[00:02:34] Shawn O’Malley: Today, I’ll be digging through the video lectures of legendary investor, Joel Greenblatt from his time as a professor at Columbia. Greenblatt is a wealth of wisdom. So you don’t want to miss out on these special insights. We’ll go over during this episode. To set the stage, I’ll just say that Greenblatt’s track record is largely unrivaled.

[00:02:52] Shawn O’Malley: From 1985 to 2005, he earned better returns than even Buffett did across much of his career, compounding at 48. 5 percent per year for over 10 years during that time. His magic formula focuses simply on companies with large earnings yields. Meaning they’re cheaply valued relative to the amount of profit they produce, while also having high returns on capital.

[00:03:13] Shawn O’Malley: He would essentially rank stocks by their cheapness and returns on capital, and then buy the top ranking ones and sell short the worst ranking ones. Using his so called magic formula, an investor would have earned a compounded annual return of 23. 8 percent from 1988 to 2009, versus the 9. 6 percent yearly return from the S& P 500 over that period.

[00:03:32] Shawn O’Malley: In 1981, at just 24 years old, Greenblatt published a research paper that would shape his career called How the Small Investor Can Beat the Market by buying stocks that are selling below their liquidation value. So early on, Greenblatt wanted to buy stocks that traded at prices so cheap that if the company fell into bankruptcy and had to sell off its assets, it could plausibly do so for more than the current market value of the stock.

[00:03:54] Shawn O’Malley: These situations are abnormal, but they’ve been observed to happen, and Greenblatt would take this starting point of ultra cheap stocks and refine things even further, cutting out the worst and most unprofitable of these businesses. With that said, the first lecture I’ll go over today is from October 2005, where Greenblatt reviews three of the best pitches to the Value Investors Club that he’s ever seen, all from the same investor.

[00:04:19] Shawn O’Malley: What’s cool is that you can actually go into the Value Investors Club website and search up the exact pitches they’re reading in Greenblatt’s class, which I’ll link to in the show notes. In June 2001, an investor with the username Charlie479 submitted NVR, which is a home builder. Again, this pitch would go on to become somewhat legendary among deep value investors, and I’d really encourage you to read it for yourself to see what a concise investment thesis looks like.

[00:04:42] Shawn O’Malley: In short, NDR’s operating model was, in Charlie’s words, somewhat unique, and it allowed them to assume the least risk in the industry to produce industry leading returns, which is just really rare. Charlie479 basically argues that home builders are largely dismissed because they’re cyclical and sensitive to interest rates, leaving them with large inventories of unsold properties and economic downturns.

[00:05:02] Shawn O’Malley: Builders with the most debt typically fall into bankruptcy, while the homebuilders that survive endure substantial write downs of their assets. Yet, NVR is, or at least was, different. Rather than purchasing land outright for development like most builders, NVR would acquire the rights to use land through options contracts, which gave them the right to buy lots, but doesn’t obligate them to do so.

[00:05:22] Shawn O’Malley: They’d put up 5-7 percent of the land value up front instead and could decide from there if it was worthwhile to complete the full purchase. As it’s laid out in the pitch, quote By avoiding the speculative practices of land purchase and development and instead using options, NVR is able to control large blocks of land in its markets while employing less capital to do so.

[00:05:42] Shawn O’Malley: The lower capital requirements of this method translate into lower inventory risk and greater returns on capital. And secondly, what differentiated NVR, according to Charlie479, at the time, was that the company presold most of its homes and collected deposits before beginning any construction, which ensured that they didn’t incur any construction costs until they were certain they had a buyer for it.

[00:06:03] Shawn O’Malley: With this superior business model, NVR traded at a surprisingly low price earnings ratio of just 8. While having a substantial backlog of ordered homes and a track record of high returns on capital. In addition, the company was buying back stock aggressively and with only a small percentage of its shares actually trading on the stock exchange.

[00:06:21] Shawn O’Malley: It was particularly vulnerable to big swings from large shareholders, something shares, which could pretty disproportionately weigh on the stock for short periods of time. But offered great chances for long term investors to buy in. So it’s a compelling pitch, and that gives you a rough idea of the first investment opportunity that Greenblatt reviewed with his class.

[00:06:38] Shawn O’Malley: I actually looked up the stock out of curiosity to see how it’s doing today, and well, it’s up 163 percent in the past five years and trades at a price to earnings ratio of almost 20. So the market has clearly come to better appreciate the quality of NVR’s business by paying a higher premium to own its shares.

[00:06:55] Shawn O’Malley: In the 23 years since it was first published, NVR’s stock price per share has compounded at an impressive 20 percent per year, versus only 7 percent per year for the S& P 500 over that same period. So with hindsight, we can say pretty safely that Charlie479 nailed it with NVR, even with the great financial crisis lurking just a few years on the horizon.

[00:07:15] Shawn O’Malley: Evidently, NVR would not only survive the crisis, but it would nearly triple the market’s average annual returns, which is just a huge testament to the quality of NVR’s business, especially relative to its competition. We obviously know how this investment played out, but what I’m interested in is, just given the plain information from the pitch, how does Greenblatt think through the pros and cons, what kind of things does he worry about, and really, what is his approach to breaking down a potential investment?

