months — up 140 per cent — so there was no worry about Mike Milken coming to yell at me for that. The problem was that after we had done so well, starting in April 1985, I called all my siblings and family members in about July 1986 and said this is going pretty well, I think you should put your money in. And of course in the next six months through year-end I lost 17 per cent of their money. They hadn't participated on the way up; I called them at the peak, and was down 17 per cent. That was probably one of the most difficult things I've done.

One of the reasons I gave back all the outside money after ten years was that I loved this business — it was fun figuring out the puzzles, making money — but the extra pressure of managing other people's money was a little too much. I was making a business I really loved into something that kept me up at night. When I gave back the outside money, did that relieve the pressure? About half of it. It turns out it's still not fun to lose a lot of your own money — but nothing like worrying about the money of people who trusted you.

Joel Greenblatt

To be a really good investor with a strong enough stomach, I think you have to have a screw loose somewhere. I do feel the kick in the stomach when I lose a lot of money, but I usually adjust in two or three days and start thinking about how to take advantage of the opportunity. Different parts of your career are different. When you're young you figure you have time to make it back. When you're older you have the experience to know that it will come back — you've seen it not once but many times.

The best thing I've found is to count your blessings fairly quickly: can I live with where I am now? Yes. Let's move forward. One of my early mentors, the head of risk arbitrage at Drexel, said to me when I was complaining about a loss — he asked whether good things had happened more often than bad things, and when I said yes, he said: then stop complaining. If you didn't take risk you couldn't make extra money. The stock market gets very emotional, creates these opportunities, but the pain comes with it. If it didn't, everyone would do it and there would be no opportunity.

Good investors still get kicked in the stomach, but they come back soon enough to take advantage of the opportunities that come with volatility. And I do think if you actually know what you own — if you can value a business and the premise you bought it on is still intact — that's the only way to deal with the emotion. You realise what you own is still good.

Joel Greenblatt

Even before 1990, reading enough Buffett, I wanted to buy good businesses — I was just cheap. I wanted everything. One of the reasons I downsized the business and gave back the outside capital was that I wanted to own both cheap and good, and if I couldn't find much of that I was just going to stay concentrated in cheap and good. The trouble was I didn't yet understand what "good" really meant at a price that seemed high.

Moody's was one of the first businesses I was willing to pay over 20 times earnings for. At the time, interest rates were much higher, so that was a lot to pay. But it took no capital, had a powerful franchise, and only a few competitors. I went back and reverse-engineered Buffett's purchase of Coca-Cola — I believe around 1990 — and looked at what he paid and adjusted for differences between the businesses. Coke had to reinvest some of its earnings to grow; Moody's really didn't, so you kept more of the earnings, which meant you could justify paying a little more.

On an apples-to-apples basis he paid ten dollars for Coke and I was paying thirteen for Moody's equivalent. If ten was going to quadruple to forty, thirteen going to forty was also pretty good. And that's what got me into paying up for truly great businesses. In some ways it's cloning: I didn't try to reinvent the wheel; I tried to think like one of the smartest and most successful people in my area.

Joel Greenblatt

I learned about myself — that I'm incredibly shy — because I was more reserved than I wanted to be when meeting my idol. He took us all out to lunch, had a great question-and-answer session, handed me his fat wallet for a photo. What struck me most was how gracious he was. Someone this successful, this admired, and he genuinely enjoyed spending time with a class of students, treating them with such kindness. The word that comes to mind is role model. I admired him even more after I left, which was hard to do.

Joel Greenblatt

I walked away feeling the same way about Warren Buffett. There's a reason the two of them have been together for so long. I know many people who are far less accomplished but don't have those qualities. I think about it a lot. To the extent that I can emulate any piece of that, it's something I aspire to. They have been extraordinary role models for me and for so many other people, and that's a remarkable thing to say about anyone.

Joel Greenblatt

When I wrote You Can Be a Stock Market Genius about my years at Gotham and special-situation investing, I decided I wasn't going to do a lot of research after the fact — I just wanted to write down what I was actually thinking at the time and why. That started me on simplifying. Then I started teaching MBAs at Columbia and realised the book was really written at MBA level — if you didn't have the background, you wouldn't really understand it. So every time I thought of a new lesson to teach, I tried to simplify it further, to get to the real essence of what I was saying.

Back in business school I had written a paper with two friends on Ben Graham's stock-picking approach — his own version of a magic formula, buying stocks only when they sold below liquidation value. He always held a portfolio of about thirty such stocks. The takeaway I had was: if you can't lose money, most other alternatives look good. If you buy something at half its cash value, it's hard to lose much, and the odds are in your favour.

