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MI381: Joel Greenblatt: Behind the Magic Formula w/ Shawn O’Malley

MI381: Joel Greenblatt: Behind the Magic Formula w/ Shawn O’Malley

Released Monday, 9th December 2024
Good episode? Give it some love!
MI381: Joel Greenblatt: Behind the Magic Formula w/ Shawn O’Malley

MI381: Joel Greenblatt: Behind the Magic Formula w/ Shawn O’Malley

MI381: Joel Greenblatt: Behind the Magic Formula w/ Shawn O’Malley

MI381: Joel Greenblatt: Behind the Magic Formula w/ Shawn O’Malley

Monday, 9th December 2024
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0:00

You're listening to TIP. Today's episode is something

0:02

of a special treat, at least in my

0:04

opinion. Rather than breaking down a company, going

0:07

through lessons from a book, or combing over

0:09

memos and letters written by great investors, we're

0:11

going into the classroom for today's episode. That

0:13

is to say, while it costs hundreds of

0:16

thousands of dollars to attend an Ivy League

0:18

school like Columbia, I'll be giving you a

0:20

preview into what an education and finance at

0:22

a top university looks like. Even better, I'll

0:25

be going off the video lectures of the

0:27

legendary investor Joel Greenblatt who has long served

0:29

as a professor at Columbia and has published

0:32

roughly a dozen hours of his lectures on

0:34

YouTube. It's so rare to have the chance

0:36

to literally be taught how to invest by

0:38

an all-time great. At best, we can usually

0:41

only hope that a tighten of finance will

0:43

have written some letters or done some interviews

0:45

over the years and maybe even have written

0:47

a book. But to have a peek into

0:50

someone like Joel Greenbot's teaching lessons is really

0:52

just invaluable material to investors. You're not familiar

0:54

with Greenblatt. You should know that not only

0:56

did he have an incredible market beating track

0:59

record, but he relied heavily on a simple

1:01

formula for success that he calls the magic

1:03

formula for investing. He breaks down the formula

1:05

in detail in his book, The Little Book

1:08

that Beats the Market, which is one of

1:10

the best-selling investing books of all time. Additionally,

1:12

he created the Value Investors Club Forum, which

1:14

is an incredible free resource for reading the

1:17

research and ideas of some of the best

1:19

investors around. Greenblatt actually calls it American Idol

1:21

for hedge fund managers. It's not a pay-to-play

1:24

kind of club, though. Instead, you have to

1:26

submit an investment idea to be admitted, which

1:28

gives you the chance to submit between two

1:30

and six investment ideas every year. But all

1:33

the ideas are available for free to anyone

1:35

to read at a delay from when they're

1:37

published. It's just that you have to have

1:39

your picture proved to be able to see

1:42

posts in real time and to contribute new

1:44

ideas directly to the forum. So much of

1:46

what I've learned as an investor has come

1:48

from this forum. And I really think it's

1:51

one of the best places for new and

1:53

intermediate investors to see how the most sophisticated

1:55

stock pickers think through potential opportunities. I'll of

1:57

course, I haven to draw. GreenBots

2:00

Lectures at Columbia. at

2:02

Columbia. Celebrating 10 years,

2:04

you are listening to millennial

2:06

you are listening to

2:08

Millennial Investing by the

2:10

Network. Since 2014, Since 2014,

2:12

we have been value

2:15

investors for for studying legendary

2:17

investors, understanding timeless books,

2:19

and breaking down great

2:21

businesses. down Now, for

2:23

your host, your host, Sean O'Malley. Today,

2:34

I'll be be digging through the video

2:36

lectures of of investor Joel Greenblatt

2:38

from his time as a as at

2:40

Columbia. Columbia. Greenblatt is a wealth of

2:42

wisdom, you so you don't want to miss

2:44

out on these special insights. We'll go over

2:46

over this episode. episode. To set the stage, just

2:48

say that GreenBot's track record

2:51

is largely is largely unrivaled. From 1985 to

2:53

2005, he earned better returns than

2:55

even Buffett did across much of

2:57

his career, compounding at 48 .5 %

2:59

per year for over 10 years

3:01

during that time. focuses formula

3:03

focuses simply on companies with large

3:05

earnings yields, meaning they're cheaply valued

3:07

relative to the amount of profit

3:09

they produce while also having high

3:11

returns on capital. capital. He would essentially

3:13

rank stocks by their by their returns in

3:15

capital and then by the top and

3:17

then buy the short the worst ranking and sell

3:20

short the his so -called magic formula,

3:22

his would have earned a compounded

3:24

annual return of 23 .8 %

3:26

from 1988 to 2009. from 1988 to

3:28

the 9 .6 % yearly return from

3:30

the S &P 500 over that period.

3:32

period. In 1981, 24 at just 24 years

3:34

old, a published a research paper

3:36

that would shape his career Small Investor can

3:39

Investor Can Beat the Market that

3:41

stocks that are selling below their

3:43

liquidation value. early on, Greenblatt on, buy

3:45

wanted to buy stocks that traded at prices

3:47

so cheap that if the company fell a

3:49

bankruptcy and had to sell off its assets, it could

3:51

It could plausibly do so for more than the current

3:53

market value of the stock. the stock. These situations are

3:55

abnormal, but they've been observed to

3:57

happen. and Greenblatt would take

3:59

the start of ultra- cheap socks and

4:01

refine things even further, cutting out the

4:03

worst and most unprofitable of these businesses.