[00:07:41] Shawn O’Malley: To begin the exercise, Greenblatt likes to condense down any given investment thesis into just two to three sentences, which is what he asked his students to do with this one. Greenblatt works through his thinking on the idea, suggesting that he’d want to know how much the company is getting in deposits for pre-sold homes to ensure that they’re actually being adequately compensated for the risk of someone backing out.

[00:08:00] Shawn O’Malley: Related to that, as an investor, he would probably try to dig up numbers on what percentage of these presold homes fall through and how that changes over time through different points in the economic cycle. He indicates that the company probably has some economies of scale advantages where their size allows them to build homes at a lower cost, and most importantly, allows them to afford options contracts on large tracts of land that other firms may not be able to afford.

[00:08:25] Shawn O’Malley: The students throw out a bunch of questions and concerns at him and take a stab at describing the thesis, but I love how Greenblatt simply is able to distill everything down. Being able to reduce nuanced points into their most understandable form without sacrificing any key information is really a superpower, in my opinion, and the mark of a truly great investor.

[00:08:45] Shawn O’Malley: Greenblatt exemplifies this by outlining that the crux of the thesis here is that this is a company that’s priced cheaply at just 8 times earnings, yet they put little capital in the business comparatively since they use options agreements instead of buying land outright, and they presell their inventory beforehand, which gives them a big cash flow advantage.

[00:09:02] Shawn O’Malley: As he puts it, since NVR is taking little financial risk, there will probably be a temporary hit to their business in a downturn, but it won’t be devastating for them. So there’s very little overall risk here, given what we understand qualitatively about the business, and based on the valuation it traded at, it would have been very unlikely to lose money in the stock at the time it was originally pitched.

[00:09:22] Shawn O’Malley: Meanwhile, the upside was considerable, assuming the company could leverage its advantages further and continue to compound capital at the rates it had already proven it could in previous years. These are exactly the sorts of companies that made Greenblatt rich over the course of his career. High quality companies that, for, at times, inexplicable reasons, traded at ultra cheap prices.

[00:09:43] Shawn O’Malley: 2001 was a long time ago, but it wasn’t that long ago. If these types of opportunities were sitting in plain sight, then, I’m pretty confident they are still now too. Part of what made this type of opportunity possible, where there was a pretty extreme degree of asymmetry and upside relative to the downside, Is that NVR had gone into bankruptcy in 1991, under a different and more conventional homebuilder business model back then?

[00:10:05] Shawn O’Malley: Greenblatt proposes that the market essentially hadn’t learned to trust NVR yet and was still leery of it, which caused investors to overlook the fact that its business model had changed and was leading to impressive returns on capital with relatively minimal risk. So there are typically good reasons for an opportunity like this to slip through the cracks, but And capitalizing on it would have required an appreciation for how the business had changed.

[00:10:27] Shawn O’Malley: I really love a point that Greenblatt makes too in response to a student who asked that if the company essentially has very few assets since it’s not holding a ton of property on its balance sheet like other home builders, does the stock become virtually worthless in a down year if it can’t sell many houses and therefore earns no profit?

[00:10:43] Shawn O’Malley: As Greenblatt puts it, what matters with a cyclical company are the average earnings. If a company like NVR can earn 10 in profits per share for 9 out of 10 years, and in the 10th year it earns a profit of 0, that doesn’t make the business suddenly worthless. On a normalized basis, where you average out results across the economic cycle, such a company would earn an average of roughly 9 per share each year, which is definitely very valuable.

[00:11:08] Shawn O’Malley: It’s not so much about having a ton of assets or never having a bad year, but on average, what can you expect from this company over time? Next, Greenblatt turns to a company called NII Holdings, which was also pitched on the Value Investors Club by Charlie479, this time in November 2002, which was honestly a good time to buy a lot of stocks given how beaten down the market was after the dot com bubble.

[00:11:31] Shawn O’Malley: As opposed to NVR, which was a cheaply priced and overlooked company that was actually quite a high quality business, NII is more of what you might call a quote unquote special situation. NII was not an attractive long term hold, but some special circumstances had made it unreasonably cheap, making for an attractive profit opportunity over a much shorter time horizon.

[00:11:52] Shawn O’Malley: This is a company that was formed in 1996 to hold all of Nextel Communications international wireless assets and over six years Nextel invested over 500 million dollars in NII While bondholders lent an additional two billion dollars to the company to build out its wireless network With all this borrowed money NII holdings struggled to essentially make the minimum payments on its debt and it filed for bankruptcy in February 2002 Eight months later, it emerged from bankruptcy restructuring with a new plan to pay back creditors that was less burdensome after converting 2.4 billion of outstanding bonds into equity. Charlie479 argues a few key points in NII’s favor. Namely, because NII had recently come out of bankruptcy, the stock was largely forgotten about by markets and therefore traded at a very low valuation. Where the entire enterprise was valued at less than three times a proxy of its operating income.

[00:12:47] Shawn O’Malley: Yet it was expected to soon move off of thinly traded over the counter markets and begin trading on the Nasdaq Stock Exchange, which would almost certainly boost demand for the stock. Relatedly, as the stigma of bankruptcy wore off and the stock traded on a major stock exchange again, it was expected to trade at a more normalized valuation, similar to its parent company.

