Teachings and Investment Strategy of Joel Greenblatt: A Comprehensive Guide

Joel Greenblatt, a prominent value investor, hedge fund manager, and author, is best known for his unique, simplified approach to investing that can benefit both seasoned professionals and beginners. Greenblatt’s teachings emphasize understanding intrinsic value, applying disciplined strategies, and maintaining a focus on long-term gains. His “Magic Formula” for investing, detailed in his book The Little Book That Still Beats the Market, has helped countless investors learn how to choose undervalued stocks with growth potential. In this post, we’ll break down Greenblatt’s investment philosophy, his strategies, and how his methods can be applied by individual investors.

1. Joel Greenblatt’s Background and Investment Philosophy

Greenblatt co-founded Gotham Capital, a hedge fund that has consistently delivered impressive returns by applying strict value investing principles. His approach is grounded in the teachings of Benjamin Graham and Warren Buffett, emphasizing value over price. Greenblatt advocates for identifying high-quality businesses that are trading below their intrinsic value, which he refers to as the company’s true worth. He believes that the stock market often misprices companies, presenting valuable opportunities for patient investors.

Greenblatt’s philosophy also stresses simplicity, as evidenced by his “Magic Formula,” which is an accessible strategy meant to demystify stock selection for investors. By focusing on only two key financial metrics (earnings yield and return on capital), Greenblatt enables investors to pinpoint strong companies that are undervalued.

2. The Magic Formula: A Simple Approach to Value Investing

The Magic Formula is Greenblatt’s signature investment strategy, outlined in The Little Book That Still Beats the Market. This formula aims to find “good companies at bargain prices” by ranking stocks based on two main criteria:

a. High Earnings Yield

• Earnings yield, calculated as EBIT (Earnings Before Interest and Taxes) divided by Enterprise Value, shows how much return a company is generating relative to its market price.
• This metric allows investors to determine if they’re getting good value compared to the company’s earnings, akin to a “cheap” valuation.

b. High Return on Capital

• Return on capital (ROC) is calculated as EBIT divided by Net Working Capital + Net Fixed Assets, giving insight into how efficiently a company uses its capital to generate earnings.
• A high ROC indicates a company that is good at reinvesting its profits into the business, meaning that it can grow and provide investors with a decent return on their investment.

These two factors combined form Greenblatt’s Magic Formula. By investing in companies with both a high earnings yield and high return on capital, Greenblatt’s approach seeks to balance value with quality.

Implementing the Magic Formula

• The formula is straightforward: create a list of stocks in the market, rank them by earnings yield and ROC, and select those that score highest on both counts.
• Greenblatt recommends buying 20-30 stocks from this list and holding them for a year, at which point you either sell or rebalance the portfolio.
• This strategy is refreshingly simple, but it’s been proven to outperform market averages over the long term, even though individual years may yield uneven results.

3. Greenblatt’s Key Investment Insights and Principles

In addition to the Magic Formula, Greenblatt shares other valuable principles in his teachings and writings:

a. Understand Intrinsic Value

• Greenblatt emphasizes that a company’s intrinsic value is distinct from its current stock price. He advises investors to evaluate a company’s worth based on its earnings potential and growth prospects rather than market fluctuations.
• This mindset aligns with the value investing approach, which seeks to buy assets at a discount to their true value, providing a margin of safety.

b. Discipline and Patience

• The effectiveness of Greenblatt’s approach lies in its systematic nature, requiring investors to stick to the process even when market conditions fluctuate.
• Greenblatt stresses the importance of patience, as his method relies on the market’s eventual “correction” of undervalued stocks. This often requires holding investments for a few years to realize gains fully.

c. Avoid Emotional Investing

• Greenblatt’s methodology deliberately simplifies stock-picking to help investors avoid emotional decisions. He argues that emotions are one of the biggest threats to investment success, often leading to premature selling or irrational buying.
• By following a pre-defined formula, investors can make objective decisions and avoid the herd mentality that often prevails in stock markets.

4. Lessons from Greenblatt’s Books: You Can Be a Stock Market Genius

In addition to The Little Book That Still Beats the Market, Greenblatt authored You Can Be a Stock Market Genius, a more advanced text that dives deeper into special investment situations. Here, he explores niche strategies like spin-offs, restructurings, and mergers that offer lucrative, albeit sometimes complex, opportunities for investors. Let’s look at a few concepts he emphasizes in this book:

a. Spin-Offs

• Greenblatt believes that spin-offs—when a company creates a new independent entity from a division or business unit—can lead to strong investment opportunities. Spin-offs often benefit from increased focus, improved management, and shareholder alignment.
• Investors can capitalize on spin-offs because the market may undervalue the new entity in its early days, leading to potential gains as it matures.

b. Merger Arbitrage

• In merger arbitrage, Greenblatt identifies profitable scenarios by investing in the stock of a company being acquired while selling short the acquirer’s stock, capitalizing on price discrepancies during the merger period.
• While more complex, this strategy can offer significant returns for those willing to dive deeper into company research and regulatory dynamics.

c. Distressed Investing

• Greenblatt highlights opportunities in distressed companies—those that are struggling or in financial trouble—but that have a viable pathway to recovery or turnaround.
• Distressed investing requires a deep understanding of the company’s financials and restructuring potential, but it can yield impressive returns if the company manages to stabilize.

5. Joel Greenblatt’s Approach to Portfolio Management

Greenblatt recommends diversification, not just across sectors but also in terms of risk. Here’s a breakdown of his approach to managing a portfolio effectively:

a. Invest in Multiple Stocks

• While the Magic Formula suggests holding 20-30 stocks, Greenblatt cautions against over-diversifying. Each stock should be a carefully selected investment rather than part of a broad-market mimicry.

b. Rebalance Periodically

• Greenblatt advises rebalancing the portfolio annually to adjust for the changes in valuation and returns of individual stocks. This also helps in capitalizing on newly available undervalued stocks.

c. Focus on Long-Term Returns

• Greenblatt’s strategies often deliver better results when held for an extended period. This long-term horizon helps counter short-term market volatility and provides an opportunity for undervalued stocks to reach their true potential.

6. Criticisms and Limitations of Greenblatt’s Strategy

While the Magic Formula has a strong track record, it’s not without its limitations:

a. Market Conditions

• Like any formulaic approach, the Magic Formula can be affected by extreme market conditions, such as during a financial crisis, where the performance of value stocks may suffer.

b. Focus on Large-Cap Stocks

• The Magic Formula often favors larger companies with stable earnings, potentially missing out on high-growth opportunities in smaller or emerging companies.

c. Requires Patience and Discipline

• Investors must be prepared to hold stocks for several years, which can be difficult for those seeking quick returns or those uncomfortable with short-term market swings.

7. Applying Joel Greenblatt’s Strategy Today

Greenblatt’s Magic Formula and special situation strategies remain relevant today, even with increased market volatility. The core principles—focusing on intrinsic value, disciplined investment, and a long-term perspective—serve as a robust foundation for any portfolio. With tools like screeners and online resources, investors can easily implement the Magic Formula approach to create a diversified, value-focused portfolio.

Conclusion

Joel Greenblatt’s teachings and investment strategies offer a refreshing mix of simplicity and rigor. His Magic Formula distills the essence of value investing into an accessible methodology, suitable for a wide range of investors. By focusing on high-quality businesses at attractive valuations and exercising patience, investors can harness Greenblatt’s approach to generate reliable, long-term returns. Whether you’re a seasoned investor or just starting, Greenblatt’s strategies provide an invaluable toolkit for navigating the complexities of the stock market with confidence.