Who Needs 'Ya?

A hedge fund legend reveals his simple strategy for retail investors

Joel Greenblatt made a fortune running Gotham Capital, a hedge fund, posting average annual returns of 40 percent since inception in 1985. Greenblatt, a mere 44 years old, has achieved such success that he and his partners have since returned investors' capital and closed the fund. They launched a new fund, a fund of funds currrently worth about $1.6 billion, in which his group manages only a portion of the assets. (Very prudent diversification, no?)

Now Greenblatt wants to help the little guy, the > retail investor — your client; and with results like that, the retail investor will be inclined to listen. Greenblatt's new book, The Little Book That Beats the Market, (John Wiley & Sons, 2005), is a simple value investing treatise that allows retail investors to create a portfolio based on Gotham Capital's own strategy (the one that made Greenblatt and his cohort rich). And guess what the message is? “You can do it yourself.” On page 113 of the book, Greenblatt writes, “If your stockbroker is like the vast majority, he or she has no idea how to help you! Most get paid a fee to sell you a stock or a bond or some other investment product. They don't get paid to make you money. Of course, while it's in their interest for you to be successful and many may be fine, well-intentioned professionals, a stockbroker's main incentive is still to sell you something.” (What do you think of that?)

There are more such anti-Wall Street sentiments, particularly in his first book, You Can Be A Stock Market Genius (Fireside), first published in 1997. But again, Greenblatt, a Long Island, N.Y., native who got his seed capital from Michael Milken, says, “The bottom line is, even if you live in Fantasyland, where fees and commission have no influence on investment advice, you still must face a harsh reality. Your broker, trustworthy or not, has no idea how to invest your money.”

But in person, Greenblatt qualifies those statements some, saying he has friends who are financial advisors, and, in any case, he didn't mean that no financial advisor can help retail clients, only the good ones can. But, that's not really the important point of either book. His theory: Buy 20 or 30 good companies at decent prices — and stick to it, even in down years, and you will do better than most. (For more details — and a prescreened list of diversified, high return-on-capital, low-P/E stocks — visit his free Web site, MagicFormulaInvesting.com.) Recently, Registered Rep. editor David A. Geracioti paid a visit to Greenblatt at his Madison Avenue office in Midtown Manhattan.

Registered Rep.: Where did you get your start?

Joel Greenblatt: I went to Wharton, undergrad and graduate. But I didn't really learn about investing there. I learned from reading. I learned from reading Ben Graham, Warren Buffet and David Dreman, people like that. That's one of the reasons I wrote; because, I always said one day, if I'm successful with this, I'd like to give back. That's why I'm teaching too [at Columbia University], plus it's fun for me. And I didn't think the individual investor really gets a break of any kind. Wall Street's a tough place. And I think if you know what you're doing you can make it work for you.

RR: This you-too-can-beat-the-market angle of your new book, didn't the 2000 to 2003 bear market discredit the wisdom of retail investors going it alone?

JG: I would say anybody can beat the market — but of course not everybody does beat the market. Being a value investor is inherently difficult, because it often doesn't outperform. Over long periods of time it always outperforms, but over short periods of time it doesn't, and, well, it's tough.

RR: The strategy you describe in the book? You're still doing that?

JG: Yes, it's value and special situations. These are the principles that we follow to look at our own investments. And I was always curious, you know, just to go back and test a very simple form of this, which is what if we looked at how good a company was and how cheap it was? We defined good as a high return on capital. Cheap we defined as a high earnings yield, or a low P/E — however you want to look at it. And we want to know if you systematically followed that system, looking for high return on capital businesses that have high earnings yield, or low P/E ratios, how would you do? So we developed the capability of a back-test.

RR: How did you do that — with what system?

JG: We used the Compustat point-in-time database. And the beauty of that is that's the exact information that Compustat's customers had at the time of the test. This was the exact information that all their customers had on the date that we back-tested.

The other thing was that what I wrote up in the book was the exact first thing that we tested. So in other words, once we got our back-testing ready, we didn't test 50 different methods to beat the market and pick the best one. We tested one. And this is what it was — the one in the book is the first thing we tried, which is what we do everyday, and it worked incredibly well.

RR: What about the fundamentals of a company?

JG: I look at the strategy as the not-trying-very-hard method, because we didn't try to make any [earnings] estimates or do anything hard. We just looked at last year's earnings, and applied this formula. Based on last year's earnings, did the company achieve a high return on capital, and is it selling at a high earnings yield? And we ranked all companies, combining those two, and the highest ranked stocks are the ones we bought, and they did incredibly well. The smaller cap stocks did over 30 percent a year, and the larger caps doubled the market's return. So it's pretty powerful. And the other thing that was very powerful about it is we ranked all companies. We ranked the top 2,500 companies based on their ranking according to the magic formula; just these two criteria: high return on capital and high earnings yield. And they actually worked in order. In other words, we divided the top 2,500 into deciles of 250 stocks each. And depending on which decile you were in, that told you how you were going to do going forward. So decile one beat decile two, two beat three, three beat four, all the way down to 10, in order. So what that effectively says is if you give me a group of stocks I'll tell you how they're going to do in the future. That's valuable information to have.

RR: But if everybody does it, as investors did with the Dow Dogs, why does it still work? Isn't this like the Dow Dogs?

JG: No. The Dow Dogs is just a few companies based on dividend yield. And I think we were looking at two criteria that make sense: How good is the company, and how cheap are you buying it? That is a little different than the Dow Dogs. Basically, what we think we're doing is buying above-average companies at below-average prices. Why it continues to work is that it's very hard for people to stick with something like buying out-of-favor companies, to, you know, continue to follow that for a year or two when it doesn't work. And then to stick with it. So I spent a lot of time in the book trying to explain why what you're doing makes sense. If you can indeed buy above-average companies at below-average prices, that has to work over time. I think anyone who observes the market and can open up a newspaper and look at a 52-week high and low list, sees that there's a huge disparity between high and low prices every year. And all those prices just can't be right.

RR: In your book, you say financial advisors have no idea how to help you.

JG: Even if a stockbroker understands that value investing works over the long term, three to five years, their clients may not understand that. So I think the most important job a stockbroker would have, if they're going to follow this system, is to explain to their clients how it works. That it works over the long term, not the short term. And that to look at the results over any one or two years is the wrong thing to look at. In the short term, emotions rule. But eventually the market gets it right and you will be rewarded for buying undervalued companies, eventually. The client has to understand that going in. Because otherwise they'll be yelling and screaming if last year wasn't good. And then the registered rep's going to go try to accommodate that, rather than explain why that's the wrong way to look at the world.

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