4:06

With that said, the first lecture I'll

4:08

go over today is from October 2005,

4:10

where Greenblatt reviews three of the best

4:12

pitches to the Value Investors Club that

4:14

he's ever seen, all from the same

4:16

investor. What's cool is that you can

4:18

actually go into the Value Investors Club

4:20

website and search up the exact pitches

4:23

they're reading in Greenblatt's class, which I'll

4:25

link to in the show notes. In

4:27

June 2001, an investor with the username

4:29

Charlie 479 submitted and Vr, which is

4:31

a home builder. Again, this pitch would

4:33

go on to become somewhat legendary among

4:35

deep value investors, and I'd really encourage

4:37

you to read it for yourself to

4:40

see what a concise investment thesis looks

4:42

like. In short, NDR's operating model was,

4:44

in Charlie's words, somewhat unique, and it

4:46

allowed them to assume the least risk

4:48

in the industry to produce industry leading

4:50

returns, which is just really rare. Charlie

4:52

479 basically argues that homebuilders are largely

4:54

dismissed because they're cyclical and sensitive to

4:57

interest rates, leaving them with large inventories

4:59

of unsold properties and economic downturns. Builders

5:01

with the most debt typically fall into

5:03

bankruptcy, while the homebuilders survive endure substantial

5:05

write-downs of their assets. Yet, NBR is,

5:07

or at least was, different. Rather than

5:09

purchasing land outright for development, like most

5:11

builders, NBR would acquire the rights to

5:13

use land through options contracts, which gave

5:16

them the right to buy lots, but

5:18

doesn't obligate them to do so. They'd

5:20

put up 5 to 7% of the

5:22

land value up front and could decide

5:24

from there if it was worthwhile to

5:26

complete the full purchase. As it's laid

5:28

out in the pitch, quote, by avoiding

5:30

the speculative practices of land purchase and

5:33

development and instead using options, NBR is

5:35

able to control large blocks of land

5:37

in its markets while employing less capital

5:39

to do so. The lower capital requirements

5:41

of this method translate into lower inventory

5:43

risk and greater returns on capital. And

5:45

secondly, what differentiated NBR, according to Charlie

5:47

479 at the time, was that the

5:50

company pre-sold most of its homes and

5:52

collected deposits before beginning any construction, which

5:54

ensured that they didn't any construction costs

5:56

until they were certain they had a

5:58

buyer for it. With this superior business

6:00

model, NDR traded at a surprisingly low

6:02

price earnings ratio of just 8, while

6:04

having a substantial backlog of ordered homes

6:07

and a track record of high returns

6:09

on capital. In addition, the company was

6:11

buying back stock aggressively and with only

6:13

a small percentage of its shares actually

6:15

trading on the stock exchange. It was

6:17

particularly vulnerable to big swings from large

6:19

shareholders' uping shares, which could pretty disproportionately

6:21

weigh on the stock for short periods

6:24

of time, but offered great chances for

6:26

long-term investors to buy in. So it's

6:28

a compelling pitch and that gives you

6:30

a rough idea of the first investment

6:32

opportunity that Greenbot reviewed with his class.

6:34

I actually looked up the stock out

6:36

of curiosity to see how it's doing

6:38

today and while it's up 163% in

6:40

the past five years and trades at

6:43

a price earnings ratio of almost 20,

6:45

so the market has clearly come to

6:47

better appreciate the quality of NBR's business

6:49

by paying a higher premium to own

6:51

its shares. In the 23 years since

6:53

it was first published, NBR's stock price

6:55

per share has compounded at an impressive

6:57

20% per year versus only 7% per

7:00

year for the S&P 500 over that

7:02

same period. So with hindsight, we can

7:04

say pretty safely that Charlie 479 nailed

7:06

it with NBR, even with the great

7:08

financial crisis lurking just a few years

7:10

on the horizon. Evidently, NBR would not

7:12

only survive the crisis, but it would

7:14

nearly triple the market's average annual returns,

7:17

which is just a huge testament to

7:19

the quality of NBR's business, especially relative

7:21

to its competition. We obviously know how

7:23

this investment played out, but what I'm

7:25

interested in is just given the plain

7:27

information from the pitch, how does Greenblatt

7:29

think through the pros and cons, what

7:31

kind of things does he worry about,

7:34

and really what is his approach to

7:36

breaking down a potential investment. To begin

7:38

the exercise, Greenblatt likes to condense down

7:40

any given investment thesis into just two

7:42

to three sentences, which is what he

7:44

asked his students to do with this

7:46

one. Greenblatt works through his thinking on

7:48

the idea, suggesting that he'd want to

7:50

know how much the company is getting

7:53

in deposits for pre-sold homes to ensure

7:55

that they're actually being adequately compensated for

7:57

the risk of someone bad. out. Related

7:59

to that, as an investor, he would

8:01

probably try to dig up numbers on

8:03

what percentage of these pre-sold homes fall

8:05

through and how that changes over time

8:07

through different points in the economic cycle.

8:10

He indicates that the company probably has

8:12

some economies of scale advantages where their

8:14

size allows them to build homes at

8:16

a lower cost. and most importantly allows

8:18

them to afford options contracts on large

8:20

tracts of land that other firms may

8:22

not be able to afford. The students

8:24

throw out a bunch of questions and

8:27

concerns at him and take a stab

8:29

at describing the thesis, but I love

8:31

how Greenblatt simply is able to distill

8:33

everything down. Being able to reduce nuanced

8:35

points into their most understandable form without

8:37

sacrificing any key information is really a

8:39

superpower in my opinion and the mark

8:41

of a truly great investor. Greenblatt exemplifies

8:44

this by outlining that the crux of

8:46

the thesis here is that this is

8:48

a company that's priced cheaply at just

8:50

eight times earnings, yet they put little

8:52

capital in the business comparatively since they

8:54

use options agreements instead of buying land

8:56

outright, and they pre-sell their inventory beforehand,

8:58

which gives them a big cash flow

9:01

advantage. As he puts it, since NBR

9:03

is taking little financial risk, there will

9:05

probably be a temporary hit to their

9:07

business in a downturn, but it won't

9:09

be devastating for them. So there's very

9:11

little overall risk here given what we

9:13

understand qualitatively about the business and based

9:15

on the valuation it traded at it

9:17

would have been very unlikely to lose

9:20

money on the stock at the time

9:22

it was originally pitched. Meanwhile the upside

9:24

was considerable assuming the company could leverage

9:26

its advantages further and continue to compound

9:28

capital at the rates it had already

9:30

proven it could in previous years. These

9:32

are exactly the sorts of companies that

9:34

made Green Blatt Rich over the course

9:37

of his career. High quality companies at

9:39

four at times in expucable reasons treated

9:41

at ultra cheap prices. 2001 was a

9:43

long time ago, but it wasn't that

9:45

long ago. If these types of opportunities

9:47

were sitting in plain sight then, I'm

9:49

pretty confident they are still now too.

