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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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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
I'm sure you're all sick of... Speaking
36:44
of opportunity, download the CFO's
36:47
guide to AI and machine
36:49
learning at netsuite.com/MI. The guide
36:52
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netsuite.com/MI. That's
36:57
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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