Joel Greenblatt

Joel Greenblatt: Million-Dollar Magic
by James Boric
The Rude Awakening
Wall Street, New York
Tuesday, November 29, 2005

James Boric discusses Joel Greenblatt and his "Magic Formula."

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Eric Fry, reporting from Wall Street...

A few days ago, two of our colleagues from the Baltimore
headquarters paid a visit to Manhattan. James Boric, editor
of Penny Sleuth and Greg Grillot, editor of Whiskey &
Gunpowder, headed up to New York City to attend the Value
Investing Congress - a three-day event led by some of the
most famous value investors in the world. The lineup of
speakers included Seth Klarman of Baupost Group, Jim Chanos
of Kynikos Associates, Bill Ackman of Pershing Square,
David Einhorn of Greenlight Capital, Richard Pzena of Pzena
Investment Management.

It may surprise you to learn that James and Greg actually
attended the event...each and every minute of it. These two
young men spent three days and three nights up here in
Manhattan. But did they ever bother to stop by our office
to say hello? No. Not even once.

"We're too busy," said James.

"Duly noted," we coolly replied.

But actually, we forgive James and Greg for "brushing us
off." In fact, we admire them for sacrificing their minimal
social graces to conduct investment research. They came
away from the three-day confab with some very valuable
insights and specific investment recommendations, as James
relates below...

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-------------------------

Million-Dollar Magic
By James Boric

Joel Greenblatt is not famous...He is merely rich.

Last week, I discovered why he is so rich. My discovery
could easily put a few extra dollar bills in your pocket as
well...Maybe even millions of dollar bills.

Joel Greenblatt is a Harvard Business School graduate, but
let's not hold that against him. He is also the founder and
managing partner of Gotham Capital, a private investment
firm established in 1985. He started with $7 million of
outside capital - mostly from junk bond king Michael
Milken. Over the next decade, he earned 50% a year -
compounded. Even after paying back all of the original seed
capital and factoring out expenses, Greenblatt grew his $7
million stake to over $350 million. A mere $1,000
investment was worth $57,665 in 1995. A $10,000 investment
was worth more than a half a million dollars.

So when Greenblatt took the podium at the recent Value
Investing Congress in New York City, I listened...intently.

Joel Greenblatt: "Magic Formula"

Greenblatt declared that he had a simple two-part
investment process that could deliver far greater returns
than the rest of the market. He called the process his
"magic formula." I thought to myself, "Wow, that's pretty
corny...but maybe there's something to it anyway." As it
turns out, there is.

Greenblatt's formula relies on a "value-oriented" process
that ranks stocks on the basis of two variables — the
earnings yield and the business's return on capital.

The first part of his formula requires that a stock trade
for a bargain price relative to earnings power (or yield).
The idea is simple. If, for example, a company can't earn
more than 5% a year - the return you would receive from 10-
year U.S. Treasury note - it isn't a business you want to
be in. Quite simply, it isn't cheap relative to the risk
you must take.

To calculate a company's earnings yield, you divide its
annual earnings per share by its share price. For
instance...

If a company earns $1 per share for an entire year and its
stock price is $10, its earnings yield is 10%. Since 10% is
double the return of a 10-year Treasury, it may be a
company worth looking into. But if you find a company in
the same industry that earns $2 per share and trades for
$10, that may be an even better investment opportunity. It
has an earnings yield of 20%! Obviously, the higher the
earnings yield, the better the bargain.

But earnings yield is only one half of the magic formula.
Investors must also ask a second question: Is the business
a solid one? The last thing you want to do is to buy stock
in a company that is cheap for a good reason - because it
stinks.
 
Greenblatt determines whether a company is "good" or not by
looking at its return on invested capital. In other words,
is it investing its capital wisely - adding to its earnings
power? Or is it wasting its cash on frivolous investments
that will create no (or even negative) value for
shareholders moving forward? For instance...

Joel Greenblatt: High capital Returns

If a company spends $1 million on a new factory and it is
able to crank out an additional $500,000 in profits the
next year, the result is a 50% annual return on capital.
That's outstanding. It says management knows how to spend
YOUR shareholder money to create added value. Clearly,
companies with high returns on capital will grow more
quickly than companies with low returns.
 
[Editor's Note: By the way, Greenblatt has authored a
terrific book about his magic formula entitled, "The Little
Book that Beats the Market." He has also created a Website
dedicated to the process, which may be found at
www.magicformulainvesting.com. For the record, we have no
business association whatsoever with Greenblatt. We are
merely providing this information as a courtesy to you].

So Greenblatt wondered how much money you would make if you
invested ONLY in good companies (those with a high return
in invested capital) that trade for a bargain price
(companies with high earnings yields).

To answer that question, he researched the historical
returns of the stocks his magic formula would have
identified. Specifically, he went back and examined the top
3,500 American stocks (from your large behemoths like
Microsoft on down to microcap companies with market caps of
$50 million) from 1988-2004, according to his formula's
ranking system. He ranked each stock in terms of earnings
yield and return on capital - from 1 to 3,500.