[00:13:06] Shawn O’Malley: This normalization of NII’s stock price alone plausibly offered upside of 2-3 times the current stock price according to Charlie479. In talking about the pitch for NII, Greenblatt calls the company a fertile place to look for value because investors like NII holdings that emerge from bankruptcy are so often overlooked by investors.

[00:13:25] Shawn O’Malley: People who used to track the company might have stopped doing so during the period it was restructuring, and others will find the odds of the company slipping back into bankruptcy court too off putting. As he explains too, because so much debt has been converted to equity, you probably have a bunch of banks that don’t want to really own the stock long term and have been selling it at their first opportunity to do so, which has left the stock trading at irrationally low prices.

[00:13:49] Shawn O’Malley: He sort of continues to go over why the situation was so ripe for the stock to be potentially misvalued. And he deconstructs how an investor like Charlie479 might have found this prospective opportunity. Firstly, they realized that because the company had recently come out of bankruptcy, that didn’t guarantee the stock was misvalued, but that increased the odds of markets being wrong about it.

[00:14:09] Shawn O’Malley: From there, Charlie479 realized that the publicly available financial information for the stock was reported in a confusing manner. And it wasn’t easy to piece together the company’s actual operating profits. So while Charlie479 was able to piece together that the company was trading at an incredibly cheap valuation relative to various measures of its profitability after reconstructing NII’s financials.

[00:14:32] Shawn O’Malley: That was not laid out simply for anyone else to see, and thus made it even more likely that the stock wasn’t being accurately priced. As Greenblatt states, the company’s earnings were being hidden, and to a value investor like him who enjoys digging beneath the surface, that is a wonderful thing to find.

[00:14:48] Shawn O’Malley: Between the messy financials that concealed the company’s operating profits, selling pressure from debt holders getting rid of the stock that was awarded to them in bankruptcy, and the general stigma surrounding recently bankrupt companies, an investor looking at NII in late 2002 could have known there was a confluence of factors working in their favor that validated why the stock was abnormally cheap.

[00:15:09] Shawn O’Malley: Which represented a buying opportunity to anyone willing to come in and hold the stock for a year or two. What I love about Greenblatt’s teaching here is the focus on what could have been known at the time. Hindsight is 20/20, and anyone can pick winning stocks by looking backward, but we have to deal with the information available to us at the moment when assessing the quality of investment decisions made.

[00:15:30] Shawn O’Malley: To some extent, we have to sort through luck and skill, and that’s what Greenblatt tries to do with his students. Plenty of people have made winning investments where they essentially got lucky because they bought a stock that went up, but their rationale for doing so was pretty unsophisticated. Whereas skilled investors are typically able to see which factors are being overlooked by markets, why that’s so, and determine how to act accordingly.

[00:15:52] Shawn O’Malley: And at the time, Greenblatt actually recognized that skill and how even through the most conservative lens possible, NII was unlikely to be a losing investment and instead offered a disproportionate amount of upside. He says, quote, if you don’t lose money, most of the other alternatives are good. As a result, he actually bought the stock after reading the pitch and jokes that he wished he had bought more and paid even closer attention since it worked out so well in hindsight.

[00:16:17] Shawn O’Malley: In the ensuing two years, NII went from 10 per share to 240 per share. That’s just a massive 24 times increase, but Greenblatt apparently knows the investor behind the Charlie479 pseudonym who originally pitched NII and knows that they sold out at 60 per share, missing out on the rest of that upside, which is really a lesson in its own way.

[00:16:40] Shawn O’Malley: Even great investors with conviction in their esoteric bets like this can jump the gun too soon and not ride their investments far enough. When you’re right about something, let yourself be right big. I’m sure Charlie479 kicked themselves for years for tapping out too soon. When you’re really deeply confident about an investment and why it’s being mispriced by markets, it’s important to not bet too small or bail too soon on what can be a once in a decade opportunity.

[00:17:03] Shawn O’Malley: That said, this is the epitome of hindsight bias, and after running up six times to 60 per share, the risk reward for continuing to hold probably looked pretty skewed, so I can’t blame Charlie479 for cashing in. With both NII and NVR, Greenblatt was focused on explaining not only why they offered good value, but why the market failed to see this value, which I think is equally important.

[00:17:26] Shawn O’Malley: There are tons of good companies where it would be easy to say they offer good value to investors, but in reality, the market can easily recognize this too. And the stock price would get bid up to a level where these positive factors are fully reflected in the price. As such, in theory at least, there would be no market beating advantage that an investor could earn by simply buying a company with an attractive business model that has a stock valuation that more than reflects that quality.

[00:17:52] Shawn O’Malley: Instead, we must explain not only what’s attractive about an investment, In terms of its business model, or assets, or whatever it is, and why that isn’t being appreciated by the market. In different ways, with both NII and NVR, their underappreciation stemmed from a past bankruptcy, which was distorting investor perceptions and thus left the stock trading at prices that was of extremely good value to patient and discerning investors.

[00:18:15] Shawn O’Malley: These case studies are just so fun to me because, as I’ve said, these are investments that Greenblatt either participated in, or at least recognized at the time as being pretty attractive, and now we get the chance to hear him break that down in an academic setting. As he explains, these types of deep value picks in small to microcap stocks can continue to create opportunities for wealth because the skilled investors who master investing in these sorts of opportunities eventually become so wealthy that they have to invest in bigger and bigger market cap companies to move the needle for them.