9:51

Part of what made this type of

9:54

opportunity possible where there was a pretty

9:56

extreme degree of asymmetry and upside relative

9:58

to the downside is that NBR had

10:00

gone into bankruptcy in 1991 under a

10:02

different and more conventional home builder business

10:04

model back then. Greenblatt proposes that the

10:06

market essentially hadn't learned to trust in

10:08

VR yet and was still leery of

10:11

it, which caused investors to overlook the

10:13

fact that its business model had changed

10:15

and was leading to impressive returns in

10:17

capital with relatively minimal risk. So there

10:19

are typically good reasons for an opportunity

10:21

like this to slip through the cracks

10:23

and capitalizing on it would have required

10:25

an appreciation for how the business had

10:27

changed. I really love a point that

10:30

Greenblatt makes too in response to a

10:32

student who asked that if the company

10:34

essentially has very few assets since it's

10:36

not holding a ton of property on

10:38

its balance sheet like other homebuilders, is

10:40

the stock become virtually worthless in a

10:42

down year if it can't sell many

10:44

houses and therefore earns no profit? As

10:47

Greenblatt puts it, what matters with a

10:49

cyclical company are the average earnings. If

10:51

a company like NBR can earn $10

10:53

in profits per share for 9 out

10:55

of 10 years, and in the 10th

10:57

year it earns a profit of 0,

10:59

it doesn't make the business suddenly worthless.

11:01

on a normalized basis where you average

11:04

at results across the economic cycle, such

11:06

a company would earn an average of

11:08

roughly $9 per share each year, which

11:10

is definitely very valuable. It's not so

11:12

much about having a ton of assets

11:14

or never having a bad year, but

11:16

on average, what can you expect from

11:18

this company over time? Next Greenblatt turns

11:21

to a company called NII Holdings which

11:23

was also pitched on the Value Investors

11:25

Club by Charlie 479 this time in

11:27

November 2002 which was honestly a good

11:29

time to buy a lot of stocks

11:31

given how beaten down the market was

11:33

after the dot-com bubble. as opposed to

11:35

NDR, which was a cheaply priced and

11:38

overlooked company that was actually quite a

11:40

high quality business. NII is more of

11:42

what you might call a quote unquote

11:44

special situation. NII was not an attractive

11:46

long-term hold, but some special circumstances had

11:48

made it unreasonably cheap, making for an

11:50

attractive profit opportunity over a much shorter

11:52

time horizon. This is a company that

11:54

was formed in 1996 to hold all

11:57

of Nextel communications international wireless assets, and

11:59

over six years invested over

12:01

$500 million in NII, while bondholders lent

12:03

an additional $2 billion to the company

12:05

to build out its wireless network. With

12:07

all this borrowed money, NII Holdings struggled

12:09

to essentially make the minimum payments on

12:11

its debt, and it filed for bankruptcy

12:13

in February 2002. Eight months later, it

12:15

emerged from bankruptcy restructuring with a new

12:17

plan to pay back creditors that was

12:19

less burdensome after converting $2.4 billion about

12:21

sending bonds into equity. Charlie Force of

12:23

a Nine argues a few key points

12:25

in NII's favor, namely because NII had

12:27

recently come out of bankruptcy, the stock

12:29

was largely forgotten about by markets and

12:31

therefore traded at a very low valuation,

12:33

where the entire enterprise was valued at

12:35

less than three times a proxy of

12:37

its operating income. Yet, it was expected

12:39

to soon move off of thinly traded

12:41

over-the-counter markets and begin trading on the

12:43

NASDAQ stock exchange, which would almost certainly

12:45

boost demand for the stock. Relatedly, as

12:47

the stigma of bankruptcy wore off and

12:49

the stock traded on a major stock

12:51

exchange again, it was expected to trade

12:53

at a more normalized valuation similar to

12:55

its parent company. This normalization of NII

12:57

stock price alone possibly offered upside of

12:59

two to three times the current stock

13:01

price, according to Charlie 479. Let's take

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earning extra money today. money today. All

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right, back to the show. talking about the

17:09

about the pitch for NII, calls the

17:11

calls the company a fertile place

17:13

to look for value because investors

17:15

like that emerge that emerge from bankruptcy

17:18

are so often overlooked by investors. who

17:20

used to People who used to track the company

17:22

might have stopped doing so during the

17:24

period it was restructuring, and others will find

17:26

the odds of the of slipping back into

17:28

bankruptcy court to off court too off putting. As

17:30

he explains too, too, because so much debt has

17:32

been converted to equity, you probably have a

17:34

bunch of banks that don't want to really

17:36

own the stock long term and have been

17:38

selling it at their first opportunity to do

17:41

so, which has left the stock trading at

17:43

irrationally low prices. has left sort of continues

17:45

to go over why the situation was

17:47

so right for the stock to be

17:49

potentially misvalued, and he deconstructs how an

17:51

investor like stock to be might have found

17:53

this perspective opportunity. and he Firstly, they how

17:55

that because the company had recently come

17:57

out of bankruptcy, this didn't guarantee the stock

17:59

was made. is valued, but that increased the

18:01

odds of markets being wrong about it. it.

18:03

From From there, 479 realized realized that

18:05

the publicly available financial information for

18:08

the stock was reported in a

18:10

confusing manner, manner, and it wasn't easy

18:12

to piece together the company's actual

18:14

operating profits. profits. So while Charlie 479 was was

18:16

able to piece together that the

18:18

company was trading at an incredibly cheap

18:20

valuation relative to various measures of

18:22

its profitability after reconstructing NII's financials, that

18:25

was not laid out simply for

18:27

anyone else to see else made it

18:29

even more likely that the stock wasn't

18:31

being accurately priced. being accurately

18:33

priced. As states, states, the earnings were being

18:35

hidden, being and to a value investor

18:37

like him who enjoys digging beneath the

18:39

surface, the that is a wonderful thing

18:41

to find. thing to find. between the

18:43

messy financials that concealed the company's

18:45

operating profits, selling pressure from debt holders

18:48

getting rid of the stock that

18:50

was awarded to them was awarded to

18:52

and the general stigma surrounding stigma surrounding An

18:54

investor looking at NII in late 2002

18:56

NII in late known there was a confluence

18:58

of factors working in their favor that

19:01

validated why the stock was abnormally cheap. cheap,

19:03

which represented a buying opportunity to anyone willing to

19:05

come in and hold the stock for a year

19:07

or two. a year or two. What I love

19:09

about Greenblatt's teaching here is the focus on what could

19:12

have been known at the time. at the time.