But because I had been "Buffett-ised" — I'd rather buy a good business than troll through the dregs — I updated that research. What if I combined cheap and good? The computer was better in the early 2000s than in 1979. I stuck my finger in the air and said: what's a crude metric for good, and what's a crude metric for cheap? Crude metric for good: high returns on tangible capital — that's really what Buffett's letters point to. Crude metric for cheap: earnings yield, roughly — if you can get a 10 per cent yield owning a business that you think is going to grow, and you could only get 5 per cent in a bank, that sounds better.

We ran it through the computer over the full period where we had good data, back to 1987, and it worked remarkably well. The top decile beat the second decile beat the third and so on, all the way down — in order. That was true not just backwards but forwards. If you were buying the top decile and shorting the worst decile in the year 2000, though, you would have lost all your money — even though if you'd survived past the losses, it would have reversed over the next few years. I've often said zero doesn't compound very well. So one lesson is: you can just buy the cheap and good ones and hope for a very good return without the leverage that wipes you out.

Joel Greenblatt

The fun of the little book was that I did not spin the computer thousands of times and optimise for the best two variables. I said: let me think of a crude metric for cheap, a crude metric for good, put them together, and see what happens. That was the very first test we ran. It worked incredibly well and in order by decile.

I agree that just buying cheap also works very well. It tends to be more volatile. It depends how you measure returns and risk — and I don't measure risk by volatility. It turns out that if you're buying big cash-flow-generating businesses, they're usually also getting good returns on capital. Think of it this way: if you open a store and earn 30 per cent returns on tangible capital, that's pretty good — not many places in the world offer that. But can you open a thousand of those stores before the return comes down? That's the real question. So I still think cheap and good is very valid for a concentrated portfolio, where you want to make sure people are buying things that are both safe and attractively priced, not just running a statistical screen.

We've run a diversified value portfolio since 2010 that's done incredibly well — almost as good as the S&P 500, which is remarkable for a deep-value approach during a period that crushed most value investors. And when I look at where that value portfolio is priced today versus the S&P, the data suggest it could earn 35 to 40 per cent over the next couple of years based on historical analogs, while the S&P looks like mid single digits.

Joel Greenblatt

Most of my money is invested in diversified portfolios — more similar to how the Magic Formula works. That's a full-time job; we run a big research team and technology team to implement those portfolios, some long-short, some long-only. I also have concentrated positions in a handful of businesses you would know — Google, Microsoft, and a couple of others — because they're businesses like I've never seen in my career. I still don't think they're fully priced. The network effects, barriers to entry, and global reach are unlike anything that came before. Usually the law of large numbers eventually slows great businesses down — you think of what happened to IBM, Polaroid, GE — but I don't see the same forces at work here, or at least not yet.

The concentrated portfolio is relatively passive because my full-time job is running the diversified portfolios. I like both approaches for different reasons. One is far less volatile; both get very nice risk-adjusted returns over time.

Joel Greenblatt

It wasn't really touchy-feely factors. It was more like a mind-meld. In both cases you mentioned, I read an investment write-up they had done. As I was thinking "but what about this?" they'd say it. And then "what about that?" They'd say it next. The way they were thinking was so aligned with the way I think that I said: all right, they're answering all the questions I would have, and even some more. I read a couple of Michael Burry's ideas he was posting online and said I don't need to know more.

With Norbert Lou, my partner John Petry and I had opened the Value Investors Club in 1999. The internet seemed like a great way to build an investment community without needing to meet in person. The Yahoo message boards at the time were worthless for investing — too much noise. So we said: if you can write an investment idea at the level of an A-plus paper in my Columbia class, you can get into the club. That's a very high bar — maybe two or three students a year from a highly selective MBA programme would reach that level.

The genesis was that we had found a write-up we thought we were the only people in the world to have done — a company trading at about twelve dollars, with roughly four dollars in cash and a complicated capital structure that hid a good business underneath. We thought because it was so complicated we had it to ourselves. John found someone on a Yahoo message board who had figured it out too. It turned out that person was working behind a deli counter at a supermarket. It said to us: there's talent in unlikely places. That became the basis of the Value Investors Club — and it inadvertently became something like American Idol for hedge fund managers.

Joel Greenblatt

I'm glad you brought up Charlie Munger as the "no man," because Rob is one of the most independent thinkers I know. It doesn't matter if I come to him with an idea I think is great — that carries no weight with him until he has done his own work. He won't be a yes-man in any way. He respects me enough to do the work and then decide whether he agrees. I feel the same way about him: any idea he brings, I value, but I want to do my own work.