[00:18:43] Shawn O’Malley: Micro cap stocks become uninvestable to them because they have to try and earn the same return as in the past with a larger pool of money, and they might trade against themselves and bid the price of a stock excessively higher if they try to put, say, 50 million into buying up shares in a company that only has a 400 million market cap.

[00:19:01] Shawn O’Malley: If there are even enough shares trading publicly to invest that kind of money into a small company, you’re going to soak up all the liquidity and cause a spike in the price as you try to build up your position. And The point being, great investors cut their teeth with bets like NII and NVR, and graduate to larger market capitalization stocks as they begin to manage more money, which then leaves these companies underfollowed and creates an opportunity for the next generation of investors to get rich on special situations and undervalued microcaps.

[00:19:30] Shawn O’Malley: So with that, I want to go over another of these investment case studies from Greenblatt as pitched by Charlie479 on the Value Investors Club forum, just to see what we can learn. The third case study is on a company called Sportsman’s Guide, ticker SGDE, which no longer trades publicly after being acquired by a private equity firm.

[00:19:49] Shawn O’Malley: It still is today, though, a popular online retailer for hunting and fishing gear and other outdoor sporting goods. Which started as a mail order catalog in the late 1970s. The pitch for the company, as articulated in June 2003 by Charlie479, was premised on the fact that the company was earning a very impressive 35 percent return on equity, while having very little debt.

[00:20:11] Shawn O’Malley: Despite those impressive results, SGDE traded at less than 5 times free cash flow, defined as the operating cash flows from the business, minus capital expenditures reinvested into it. That’s a bit jargony, but another way to say that is, the price you paid for the stock would be recouped in less than 5 years by the company’s free cash flows, assuming they stayed roughly the same over that time, and sooner if free cash flows grew.

[00:20:35] Shawn O’Malley: I’ll use another example where the accounting is slightly different, but the idea is the same. If you paid a price to earnings ratio of 20 for a stock, and its earnings remained flat, then it would take 20 years to earn back that investment. As in, if the company produces 1 per share in profit each year, and you paid 20 for one share, then it would take two decades for the business to make back that 20 on your behalf in retained earnings.

[00:21:00] Shawn O’Malley: Thinking in payback periods like this is a nice way to contextualize the valuation you’re paying for a company, and with SGDE trading at less than 5x free cash flows, the company was offering what I’d say was an unusually large amount of upside with relatively less risk. As the 2003 pitch on the value investors club puts it, the company has a strong brand with a loyal customer following cultivated over decades of delivering quality products to a niche audience.

[00:21:26] Shawn O’Malley: The catalog was earning around 180 million of revenue per year and a partnership with buyers’ club where paid members could get special discounts on sportsman’s guides products was really boosting business. Much of the company’s value also came from its database of 5. 2 million customers, where they knew their customers well because 85 percent of sales came from recurring shoppers.

[00:21:47] Shawn O’Malley: On top of that, its competitive advantage lied in offering 25-60 percent discounts for items relative to normal retail pricing, which they could offer because their buying agents would comb through vast quantities of discounted or overstocked items from a network of over 1200 suppliers. All of that sounds pretty good.

[00:22:05] Shawn O’Malley: And the most exciting part was that the company could save millions of dollars a year from printing and shipping its catalogs by migrating its offerings to being solely shown online. This was obviously the early days of online retailing, but in five years, Sportsman Guide’s online sales went from just 1 million per year to 53 million.

[00:22:23] Shawn O’Malley: Thanks to the internet, a major source of SGDE’s operating costs were being phased out, and the catalyst for the stock’s price, as it often is, was a recently announced share repurchase program, where the company planned to buyback 10% of its outstanding stock, presumably because management also recognized that the stock’s market price didn’t reflect its value.

[00:22:32] Shawn O’Malley: What’s not to love about a debt free, cheaply priced, profitable company phasing out one of its biggest operating expenses, massively buying back stock, and gaining traction with online sales? Even though I know this was a real opportunity that anyone had the chance to read about at a time for free on the VIC forum.

[00:23:03] Shawn O’Malley: It just still sounds too good to be true. However, as Greenblatt frames it, the thesis is pretty straightforward, and it doesn’t take a genius to see the opportunity here. Sometimes, it’s really as simple as just saying that coming out of the dot com bubble, this was a time when there were a ton of cheap socks to buy, which means some will slip through the cracks longer than others.

[00:23:23] Shawn O’Malley: Given it was such a small business with few shares trading publicly and was transitioning to more online sales at a time when markets had been spooked by a bunch of hyped up internet stocks in the 90s going bust, that contributed to the stock price dwindling on a level that seems like a no brainer in hindsight.

[00:23:39] Shawn O’Malley: From the time it was pitched, SGD stock rose about four times over the next two years, which is a pretty nice return on investment that I’d be more than satisfied with. In reflecting on the three case studies we’ve gone over so far, Greenblatt tells the students that what matters is in seeing what management is going to do with the earnings they’ve generated.