19:14

Hindsight is is anyone can pick and anyone can

19:16

pick winning stocks by looking to deal with but

19:18

we have to deal with the information available

19:20

to us at the moment when assessing

19:22

the quality of investment decisions made. made. To some

19:24

To some extent we have to sort through luck

19:26

and skill, and that's that's what Green Black tries to

19:28

do with his students. students. Plenty of people have made

19:30

winning investments where they essentially got lucky because

19:32

they bought a stock that went up. a stock that

19:35

But their rationale for doing so

19:37

was pretty unsophisticated. Whereas investors

19:39

are typically able to see which

19:41

factors are being overlooked by by why why

19:43

so, so, and determine how to act

19:45

accordingly. And at And at

19:47

the time, Greenblatt actually recognized that

19:50

skill and how through the most conservative

19:52

lens possible, NII was unlikely to be

19:54

a losing investment and instead offered

19:56

a disproportionate amount of upside. of upside.

19:58

He says, quote, if if you don't lose money, most

20:00

of the other alternatives are good. As

20:03

a result, he actually bought the stock

20:05

after reading the pitch and jokes that

20:07

he wished he had bought more and

20:09

paid even closer attention since it worked

20:11

out so well in hindsight. In the

20:13

ensuing two years, NII went from $10

20:16

per share to $240 per share. That's

20:18

just a massive 24 times increase, but

20:20

Greenblatt apparently knows the investor behind the

20:22

Charlie 479 pseudonym who originally pitched an

20:24

AI and knows that they sold out

20:26

at $60 per share, missing out on

20:29

the rest of that upside, which is

20:31

really a lesson in its own way.

20:33

Even great investors with conviction in their

20:35

esoteric bets like this can jump the

20:37

gun too soon and not ride their

20:39

investments far enough. When you're right about

20:41

something, let yourself be right big. I'm

20:44

sure Charlie 479 kicked themselves for years

20:46

for tapping out too soon. When you're

20:48

really deeply confident about an investment and

20:50

why it's being mispriced by markets, it's

20:52

important to not bet too small or

20:54

bail too soon on what can be

20:57

a once in a decade opportunity. That

20:59

said, this is the epitome of hindsight

21:01

bias, and after running up six times

21:03

to $60 per share, the risk reward

21:05

for continuing to hold probably looked pretty

21:07

skewed. So I can't blame Charlie 479

21:10

for cashing in. With both NII and

21:12

NBR, Greenblatt was focused on explaining not

21:14

only why they offered good value, but

21:16

why the market failed to see this

21:18

value, which I think is equally important.

21:20

There are tons of good companies where

21:23

it would be easy to say they

21:25

offer good value to investors, but in

21:27

reality the market can easily recognize this

21:29

too, and the stock price would get

21:31

bit up to a level where these

21:33

positive factors are fully reflected in the

21:36

price. As such, in theory at least,

21:38

there would be no market-bidding advantage that

21:40

an investor could earn by simply buying

21:42

a company with an attractive business model

21:44

that has a stock valuation that more

21:46

than reflects that quality. Instead, we must

21:49

explain not only what's attractive about an

21:51

investment in terms of its business model

21:53

or assets or whatever it is, and

21:55

why that isn't being appreciated by the

21:57

market. In different ways, with both NII

21:59

and NBR, they're under a predetermined from

22:02

a past bankruptcy, which was distorting investor

22:04

perceptions and thus left the stock trading

22:06

at prices that was of extremely good

22:08

value to patient and discerning investors. These

22:10

case studies are just so fun to

22:12

me because, as I've said, these are

22:15

investments that Greenblatt either participated in or

22:17

at least recognized at the time as

22:19

being pretty attractive, and now we get

22:21

the chance to hear him break that

22:23

down in an academic setting. As he

22:25

explains, these types of deep value picks

22:27

in small to microcrap socks can continue

22:30

to create opportunities for wealth because the

22:32

skilled investors who master investing in these

22:34

sorts of opportunities eventually become so wealthy

22:36

that they have to invest in bigger

22:38

and bigger market cap companies to move

22:40

the needle for them. Microcap stocks become

22:43

uninvestable to them because they have to

22:45

try and earn the same return as

22:47

in the past with a larger pool

22:49

of money and they might trade against

22:51

themselves and bid the price of a

22:53

stock excessively higher if they try to

22:56

put say $50 million into buying up

22:58

shares in a company that only has

23:00

a $400 million market cap. If there

23:02

are even enough shares trading publicly to

23:04

invest that kind of money into a

23:06

small company, you're going to soak up

23:09

all the liquidity and cause a spike

23:11

in the price as you try to

23:13

build up your position. The point being,

23:15

great investors cut their teeth with bets

23:17

like NII and NBR and graduate to

23:19

larger market capitalization stocks as they begin

23:22

to manage more money, which then leaves

23:24

these companies under followed and creates an

23:26

opportunity for the next generation of investors

23:28

to get rich on special situations and

23:30

undervalued microcaps. So with that, I want

23:32

to go over another of these investment

23:35

case studies from Greenblatt as pitched by

23:37

Charlie 479 on the Value Investors Club

23:39

Forum just to see what we can

23:41

learn. The third case study is on

23:43

a company called Sportsman's Guide, ticker SGDE,

23:45

which no longer trades publicly after being

23:48

acquired by a private equity firm. It

23:50

still is today, though, a popular online

23:52

retailer for hunting and fishing gear and

23:54

other outdoor sporting goods, which started as

23:56

a mail-order catalog in the late 1970s.