We're both wired just to get to the right answer. If you can focus on what are the facts in front of me, be cold-hearted, and be willing to say what you think even if it stings — because the other person actually wants to hear it — that's our relationship. If an idea gets past both of us, it's usually pretty good.

What makes it work is also that when things go wrong — and things always go wrong — there's no finger-pointing. Mistakes are both of ours. We only do things we agree on together. That's a real partnership. It's very hard to maintain because of personalities, stress, and the sheer volume of things going wrong. I think it's more to Rob's incredible qualities than mine. He's selfless, thoughtful, and independent-minded. I consider myself an average analyst; Rob is one of the best I've ever seen. He cuts to the heart of matters very quickly, and since we're only going for truth, that saves a lot of time.

The other thing is: some of the most brilliant investors eventually stop listening to anyone — because they're right so often, and no one around them will push back. I've seen people with great careers make mistakes you can't even fathom, simply because nobody told them they weren't wearing any clothes. Buffett has Munger for exactly that reason, and I have Rob.

Joel Greenblatt

Number one, if I'm lying in the foetal position under my desk you can't really see me. But truthfully I feel overall very lucky and I keep that perspective. I've been blessed with a wonderful family. I got into the stock market at the beginning of the 1980s, right before this amazing bull market, so the wind has been at my back. I have no illusions about that. I've tried to give back because of it, not because I've overcome some dramatic adversity I can now share wisdom about.

I returned the outside money partly because I realised I was making a business I loved into something that kept me up at night. Knowing when enough is good enough — knowing your circle of competence and not straining beyond it — that helps. And the other part is that I just got very lucky with who I married and with how my kids have turned out, and I give my wife Julie most of the credit for the latter.

Joel Greenblatt

Together with my partner John Petry, we really took a business approach. We're not education experts, but we know what makes businesses work. The challenge in education is scaling. There are plenty of great one-off schools — if you get the best teachers and give them enough resources, you can have a really good school. But can you replicate that for kids who have fewer resources coming in?

From a business standpoint, we knew that if you rely only on the top one per cent of teachers, you'll run out. So the question becomes: can you give an average teacher a model that allows them to be great? Whatever you do has to be replicable. We hired one of the most brilliant women I've ever met — Eva Moskowitz — to design a school around that principle. We started with one school and when it was doing well a couple of years later, we opened three more. The only question I asked was not "are these schools great?" but "how much ahead are these three schools compared to the first one?" That's measuring outputs — are kids learning? — not inputs — does this teacher have this many years of experience?

There was a lot of trial and error. What worked, what worked better, how to recruit and train teachers. I give total credit to Eva Moskowitz, who has been incredible. She is the one part that's not replicable, but she has created a system that others can learn from. The 23,000 kids at Success Academy today — mostly on free and reduced lunch, mostly minority — outperform students in the wealthiest school districts in New York. That says we are wasting a lot of potential. These kids, with the right resources, can achieve at the highest levels.

Joel Greenblatt

Buffett puts it better than anyone: understand what your circle of competence is. It doesn't mean you can't expand it, but understand what it is and only play the game you can play. Find out what you're good at, what you enjoy, and what you can be successful at. That's most of the advice I've given my kids — I didn't say go be an investor; I said find that thing.

In terms of what actually works in investing: buying cheap and good businesses, as rigorously as you can define those two qualities, has an extraordinary long-term record. Concentration works when you genuinely understand what you own and your premises are intact. Great partnerships make you better — they catch the things you miss and keep you honest when you're tempted to go along with your own prior conclusions.

And on the other side of the ledger: don't speculate with money you care about in areas you can't value. Size your bets appropriately to the confidence you actually have. Understand the difference between a calculated risk and a gamble. Don't try to get to 100 per cent of everything — find the one-foot hurdles you can clear reliably rather than the ten-foot hurdles that look exciting.

Joel Greenblatt

I gave them a lot of Warren Buffett's writings, and told them which chapters to read in what order. Then the same things that got me started: Ben Graham, Buffett's letters, David Dreman. All the things that started me thinking about the world in the way that I do. And I have two out of five who are going into professional investing — my oldest, who started as an opera singer, has been working with me for over ten years and has already passed me by, about five years ago. And a younger son who is starting out but showing great promise. Which is exactly what I hoped for all of them — to find whatever they are, and then be great at it.

Joel Greenblatt

Thank you for sharing everything you've learned over time. As a writer, you're pretty incredible, and I just wanted you to know that.