[00:23:57] Shawn O’Malley: From a shareholder perspective, companies can earn as much income as they want, but if management wastes it away, then it was all for nothing, at least from a shareholder’s perspective. Ongoing profitability combined with share repurchases where investors could know that at least some of those earnings would be returned to them is a pretty good start for an investment case.

[00:24:16] Shawn O’Malley: As we saw with SGDE, he says, quote, what your perception of management is and what they’re going to be doing with earnings is very important. He goes on to say that with each of these opportunities, any investor with enough practice would have easily been able to recognize how attractive they were. It’s almost a know it when you see it type of thing.

[00:24:34] Shawn O’Malley: When it comes to the best types of investment opportunities. What’s cool about these examples is that I don’t think it takes a ton of experience to see why they worked out. You’ve seen for yourself now, but there really are instances and markets of hugely winning investments that were not only possible to find, but also reasonably understandable, especially among small and micro-cap stocks. Here’s a little snippet from Greenblatt’s lecture to make the point.

[00:24:59] Joel Greenblatt: And none of this was taking something to the 37th decimal point. This was all like, this is so cheap, right? If I’m even close to right, this is so cheap, I’ll make money. And if I’m not right, it’s going to be hard for me to lose money. So, that’s under, those are all underlying themes to this.

[00:25:16] Joel Greenblatt: And I, um, the whole construct of, um, You know, what’s been taught generally in business schools over the last 40 years about efficient markets and beta. I know you’re in the value investing program, so you’ve already dismissed that already. But it just seems, it just seems so ridiculous when you can, uh, look for opportunities and it’s the same guy time and time again.

[00:25:43] Joel Greenblatt: And speaking of the same guy, you know, second part of the class where you get to win your, uh, Warren Buffett cartoon book, is the same guy who time and time again has a certain theme, certain things that he looks for in investment, certain qualities of a business that he, that he’s looking for that, that can make you money.

[00:26:01] Joel Greenblatt: And the funny thing is we’re going to talk about Buffett and I’m sure you’re all sick of, you know, I mean, you all feel, you know, pretty knowledgeable about Buffett. But, uh, I can tell you this, as many times as I read it, I keep saying, oh yeah, I have to remember that, um, every time I read it. So the more that you pound it, and I’ve been doing this for, you know, unfortunately a long time.

[00:26:24] Shawn O’Malley: Greenblatt continues his lecture by leading students through an exercise where he role plays as Warren Buffet, as they throw questions at him related to the case studies on NBR, NII, and SGDE. He discusses the importance of management and how management’s actions will speak for themselves. With the homebuilder NVR that we went over, Greenblatt says it was clear that management was thinking with the shareholders best interests in mind because they were shareholders too, with large stakes in the company.

[00:26:51] Shawn O’Malley: Especially after they’d overseen the company’s buybacks in the past five years that repurchased more than half of NVR’s outstanding stock. I’d add to that just to say that listening to management talk can be a tricky business because to rise to the top of the ranks in corporate America, you probably have to be an unbelievably charismatic person.

[00:27:09] Shawn O’Malley: So any half decent CEO of a publicly traded company should be able to sell you on their vision for the company because that’s their job rather than giving them a chance to bias you. I wouldn’t necessarily suggest not to listen to what management has to say on earnings calls or in interviews but take it with a grain of salt compared to what the numbers are telling you.

[00:27:29] Shawn O’Malley: If a CEO says their company is the best in the business, but you can tell from looking at the numbers that they’ve lagged their competitors and generating returns in capital, then obviously their claims don’t pass the smell test. And if management says they’re thinking like shareholders, but they don’t actually own any stock in the company they’re running or aren’t returning capital to shareholders through dividends and buybacks.

[00:27:48] Shawn O’Malley: Then you can really just use the numbers again to call their bluff. Every situation is different, but again, Greenblatt loves to find no brainer investments where you don’t have to debate the merits of an investment ad nauseum because it’s sitting in some gray area. With NVR, for example, at least with respect to management, just by looking at the numbers for return on capital and share buybacks, you could have felt pretty confident that they knew what they were doing, which removes one less variable of concern for you as an investor.

[00:28:14] Shawn O’Malley: He continues into a really interesting conversation on how to think about earning back returns, which we’ve discussed a bit already. A lot of times people look for a specific catalyst to drive returns like buybacks, new product launches or management changes, but sometimes it can be as simple as a company just delivering the earnings that you expected it to in the market, catching up to your outlook.

[00:28:33] Shawn O’Malley: For example, if you expected Walmart’s earnings to grow at 15 percent per year for the next five years, you might expect its stock to follow the same trajectory and also grow at 15 percent per year, which after five years would mean it’s going to double from say 10 to 20 per share. Rather than having to wait that entire five year period though, to double your investment because markets are forward looking those higher earnings would eventually get priced in and 30 to 50 percent of a hundred percent returns to be earned over five years might come in the first 12 months.

[00:29:05] Shawn O’Malley: And once you’ve pulled forward a bunch of those returns, rather than holding for another four years, you might look somewhere else for another opportunity to double your money. The message here, which I think really bears repeating is not only that markets can correct sharply to price in new information, but that when they do correct that pulls forward returns from the future, which means anyone buying in after that upward correction would be implicitly accepting a lower rate of expected return.