23:58

The pitch for the company, as articulated

24:00

in June 2003 by Charlie 479, was

24:03

premises the fact that the company was

24:05

earning a very impressive 35% return on

24:07

equity while having very little debt. Despite

24:09

those impressive results, SGDE treated at less

24:11

than five times free cash flow defined

24:13

as the operating cash flows from the

24:16

business minus capital expenditures reinvested into it.

24:18

That's a bit jargony, but another way

24:20

to say that is the price you

24:22

paid for the stock would be recouped

24:24

in less than five years by the

24:26

companies free cash flows, assuming they stayed

24:29

roughly the same over that time, and

24:31

sooner if free cash flows grew. I'll

24:33

use another example where the accounting is

24:35

slightly different, but the idea is the

24:37

same. If you paid a price to

24:39

earnings ratio of 20 for a stock,

24:42

and its earnings remain flat, then it

24:44

will take 20 years to earn back

24:46

that investment. As in, if the company

24:48

produces $1 per share in profit each

24:50

year and you paid $20 for one

24:52

share, then it would take two decades

24:55

for the business to make back that

24:57

$20 on your behalf and retained earnings.

24:59

Thinking in payback periods like this is

25:01

a nice way to contextualize the evaluation

25:03

you're paying for a company, and with

25:05

SGDE trading at less than five times

25:08

for cash flows, the company was offering

25:10

what I'd say was an unusually large

25:12

amount of upside with relatively less risk.

25:14

As the 2003 pitch on the value

25:16

Investors Club puts it, the company has

25:18

a strong brand with a loyal customer

25:21

following cultivated over decades of delivering quality

25:23

products to a niche audience. The catalog

25:25

was earning around $180 million of revenue

25:27

per year. And a partnership with Buyers

25:29

Club where paid members could get special

25:31

discounts on sportsmen's guides products was really

25:33

boosting business. Much of the company's value

25:36

also came from its database of 5.2

25:38

million customers where they knew their customers

25:40

well because 85% of sales came from

25:42

recurring shoppers. On top of that, its

25:44

competitive advantage lied in offering 25 to

25:46

60% discounts for items relative to normal

25:49

retail pricing, which they could offer because

25:51

their buying agents would comb through vast

25:53

quantities of discounted or overstocked items from

25:55

a network of over 1,200 suppliers. All

25:57

that sounds pretty good. the most exciting

25:59

part was that the company could save

26:02

millions of dollars a year from printing

26:04

and shipping its catalogs by migrating its

26:06

offerings to being solely shown online. This

26:08

was obviously the early days of online

26:10

retailing, but in five years, Sportsman Guides

26:12

online sales went from just $1 million

26:15

per year to $53 million. Thanks to

26:17

the internet, a major source of SGDEs

26:19

operating costs were being phased out. And

26:21

the catalyst for the stock's price, as

26:23

it often is, was a recently announced

26:25

share repurchase program where the company planned

26:28

to buy back 10% of its outstanding

26:30

stock, presumably because management also recognized that

26:32

the stock's market price didn't reflect its

26:34

value. What's not to love about a

26:36

debt-free, cheaply priced, profitable company phasing out

26:38

one of its biggest operating expenses, massively

26:41

buying back stock, and gaining traction with

26:43

online sales? Even though I know this

26:45

was a real opportunity that anyone had

26:47

the chance to read about at the

26:49

time for free on the VIC forum,

26:51

it just still sounds too good to

26:54

be true. However, as Greenblatt frames it,

26:56

the thesis is pretty straightforward, and it

26:58

doesn't take a genius to see the

27:00

opportunity here. Sometimes it's really as simple

27:02

as just saying that coming out of

27:04

the dot-com bubble, this is a time

27:06

when there were a ton of cheap

27:09

socks to buy, which means some will

27:11

slip through the cracks longer than others.

27:13

Given it was such a small business

27:15

with few shares trading publicly and was

27:17

transitioning to more online sales at a

27:19

time when markets had been spooked by

27:22

a bunch of hyped up internet stocks

27:24

in the 90s going bust, that contributed

27:26

to the stock price dwindling on a

27:28

level that seems like a no-brainer in

27:30

hindsight. From the time it was pitched,

27:32

SGD stock rose about four times over

27:35

the next two years, which is a

27:37

pretty nice return on investment that I'd

27:39

be more than satisfied with. In reflecting

27:41

on the three case studies we've gone

27:43

over so far, Greenblatt tells the students

27:45

that what matters is in seeing what

27:48

management is going to do with the

27:50

earnings they've generated. From a shareholder perspective,

27:52

companies can earn as much income as

27:54

they want, but if management wastes it

27:56

away, then it was all for nothing,

27:58

at least from a perspective.

28:01

Ongoing profitability combined with share repurches, where

28:03

investors could know that at least some

28:05

of those earnings would be returned to

28:07

them, is a pretty good start for

28:09

an investment case, as we saw with

28:11

SGDE. He says, quote, what your perception

28:13

of management is and what they're going

28:16

to be doing with earnings is very

28:18

important. It goes on to say that

28:20

with each of these opportunities, any investor

28:22

with enough practice would have easily been

28:24

able to recognize how attractive they were.

