Joel Greenblatt, the hedge fund hero
by Frederik Vanhaverbeke
In the latest of a new series for SBM Frederik Vanhaverbeke, author of Excess Returns: A comparative study of the methods of the world’s greatest investors, looks at how some of the world’s greatest investors are so successful.
If you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), you can end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away.
—-Joel Greenblatt
Joel Greenblatt is a value investor with one of the most impressive track records in the hedge fund industry.
Between 1985 and 1995 he earned an annual compound return of almost 50% a year on his portfolio. This was an amazing 35% better a year than the S&P 500 (with dividends reinvested). Interestingly, in spite of this impressive track record, he underperformed the market by 2% in 1991 and performed in line with the market in 1989 (see figure below). Remember that also Peter Lynch and Warren Buffett lost out to the market from time to time. This and Greenblatt’s track record illustrate that consistent outperformance is not of this world.
The greatest investors stand out over the long term, but do not necessarily beat the market in every single year. By the way, Greenblatt’s 10-year winning streak was no accident. After returning assets to investors Greenblatt continued on his own. It is rumoured that he earned about 30% a year between 1995 and 2005, which was again 20% a year better than the market.
Outperformance of Joel Greenblatt versus the S&P 500 (with dividends reinvested) between 1985 and 1995.
Apart from his investing activities, Joel Greenblatt is also an academic who teaches value investing. Much about the way he beat the market throughout his career is therefore known. In particular, his advice on where to look for bargains is invaluable, and takes a central place in my book Excess returns: a comparative study of the methods of the world’s greatest investors. In this article we will briefly touch upon some of his basic ideas. For a thorough discussion I refer the reader to my book.
When managing his hedge fund between 1985 and 1995, Joel Greenblatt had a soft spot for so-called special situations. These are corporate events where specific types of stocks (or other types of securities, such as bonds or warrants) are distributed or sold to investors. Examples are spin-offs, mergers, restructurings, going-private operations, or recapitalizations. He argued that many of these special situation securities are attractive investments for a number of reasons.
They often suffer from selling pressure by investors who don’t understand them, who are not allowed to hold them or who don’t have the time to do a due diligence on them. The selling pressure tends to depress the price (and valuation) of such stocks some time after issuance.
A second reason for the appeal of many special situation securities is that management sometimes has an incentive to bring them to the market at an attractive price. For instance, when shares of a business unit are distributed to the shareholders in a spin-off operation, management of the parent company has a vested interest in good price action of the spin-off because this will keep the shareholders happy. Therefore, it is in management’s interest that the spin-off comes to the market at an attractive price.
A third reason is that the special event can unleash entrepreneurial spirits. For instance, when a unit is spun out of a company management of the spin-off can start to run its own business without interference from the parent company.
Similar to many other top investors, when Joel Greenblatt managed his hedge fund he was a focus investor who had most of his portfolio in a limited number of his best ideas. He commonly had about 80% of his portfolio in five stocks.
By the mid-2000s Greenblatt began to promote another type of investing which he called “magic formula investing.” His idea was to spread one’s portfolio over a basket of magic formula stocks. These are stocks, excluding financials and utilities, that rank best on a combination of return on invested capital and earnings yield. He recommended investors to buy the 20-30 highest ranked stocks and hold them for an entire year, after which they should be replaced with the 20-30 stocks that are ranked highest at that moment, and so on. According to his simulations magic formula investing beats the market by an impressive margin. Even after publication of the method, magic formula investing continued to beat the market substantially. Another application of the list of magic formula stocks is to see it as a starting point for the selection of ideas that may deserve further scrutiny.
More recently Joel Greenblatt introduced other types of value-based formulas that investors can use to beat the market. He appears to have turned his attention completely to quantitative investing (i.e., investment methods that invest in baskets of stocks that rank best on a number of quantitative criteria). Next up in my series is another hedge fund star: Seth Klarman.
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