[00:29:31] Shawn O’Malley: If a stock you expect to go from 10 today to 20 after 5 years sees a 35 percent return in the first year as the market catches up to a higher earnings growth outlook, expected returns fall from 15 percent per year initially to 10 percent per year. There’s still meat on the bone there, but for investors trying to beat the market, they’d probably lock in that 35 percent gain after 12 months and look elsewhere, since 10 percent expected returns per year going forward doesn’t really offer enough upside.

[00:30:00] Shawn O’Malley: This is how legend investors like Greenblatt think through investment opportunities. Not only are they excellent at digging into companies financials and understanding their situations, but they’re also able to think strategically about the expected return going forward and how market fluctuations change those expected returns.

[00:30:17] Shawn O’Malley: Continuing on in his lectures, it’s fascinating to see what is effectively an early preview of the so called magic formula for investing that we talked about at the top of the show, and that which defined Greenblatt’s famous book on beating markets. He outlines how, in compiling studies for the book, Over basically any period in any market in any country, you can rank stocks by deciles according to their cheapness, and that directly corresponds to the ranking for their returns over a certain following period.

[00:30:44] Shawn O’Malley: So the top decile of cheapest stocks, sorted by their price to earnings ratio, end up with the best returns. The second decile of cheapest stocks have the second best returns, all the way down to the most expensive stocks, which have the worst returns. The question is, why does buying cheap continue to work across time?

[00:31:02] Shawn O’Malley: Greenblatt explains to his students that, before he even started as a professional investor in the 1970s, he saw studies on cheap stocks outperforming, and even so, he didn’t know Buying them continued to work for him throughout his career. Although it would seem that as a teacher and author, Greenblatt is giving away his secret sauce, he claims that teaching and writing are immensely valuable to him because they challenge him to think through his investment decisions more meaningfully.

[00:31:26] Shawn O’Malley: He also isn’t worried that his strategies will stop working if he shares them with the public. He says the world is a big place and there are plenty of companies to invest in. The bigger reason is that there’s a fundamental reason cheap stocks exist. Firstly, cheapness is relative and there will always be a decile of the cheapest stocks to invest in.

[00:31:46] Shawn O’Malley: Secondly, cheap stocks exist because there are real reasons to dislike them. If you filter down the U. S. stock market down to the companies with the lowest P. E. ratios, you get a bunch of unloved names, quite literally companies that nobody wants to own. Maybe they’re tobacco or gun companies, maybe they’ve gotten a ton of bad press and are laying off staff, or maybe they just have a big headwind that’s going to suppress profits for two quarters.

[00:32:09] Shawn O’Malley: Whatever it is, these are companies that investors have decided that in this moment, they don’t want to have them in their portfolio. And while Greenblatt has shown you can do well from simply buying the cheapest deciles of stocks and holding them for a few years. You can do even better by digging into these lists of cheap stocks and determining which companies are facing permanent headwinds, and which ones are facing only temporary challenges.

[00:32:31] Shawn O’Malley: Cheap stocks come from people owning them when they were, well, not cheap stocks, and selling them out of frustration or panic over some turbulence in the company’s future Leaving them temporarily discounted enough to attract folks like Greenblatt to check them out further. To make this point even more, in a talk before the CFA Society of Chicago in 2019, Greenblatt explains how he taught the shortcomings of the stock market to a group of teenagers in Harlem.

[00:32:55] Shawn O’Malley: He filled up a jar with jellybeans and asked the students on their own to calculate how many they thought were in the jar, and then submit their answer independently on a note card. Then he asked the students to go around one by one and say their answers out loud with the caveat that they could either keep their original answer submission or change their answer based on what others had said.

[00:33:14] Shawn O’Malley: When these students thought critically on their own, their average answer was 1, 771 jellybeans, which was actually just 5 away from the correct answer. Yet, when these students gave answers aloud and were biased by what others had said, The average answer fell to 870 jellybeans. As Greenblatt puts it, the stock market is the latter scenario, where investors are hugely biased by what their colleagues have said, what they’ve read in the newspaper, the headlines they see on TV, and so on.

[00:33:44] Shawn O’Malley: His approach, then, is to try and be as independent as possible, covering his ears and blocking out all the noise that can blind him from accurately estimating, as the metaphor goes, the number of jellybeans in the jar. What I love about Greenblatt is that while he acknowledges the nuances and difficulty of investing, he’s also open about the fact that it doesn’t have to be rocket science.

[00:34:06] Shawn O’Malley: Simple principles like buying the cheapest S.O.S. stocks, filtering them down further by quality, and selling them after a year or two or continuing to hold the truly rare but cheap quality compounders like the Homebuilder and VR will work pretty well for you. To some extent, it’s a question of having the courage and patience to buy unloved stocks.

[00:34:25] Shawn O’Malley: When everyone is telling you that Intel is imploding and irrelevant in the age of AI, can you really disregard that sentiment and buy the stock? Or will you second guess yourself enough that you wait to see what happens and then the stock bounces back 20 percent and the opportunity is mostly gone. I use Intel because it’s a timely example of a well-known company that has self-destructed this year but also bounced back from its lows after hitting some truly cheap valuation levels where there’s little room for things to get much worse and a lot of upside if the outlook even modestly improves.