28:26

It's almost a know it when you

28:29

see it type of thing when it

28:31

comes to the best types of investment

28:33

opportunities. What's cool about these examples is

28:35

that I don't think it takes a

28:37

ton of experience to see why they

28:39

worked out. You've seen for yourself now,

28:42

but there really are instances and markets

28:44

of hugely winning investments, or not only

28:46

possible to find, but also reasonably understandable,

28:48

especially among small and micro-cap stocks. Here's

28:50

a little snippet from Greenblatt's lecture to

28:52

make the point. And none of this

28:54

was taking something to the 37th decimal

28:57

point. This was all like, this is

28:59

so cheap, right? If I'm even close

29:01

to right, this is so cheap, I'll

29:03

make money, and if I'm not right,

29:05

it's going to be hard for me

29:07

to lose money. So that's under, those

29:10

are all underlying themes to this, and

29:12

I, um... the

29:14

whole construct of you know what's

29:16

been taught generally in business schools

29:19

over the last 40 years about

29:21

efficient markets and beta i know

29:23

you in the value investing program

29:26

so you've already dismissed that already

29:28

but it just seems It

29:31

just seems so ridiculous when you can

29:33

look for opportunities and it's the same

29:35

guy time and time again. And speaking

29:37

of the same guy, you know, second

29:39

part of the class where you get

29:41

to win your Warren Buffett cartoon book

29:43

is the same guy who time and

29:45

time again has a certain theme, certain

29:47

things that he looks for in investment,

29:50

certain qualities of a business that he

29:52

that he's looking for, that can make

29:54

you money. And the funny thing is

29:56

we're going to talk about Buffett and

29:58

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36:44

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36:47

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36:49

learning at netsuite.com/MI. The guide

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netsuite.com/MI. That's

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netsuite.com/MI. The

38:36

bigger reason is that there's a fundamental

38:38

reason cheap stocks exist. Firstly, cheapness is

38:40

relative and there will always be a

38:43

decile of the cheapest stocks to invest

38:45

in. Secondly, cheap stocks exist because there

38:47

are real reasons to dislike them. If

38:49

you filter down the US stock market

38:51

down to the companies with the lowest

38:53

PE ratios, you get a bunch of

38:55

unloved names, quite literally companies that nobody

38:58

wants to own. Maybe their tobacco or

39:00

gun companies, maybe they've gotten a ton

39:02

of bad press and are laying off

39:04

staff, or maybe they just have a

39:06

big headwind that's going to suppress profits

39:08

for two quarters. Whatever it is, these

39:10

are companies that investors have decided that

39:12

in this moment, they don't want to

39:15

have them in their portfolio. And while

39:17

Greenblatt has shown you can do well

39:19

from simply buying the cheapest debt sales

39:21

of stocks and holding them for a

39:23

few years, you can do even better

39:25

by digging into these lists of cheap

39:27

stocks and determining which companies are facing

39:30

permanent headwinds and which ones are facing

39:32

only temporary challenges. Cheap stocks come from

39:34

people owning them when they were, well,

39:36

not cheap stocks, and selling them out

39:38

of frustration or panic over some turbulence

39:40

in the company's future, leaving them temporarily

39:42

discounted enough to attract folks like Greenblatt

39:44

to check them out further. To make

39:47

this point even more, in a talk

39:49

before the CFA Society of Chicago in

39:51

2019, Greenblatt explains how he taught the

39:53

shortcomings of the stock market to a

39:55

group of teenagers in Harlem, he filled

39:57

up a jar with jelly beans and

39:59

asked the students on their own to

40:02

calculate how many they thought in the

40:04

jar, and then submit their answer independently

40:06

on a note card. Then he asked

40:08

the students to go around one by

40:10

one and say their answers out loud

40:12

with the caveat that they could either

40:14

keep their original answer submission or change

40:16

their answer based on what others had

40:19

said. When the students thought critically on

40:21

their own, their average answer was 1,71

40:23

jelly beans, which was actually just five

40:25

away from the correct answer. Yet, when

40:27

the students gave answers allowed and were

40:29

biased by what others had said, the

40:31

average answer fell to 870 jelly beans.

40:34

As Greenblatt puts it, the stock market

40:36

is the latter scenario, where investors are

40:38

hugely biased by what their colleagues have

40:40

said, what they've read in the newspaper,

40:42

the headlines they see on TV, and

40:44

so on. His approach then is to

40:46

try and be as independent as possible,

40:48

covering his ears and blocking out all

40:51

the noise that can blind him from

40:53

accurately estimating, as the metaphor goes, the

40:55

number of jelly beans in the jar.

40:57

What I love about Greenblatt is that

40:59

while he acknowledges the nuances and difficulty

41:01

of investing, he's also open about the

41:03

fact that it doesn't have to be

41:05

rocket science. Simple principles like buying the

41:08

cheapest decile of stocks, filtering them down

41:10

further by quality, and selling them after

41:12

a year or two, or continuing to

41:14

hold the truly rare but cheap quality

41:16

compounders like the home builder and VR,

41:18

will work pretty well for you. To

41:20

some extent, it's a question of having

41:23

the courage and patience to buy unl

41:25

loved stocks. When everyone is telling you

41:27

that Intel is imploding and irrelevant in

41:29

the age of AI, can you really

41:31

disregard that sentiment and buy the stock?

41:33

Or will you second-guess yourself enough that

41:35

you wait to see what happens and

41:37

then the stock bounces back 20% and

41:40

the opportunity is mostly gone? I

41:42

use Intel because it's a timely example

41:45

of a well-known company that has self-destructed

41:47

this year, but also bounced back from

41:49

its lows after hitting some truly cheap

41:52

valuation levels where there's little room for

41:54

things to get much worse and a

41:56

lot of upside if the outlook even

41:58

modestly improves. After we followed Green through

42:01

three separate case studies, originally pitched by

42:03

this Charlie 479 guy. You might be

42:05

wondering who he is. That is, the

42:07

investor who pitched NBR, NII, and SGDE

42:10

on the Value Investors Club Forum. For

42:12

the sake of simplicity, and out of

42:14

respect for his privacy, I'll continue to

42:16

refer to this investor as Charlie, but

42:19

I can tell you a bit more

42:21

about him if you're curious. After becoming

42:23

something of a legend on the Value

42:26

Investors Club forum for his post, the

42:28

pseudonymous Charlie 479's last post was in

42:30

early 2009, so unfortunately he's not still

42:32

posting winning ideas that we can study

42:35

or clone, but we do know that

42:37

he was and probably still is close

42:39

friends with Joel Greenblatt and reportedly earned

42:41

returns of 38% per year from 1994

42:44

through 2003 as money manager. And with

42:46

Greenblatt's help, Charlie started an investment fund

42:48

called Punch Card Capital with around $100

42:51

million in assets under management, Matt, at

42:53

least through 2011, was outperforming the S&P

42:55

500 by 12 percentage points per year.

