Joel Greenblatt (Trades, Portfolio) is an iconic value investor and the founder of Gotham Asset Management, where he has achieved an annual return of approximately 40% over the past two decades according to my estimates.
In April 2023, at a Hedge Fund Association event, Greenblatt sat down for a fireside-style chat with Paul Gray, a rising hedge fund star, as the founder and Managing Partner at Ironhold Capital Management. In this two-part post series, I have summarized my notes on this discussion, which covers topics such as Greenblatt’s value investing roots and his special situation investment strategy; let’s dive in.
Value investing roots
Greenblatt studied at Wharton as an undergraduate in the late 1970s. At the time he was taught about the efficient market hypothesis. This “didn’t make a lot of sense” to Greenblatt as stock prices could fluctuate wildly even just a “few months apart."
Luckily for Greenblatt, he stumbled across an article in Forbes about Benjamin Graham. This detailed his formula for stock picking, as well as the concept of “Mr. Market." This analogy explains how stock prices fluctuate from being “overly optimistic” to “over pessimistic." This made a lot more sense to Greenblatt as opposed to prices always being efficient.
This led Greenblatt down a rabbit hole to read “everything” ever written by Graham and then everything was ever written by his “best student” Warren Buffett (Trades, Portfolio).
The simple takeaway was to “figure out what a stock is worth” and then “pay a lot less," leaving a large “margin of safety."
For context, the margin of safety is a concept that originally came from engineering and was used in the design of bridges. This involves not building a bridge exactly to the expected load, as that could lead to a disaster if miscalculated. Instead, engineers would ensure the bridge could handle much greater loads. The same is true when investing, as if a stock's intrinsic value is calculated wrong or factors change, you want to ensure you can still make a profitable investment.
Buffett's “twist” on the concept which made him one of the richest people in the world was to “buy a good business cheap," which was “even better” according to Greenblatt.
The stock market and the economy is a “complex adaptive system” with a “million things which affect it." However, the “simple lens” of value investing helps to cut through the noise.
Value investing is investing
Greenblatt also references Charlie Munger (Trades, Portfolio), who once stated, “Value investing can also be called investing." This is because one wouldn’t wish to pay more for something than it is worth. The complicating part is really “figuring out what something is worth." Then an investor must be disciplined to “avoid the noise” in order to be successful.
Greenblatt believes a stock is not a “piece of paper which bounces around," it's an “ownership share of a business." The challenge is the “market may not recognize” the value for a couple of years, but that doesn’t mean he will stop the process.
Greenblatt describes that when teaching at Columbia University he used to tell his students that as long as they do “good valuation work” the market will eventually agree with them in time. He goes on to joke, however, that he “just would not tell them when” the market would actually reward them. Whether it is in one year or four years, no one can ever say for sure, though the “rubber band of value” usually snaps back to reality over time.
It also helps to think about valuing a company the same way a private equity firm would. They wouldn’t look at price ratios but instead cash flow and how secure that cash flow is.
Undiscovered treasures
Greenblatt explains a great analogy that can be used to describe value investing from his book “You Can Be a Stock Market Genius." The first story is about his in-laws who used to scour antique stores in an effort to find “undiscovered treasures” such as artifacts and paintings. When discovering a painting, they didn’t ask, “Is this artist going to be the next Picasso?” They asked if there was a similar painting, in the same genre by the same artist, which recently sold at auction two and three times” more. Greenblatt refers to this as “looking off the beaten path” for investment opportunities. He insightfully related this to “special situation investing."
Marriott spin-off: A contrarian investment
One of Greenblatt's most successful investments was a spin-off of a special situation related to the Marriott hotel chain in the early 1990s.
At the time, Marriott had two segments, one of which was related to hotel management and included a reservation system. This was an “asset-light” business segment with “high returns." Marriot also had another business segment which was “asset heavy” as the company bought and built hotels itself.
During the recession of the 1990s, Marriot’s chief financial officer decided to spin off its asset-heavy business, which contained most of its debt. This was published in the Wall Street Journal, and Greenblatt realized that most people would “love” the asset-light “good” management business. However, Greenblatt decided to take a contrarian approach and analyze the “bad” asset-heavy business, as it may end up trading very cheaply.
Expanding further, he stated how as a result of taking the time and effort to read a massive 400-page prospectus, he discovered that on page 186, there was a chart that showed that most of the debt was actually on a subsidiary.
Prior to the spin-off the combined company was trading at around $24 per share. Then when it split, the management company was trading at around $20 per share and the asset business was trading at just $4 per share. However, the debt was on the subsidiary and its assets were “worth close to $6 per share." Greenblatt saw an opportunity to invest. The debt-ridden subsidiary also had the opportunity to be worth “a lot of money” as a bonus.
The end result was just four months after the spinoff this business went from $4 per share to an incredible $12 per share. This when on to become one of the most successful investments of his professional career.
Final thoughts
Greenblatt explained that if an investor has a disciplined approach to valuing the business, there are still opportunities available to buy. Looking at investments and anticipating returns for later rather than sooner is a much better strategy as the market shifts and changes and stresses the importance of patience.
Towards the end of the interview, Greenblatt spoke about a new book he is currently writing. He couldn’t dive too much into it, but he gave a hint about the contents, saying that “diversification is the only free lunch in finance” and that he found a “second free lunch."