[00:34:58] Shawn O’Malley: After we followed Greenblatt through 3 separate case studies, originally pitched by this Charlie479 guy, you might be wondering who he is. That is, the investor who pitched NVR, NII, and SGDE on the Value Investors Club forum. For the sake of simplicity, and out of respect for his privacy, I’ll continue to refer to this investor as Charlie, but I can tell you a bit more about him if you’re curious.

[00:35:22] Shawn O’Malley: After becoming something of a legend on the value investors club forum for his posts, the pseudonymous Charlie479’s last post was in early 2009, so unfortunately, he’s not still posting winning ideas that we can study or clone. But we do know that he was, and probably still is, close friends with Joel Greenblatt and reportedly earned returns of 38 percent per year from 1994 through 2003 as money manager.

[00:35:46] Shawn O’Malley: And with Greenblatt’s help, Charlie started an investment fund called Punch Card Capital with around 100 million in assets under management that, at least through 2011, was outperforming the S& P 500 by 12 percentage points per year. If you’re really curious to learn more about Charlie479 and his firm punch card capital in the show notes I’ll link to his only public interview ever from 2011 for you to check out The name Punch Card Capital is inspired by Warren Buffet’s punch card analogy.

[00:36:14] Shawn O’Malley: Quoting Buffet, the analogy goes as follows, I always tell students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision, they used up one of their punches because they aren’t going to get 20 great ideas in their lifetime.

[00:36:31] Shawn O’Malley: They’re going to get 5, or 3, or 7, and you can get rich off 5, or 3, or 7, but what you can’t get rich doing is trying to get one every day. As of earlier this year, disclosures from Punch Card Capital revealed at least four of its holdings, which unsurprisingly included Berkshire Hathaway, but also Ally Financial, Winnebago Industries, and Smith Wesson.

[00:36:53] Shawn O’Malley: Because Charlie479 has already contributed so much to this episode and obviously thinks about investing similar to Greenblatt. I want to share a passage from another of his posts addressing the tension between buying cheap stocks and buying high quality compounders, which is something I’ve covered at length in last week’s episode and in the week before.

[00:37:11] Shawn O’Malley: He’s referencing his 2001 pitch on Windmill and company ticker WNMLA, where the company had more net cash per share than the stock’s current price, meaning the company could be simply liquidated and shareholders would immediately roughly double their money. There was effectively zero downside, Not reduced downside, but again, essentially none.

[00:37:32] Shawn O’Malley: These types of opportunities are known as cigar butt stocks because they’re usually dying companies where you can get one last puff of profit out of them since they’re just ludicrously cheap. And they’re exactly the types of opportunities that both Warren Buffett and Joel Greenblatt made a living on, especially in their early days.

[00:37:48] Shawn O’Malley: Charlie479 writes quote, it is always amazing to me how many people will turn down the chance to buy 1 of cash for 40 cents because they say you’ll never see the full value of it. The main reason these types of companies sell at those prices is because most folks won’t touch them until they think they have the scoop that the company is about to be sold.

[00:38:07] Shawn O’Malley: There is a shortage of investors that are willing to be patient and wait for the 45 cents to be liquidated into a dollar. This creates the opportunity. He adds, quote, I am happy to buy dollar bills for 45 cents and wait for payday to come around as long as there is no cash burn and there are signs that management is headed in the right direction.

[00:38:26] Shawn O’Malley: As long as I know that I have more than 2 of net cash behind each 1 I put up and that there are certain clues as to a potential payoff, it’s not a terrible proposition. Charlie continues by saying, WNMLA is a cigar butt. Cigar butts are inferior to great operating companies with defensible market positions, generating 25 percent returns on invested capital, and selling at 8x PE like NVR.

[00:38:49] Shawn O’Malley: However, there are extremely few of these high quality companies that are trading for such low values. Coke is a great company, but fully priced. Ditto for Moody’s, American Express, etc. The companies that don’t have high multiples are usually average businesses that will produce average long term rates of return on capital.

[00:39:08] Shawn O’Malley: Look at the Value Investors Club board. It is littered with low P. E. stocks with either unexciting returns on equity or very high leverage. I’d say that the WNMLA Cigar Butt types of stocks have better risk reward than both of these two types of low P. E. average businesses. I’d prefer to let cash sit in these asset rich situations until some of the great operating companies fall back down to 10 times price to earnings ratios.

[00:39:34] Shawn O’Malley: Charlie’s comments here shed light on how he thought about the balance between cheap cigar butt stocks like WNMLA, which he saw as a substitute for cash with some upside potential versus investments that compound intrinsic value over time like NVR, which are what he prefers most. For instance, take a look at the chart of NVR and WNMLA, which you can see if you’re watching this podcast on YouTube.

[00:39:57] Shawn O’Malley: To summarize it briefly, it is up and to the right for NVR, outpacing 500, while the cigar butt stock WNMLA offered periods of upside but otherwise mostly preserved value with flat returns. The stock prices correspond to intrinsic value over time, and over time, NVR has compounded intrinsic value, while WNMLA has not.

[00:40:19] Shawn O’Malley: But that doesn’t mean that at 45 cents on the dollar, which is effectively what an investor in WNMLA in 2001 would have gotten, was a bad investment. Basically, Charlie479 says he likes great businesses at low prices, but those are hard to find. So in the meantime, if he can invest in a money market fund, a cigar butt stock with a possible 100 percent upside, he’s more than happy to do it.