The idea was to invest in the companies with the best
combined score – those with the highest earnings yield AND
the highest return on capital. So if a company ranked 100th
in terms of earnings yield and 50th in terms of return on
invested capital, it got a score of 150. And if another
company ranked 6th in terms of earnings yield and 10th in
terms of return on capital, it got a combined score of 16.

After generating a score for each company, Greenblatt
created a portfolio of the top 30 companies. Greenblat
created a new "Top 30" at the beginning of every year
within his test, and then calculated the return an investor
would have received by investing in each year's top-30
stocks.

Joel Greenblatt: The Top 30 Every Year

From 1988-2004, if you had bought the top 30 companies
generated every year using Greenblatt's formula, you would
have averaged a 30.8% return for 17 years. During that same
time frame, the market averaged a 12.3% return.

So Greenblatt's ideal portfolio (using his two-part
formula) beat the market by almost three times over. And it
gets even better...

There was NEVER a three-year period between 1988 and 2004
where this portfolio of 30 solid, bargain stocks was not
profitable. Indeed, there was never a three-year period in
which it failed to beat the return of the S&P 500. In other
words, an $11,000 investment in 1988 in Greenblatt's magic
formula stocks would have been worth over $1 million by
2004.

As a small-cap specialist, I was particularly intrigued by
the fact that the small-cap value stocks within
Greenblatt's system dramatically boosted the overall
results. For example, when Greenblatt excluded the smallest
2,500 stocks from his sample universe of 3,500, he
discovered that his magic-formula portfolios produced an
annual return of "only" 22.9%. That result was still far
better than the S&P 500's, but the not nearly as good as
the 30.8% annual returns that resulted when the mid- and
small-cap stocks were included.

In other words, small cap value stocks are some of the
market's most valuable stocks of all. So I wondered, what
small-cap companies in today's market would meet
Greenblatt's stringent value criteria? I ran some numbers
of my own, and came up with 10 companies that had at least
a 25% return on capital and an earning yield north of 9%.
Check 'em out...

You will notice immediately that most of the stocks in the
table above have been performing very poorly all year. That
should be no great surprise. You don't find value stock on
the "New Highs" list. Instead, value always dwells among
the stock market's worst performing stocks. The trick, of
course, is to identify the one's that will soon begin to
perform well. That's where Greenblatt's magic formula comes
in handy.

Over the coming weeks and months in Penny Stock Fortunes,
I'll be tracking these 10 companies – and many others like
them – to seek out some great value investments in the
places where Wall Street's big boys rarely bother to look.
And we'll apply Greenblatt's magic formula to the research
processes we already conduct.

The results may surprise us all!

A P.S. from James Boric...

Joel Greenblatt is no doubt one of the finest investors of
all time. But unless you are a money manager, run a hedge
fund or follow the market every day, there's a good chance
you have never heard of him before today's Sleuth essay. He
isn't as high profile as Peter Lynch. And he isn't quoted
like Buffett or Templeton. But he is every bit as
successful. And his investment theories are priceless. You
would do well to follow them. In fact, if you did, I can't
imagine you would ever lose money.

Of course, the one problem most investors have is they
simply don't have the time to look for the handful of
companies that fit Greenblatt's investment strategy.
It's not like you can spend 10 hours a day running screens,
looking at annual reports and listening to Webcasts of
earnings announcements. So what can you do?

The best thing I can recommend is to pay a small amount of
money to have someone do that work for you. For instance...

Chris Mayer runs the finest value-investing service I've
ever seen - Capital & Crisis. He bases his investment ideas
off many of the same principles Greenblatt used to earn 50%
a year for an entire decade. And for $59 a year, you can
get all of Chris's research and stock recommendations. I
highly recommend you give his service a try. Learn more
here:

Chris Mayer's Capital and Crisis
http://www.agora-inc.com/reports/FST/EFSTFB06

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-------------------------

[Joel's Note: I hope you enjoyed Mr. Boric's insights above
as much as we did. Being that he is not a regular on the
Rude circuit, we decided to give you a couple of other
essays he's written to tide you over until we can coax him
back again.

Oddball Investing
http://www.dailyreckoning.com/Issues/2004/111704.html

Low Cut Dresses and Ugly Ducklings
http://www.dailyreckoning.com/Issues/2005/DR061505.html

Here is another man you should be keeping an eye out for –
Chris Mayer. We dug around for this little gem Chris wrote
for you a while ago. This is vintage Rude...enjoy:

Let's Play Monopoly
www.dailyreckoning.com/RudeAwake/Articles/RA101905.html

That should tide you over until tomorrow's edition. You can
email any comments to my sore head at:

aussiejoel@the-rude-awakening.com

Cheers,

jOEL

And the Markets...