42:57

If you're really curious to learn more

43:00

about Charlie 479 and his firm Punch

43:02

Card Capital, and the show notes, I'll

43:04

link to his only public interview ever

43:06

from 2011 for you to check out.

43:09

The name Punch Card Capital is inspired

43:11

by Warren Buffett's Punch Card Analogy. Quoting

43:13

Buffett the analogy goes as follows, I

43:16

always tell students in business school they'd

43:18

be better off when they got out

43:20

of business school to have a punch

43:22

card with 20 punches on it. And

43:25

every time they made an investment decision,

43:27

they used up one of their punches

43:29

because they aren't going to get 20

43:31

great ideas in their lifetime. They're going

43:34

to get 5 or 3 or 7,

43:36

but what you can't get rich doing

43:38

is trying to get one every day.

43:41

As of earlier this year, disclosures from

43:44

Punchcard Capital revealed at least four of

43:46

its holdings, which unsurprisingly included Berkshire Hathaway,

43:48

but also Ally Financial, Winnebago Industries, and

43:50

Smith & Wesson. Because Charlie 479 has

43:53

already contributed so much to this episode,

43:55

and obviously thinks about investing similar Greenblatt,

43:57

I want to share a passage from

43:59

another of his posts addressing the tension

44:02

between buying cheap stocks and buying high-quality

44:04

compounders, which is something I've covered at

44:06

length in last week's episode and in

44:08

the week before. He's referencing his 2001

44:11

pitch on Windmill and Company ticker W&MLA,

44:13

where the company had more net cash

44:15

per share than the stock's current price,

44:17

meaning the company could be simply liquidated

44:20

and shareholders would immediately roughly double their

44:22

money. There was effectively zero downside, not

44:24

reduced downside, but again, essentially none. These

44:26

types of opportunities are known as cigar

44:29

butt stocks because they're usually dying companies

44:31

where you can get one last puff

44:33

of profit out of them since they're

44:35

just ludicrously cheap. And they're exactly the

44:38

types of opportunities that both Warren Buffett

44:40

and Joel Greenblatt made a living on,

44:42

especially in their early days. Charlie 479

44:44

writes, quote, it is always amazing to

44:47

me how many people will turn down

44:49

the chance to buy $1 of cash

44:51

for 40 cents because they say you'll

44:54

never see the full value of it.

44:56

The main reason these types of companies

44:58

sell at those prices is because most

45:00

folks won't touch them until they think

45:03

they have the scoop that the company

45:05

is about to be sold. There is

45:07

a shortage of investors that are willing

45:09

to be patient and wait for the

45:12

45 cents to be liquidated into a

45:14

dollar. This creates the opportunity. He adds,

45:16

quote, I am happy to buy dollar

45:18

bills for 45 cents and wait for

45:21

payday to come around as long as

45:23

there is no cash burn and there

45:25

are signs that management is headed in

45:27

the right direction. As long as I

45:30

know that I have more than $2

45:32

of net cash behind each $1 I

45:34

put up, and that there are certain

45:36

clues as to a potential payoff, it's

45:39

not a terrible proposition. Charlie continues by

45:41

saying, WNMLA is a cigar butt. Cigots

45:43

are inferior to great operating companies with

45:45

defensible market positions, generating 25% returns on

45:48

invested capital and selling at 8x PE

45:50

like NBR. However, there are extremely few

45:52

of these high quality companies that are

45:54

trading for such low values. Coke is

45:57

a great company but fully priced. Ditto

45:59

for Moody. Express, etc. The

46:01

companies that don't have high multiples are

46:03

usually average businesses that will produce average

46:06

long-term rates of return on capital. Look

46:08

at the Value Investors Club Board. It

46:10

is littered with low PE stocks with

46:12

either unexciting returns on equity or very

46:14

high leverage. I'd say that the W&MLA,

46:17

CIGARBOT types of stocks, have better risk

46:19

reward than both of these two types

46:21

of low PE average businesses. I'd prefer

46:23

to like cash sit in these asset-rich

46:25

situations until some of the great operating

46:28

companies fall back down to 10 times

46:30

price to earnings ratios. Charlie's comments here

46:32

shed light on how he thought about

46:34

the balance between cheap cigar butt stocks

46:36

like W&MLA, which he saw as a

46:39

substitute for cash with some upside potential,

46:41

versus investments that compound intrinsic value over

46:43

time, like NBR, which are what he

46:45

prefers most. For instance, take a look

46:48

at the chart of NBR and W&MLA,

46:50

which you can see if you're watching

46:52

this podcast on YouTube. To summarize it

46:54

briefly, it is up to the right

46:56

for NBR, outpacing the S&P 500, while

46:59

the cigar butt stock W&MLA offered periods

47:01

of upside but otherwise mostly preserved value

47:03

with flat returns. The stock prices correspond

47:05

to intrinsic value over time, and over

47:07

time, NBR has compounded intrinsic value while

47:10

W&MLA has not. But that doesn't mean

47:12

that at 45 cents on the dollar,

47:14

which is effectively what an investor in

47:16

W&MLA in 2001 would have gotten, was

47:18

a bad investment. Basically, Charlie 479 says

47:21

he likes great businesses at low prices,

47:23

but those are hard to find. So

47:25

in the meantime, if he can invest

47:27

in a money market fund, a cigar

47:29

butt stock with a possible 100% upside,

47:32

he's more than happy to do it.