[00:40:41] Shawn O’Malley: While many of the investors on the value investors club are quite savvy and Charlie479 is probably one of the best you ever post there, there are a lot of recommendations there for companies that produce mediocre returns on capital yet sell at modest prices of say 12 times earnings. Thanks. These aren’t always bad ideas, but the majority of them will lead to just average results.

[00:41:01] Shawn O’Malley: The real outstanding returns come from identifying the relatively few, truly undervalued situations, whether from an average business selling for half of net cash, like WNMLA, or an exceptional business selling at a single digit earnings multiple like NVR. So, we’ve spent a lot of time today going through some wonderful investments and magic formulas for investing and all that good stuff, but for good measure, I want to go over the story of what Joel Greenblatt told his students was his worst investment ever.

[00:41:29] Shawn O’Malley: As so many terrible investments do, everything looks good on paper for what it’s worth, The company was growing, had impressive returns on capital, and he was wooed by management after an executive painted a rosy but seemingly realistic picture of the future. In a nutshell, it was a company that hosted trade shows in Las Vegas.

[00:41:46] Shawn O’Malley: At the turn of the 21st century, there were thousands of companies in the computing and internet industries willing to sign up to participate in trade shows and show off their offerings to prospective customers. And this company was essentially the organizer for those events. They’d pay for a few hundred thousand square feet of space on the Vegas Strip for around two dollars per square foot, and then turn around and rent out the space for the trade show at a cost of sixty dollars per square foot.

[00:42:10] Shawn O’Malley: But they didn’t own the real estate and they could easily rent more as these shows expanded. Thus, they had massive operating leverage, meaning that they didn’t have a ton of costs that scaled up. If they were able to rent out the space for trade shows at more than 60 per square foot, those incremental gains would almost entirely ripple down to their bottom line.

[00:42:30] Shawn O’Malley: And as more and more computer hardware and software companies arose to take advantage of the internet boom, the trade shows would probably only grow bigger and bigger each year, especially now that the former head of Ticketmaster was taking over the operation that had been managed previously by a Japanese company, which was not really paying attention to it enough as it should have.

[00:42:47] Shawn O’Malley: At least that was the idea for Greenblatt’s thesis here. It seemed like a no brainer, the company was an intermediary, seemingly best positioned to benefit from the secular rise on the internet. With the business being immensely profitable and having plenty of space in Las Vegas to expand into more and more bigger trade shows, there was a pretty strong case for the company being able to continue generating excellent returns for shareholders.

[00:43:11] Shawn O’Malley: Obviously, that’s not what happened, and as Greenblatt points out, operating leverage can work both ways, boosting profitability as the business expands, and cutting profits quickly if the size of the trade show’s contracts or the rates they can charge to rent the space narrow. Operating leverage, if you’re not familiar with the term, can come about in a few different ways, but it’s similar to the concept of economies of scale.

[00:43:34] Shawn O’Malley: A company with economies of scale advantages can spread out fixed costs and capture a higher percentage of profit with incremental sales, and they correspondingly have high operating leverage. Put differently, operating leverage refers to how much operating profits change due to changes in sales, And this company had a lot of it, which is normally seen as a good thing.

[00:43:54] Shawn O’Malley: After hype around the internet peaked, interest in trade shows fell off, and they got smaller and smaller until the company finally went bankrupt. As Greenblatt puts it, for every foot the trade shows shrank, 60 subtracted from the bottom line. Strong past returns, attractive unit economics, and a plausible outlook for growth were not enough to save the company.

[00:44:15] Shawn O’Malley: His position in the company fell from 12 per share to 1 per share before Greenblatt was able to get out, which just goes to show even great investors can fall for misleading stories about a company even when everything looks good on paper. As Greenblatt says, there were many times along the way where we could have gotten out with a profit.

[00:44:33] Shawn O’Malley: Yet we compounded our mistakes by waking up too late to wrap things up today. I’ll just say that it’s an incredible resource to have green butts lectures available on YouTube, and I’ll link to a playlist of them. So you can watch them for free. If you’re interested, Greenblatt has the rare combination of investing brilliance interests in sharing his learnings and an intuitive ability to distill complicated financial information into digestible insights.

[00:44:59] Shawn O’Malley: I would, of course, also recommend his books to learn more about the magic formula in addition to checking out our interview directly with Greenblatt on our We Study Billionaires and Richer Wiser Happier podcast, which I’ll also link to below. If you take anything away from this episode, I hope it’s to pick up the habit of frequently reading through the Value Investors Club forum.

[00:45:18] Shawn O’Malley: You’ll probably find some wonderful investment ideas and at worst, you’ll learn a lot about how to think through investment opportunities. As a final note, I’d like to, in the spirit of today’s theme, end the episode with one last quote from Joel Greenblatt. He tells us the following quote, choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot. Please don’t be an idiot running through a dynamite factory with a burning match. Know what you’re looking for. And if you don’t already know, I’ve shared some resources today that will more than point you in the right direction. With that, I hope you enjoyed today’s episode and I’ll see you again next week.

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