47:34

While many of the investors on the

47:36

Value Investors Club are quite savvy, and

47:38

Charlie 479 is probably one of the

47:40

best to ever post there. There are

47:43

a lot of recommendations there for companies

47:45

that produce mediocre returns and capital yet

47:47

sell at modest prices of, say, 12

47:49

times earnings earnings. These aren't always bad

47:52

ideas, but the majority of them will

47:54

lead to just average results. The real

47:56

outstanding returns come from identifying the relatively

47:58

few truly undervalued situations, whether from an

48:00

average business selling for half of net

48:03

cash like W&MLA, or an exceptional business

48:05

selling at a single-digit earnings multiple like

48:07

NDR. So we've spent a lot of

48:09

time today going through some wonderful investments

48:11

in magic formulas for investing and all

48:14

that good stuff, but for good measure,

48:16

I want to go over the story

48:18

of what Joel Greenblatt told his students

48:20

was his worst investment ever. As so

48:22

many terrible investments do, everything looked good

48:25

on paper for what it's worth. The

48:27

company was growing, had impressive returns in

48:29

capital, and he was wooed by management

48:31

after an executive painted a rosy but

48:33

seemingly realistic picture of the future. In

48:36

a nutshell, it was a company that

48:38

hosted trade shows in Las Vegas. At

48:40

the turn of the 21st century, there

48:42

were thousands of companies in the computing

48:44

and internet industries willing to sign up

48:47

to participate in trade shows and show

48:49

off their offerings to prospective customers. And

48:51

this company was essentially the organizer for

48:53

those events. They'd pay for a few

48:56

hundred thousand square feet of space on

48:58

the Vegas strip for around two dollars

49:00

per square foot, and then turn around

49:02

and rent out the space for the

49:04

trade show at a cost of sixty

49:07

dollars per square foot. But they didn't

49:09

own the real estate and they could

49:11

easily rent more as these shows expanded.

49:13

Thus, they had massive operating leverage, meaning

49:15

that they didn't have a ton of

49:18

costs that scaled up. If they were

49:20

able to rent out the space for

49:22

trade shows at more than $60 per

49:24

square foot, those incremental gains would almost

49:26

entirely ripple down to their bottom line.

49:29

and as more and more computer hardware

49:31

and software companies arose to take advantage

49:33

of the internet boom, the trade shows

49:35

would probably only grow bigger and bigger

49:37

each year, especially now that the former

49:40

head of ticket master was taking over

49:42

the operation that had been managed previously

49:44

by a Japanese company, which was not

49:46

really paying attention to it enough as

49:48

it should have. At least that was

49:51

the idea for GreenBots thesis here. It

49:53

seemed like a no-brainer. The company was

49:55

an intermediary, seemingly best position to benefit

49:57

from the secular rise in the internet.

50:00

the business being immensely profitable and having

50:02

plenty of space in Las Vegas to

50:04

expand into more and more bigger trade

50:06

shows, there was a pretty strong case

50:08

for the company being able to continue

50:11

generating excellent returns for shareholders. Obviously, that's

50:13

not what happened. And as Greenblatt points

50:15

out, operating leverage can work both ways,

50:17

boosting profitability as the business expands and

50:19

cutting profits quickly if the size of

50:22

the trade show's contracts or the rates

50:24

they can charge to rent the space

50:26

narrow. Operating leverage, if you're not familiar

50:28

with the term, can come about in

50:30

a few different ways, but it's similar

50:33

to the concept of economies of scale.

50:35

A company with economies of scale advantages

50:37

can spread out fixed costs and capture

50:39

a higher percentage of profit with incremental

50:41

sales, and they correspondingly have high operating

50:44

leverage. Put differently, operating leverage refers to

50:46

how much operating profits change due to

50:48

changes in sales, and this company had

50:50

a lot of it, which is normally

50:52

seen as a good thing. After

50:55

hype around the internet peaked, interest and trade

50:57

shows fell off, and they got smaller and

50:59

smaller until the company finally went bankrupt. As

51:01

Greenblatt puts it, for every foot the trade

51:03

shows shrank, $60 subtracted from the bottom line.

51:05

Strong past returns, attractive unit economics, and a

51:07

plausible outlook for growth were not enough to

51:09

save the company. His position in the company

51:11

fell from $12 per share to $1 per

51:13

share before Greenblatt was able to get out,

51:15

which just goes to show even great investors

51:17

can fall for misleading stories about a company,

51:19

even when everything looks good on paper. As

51:21

Greenblatt says, there were many times along the

51:23

way where we could have gotten out with

51:25

a profit, yet we compounded our mistakes by

51:27

waking up too late. To wrap things up

51:29

today, I'll just say that it's an incredible

51:31

resource to have Greenblatt's lectures available on YouTube,

51:33

and I'll link to a playlist of them

51:35

so you can watch them for free if

51:37

you're interested. Greenblatt has the rare combination of

51:39

investing brilliance, interest in sharing his learnings, and

51:41

an intuitive ability to distill complicated financial information

51:43

into digestible insights. course, course, also recommend

51:46

his to learn more

51:48

about the magic formula in

51:50

addition to checking out

51:52

our interview directly with

51:54

Greenblatt on our We

51:56

Study on our We Study billionaires and

51:58

Richard Weiser which I'll also

52:00

link to below. link to

52:02

below. If you take

52:04

anything away from this

52:06

episode, it's I hope it's

52:08

to pick up the

52:10

habit of frequently reading

52:12

through the Investors Club Forum. You'll

52:14

You'll probably find some

52:16

wonderful investment ideas, and

52:18

at worst, at worst, learn

52:20

a lot about how

52:22

to think through investment

52:24

opportunities. As a

52:26

a final note, to, in like to,

52:28

in the spirit of today's

52:30

theme, episode episode with one last

52:33

quote from Joel Greenblatt. he He

52:35

tells us the following. choosing individual individual

52:37

stocks without any idea of

52:39

what you're looking for is like

52:41

running through a through a factory

52:43

with a burning match. a You

52:45

may live, may but you're still

52:47

an idiot. an idiot. Please don't be an be

52:50

an idiot running through a

52:52

dynamite factory with a burning match.

52:54

match. Know what you're looking for,

52:56

and if you don't already

52:58

know, know, I've shared some resources

53:00

today that will more than point

53:02

you in the right direction. direction.

53:04

With that, hope I hope you

53:07

enjoyed today's episode, and and I'll

53:09

see you again next week. week.

53:11

Thank you for listening to TIP. Make sure to follow millennial

53:13

investing on your favorite podcast app and never miss out on

53:15

our episodes. To access our show notes, transcripts or courses, go

53:17

to the investors podcast.com. This show is for entertainment purposes only,

53:19

before making any decision, consult a professional. This show is copyrighted

53:21

by the Investors Podcast Network. Written permission permission must

53:24

be granted before syndication or rebroadcasting.

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