Joel Greenblatt: Behind the Magic Formula w/ Shawn O’Malley (MI381)
Summary
Value Framework: The discussion centers on Joel Greenblatt’s value discipline and Magic Formula, emphasizing cheap, high-ROC stocks and why markets misprice them.
NVR (NVR): A homebuilder with a low-capital, options-based land strategy and pre-sold homes, high returns on capital, and aggressive buybacks highlighted as a mispriced quality compounder.
NII Holdings (NIHD): A post-bankruptcy wireless operator framed as a special situation with hidden earnings, forced selling, and a relisting catalyst from OTC to NASDAQ.
Sportsman’s Guide (SGDE): An internet/catalog retailer trading at under 5x FCF with 35% ROE, transitioning online, cutting catalog costs, and announcing share repurchases.
Post-Bankruptcy & Micro Caps: Emerging-from-bankruptcy equities and underfollowed micro caps are flagged as fertile hunting grounds due to stigma, liquidity gaps, and investor neglect.
Capital Allocation & Buybacks: Management quality and shareholder-friendly buybacks are stressed as key drivers of upside and a simple, reliable return mechanism.
Risks & Returns: Lessons include operating leverage risks and the importance of not exiting too early when conviction is high, plus understanding how markets pull forward expected returns.
Transcript
(00:00) 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 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 greenblat 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 there are (00:27) 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 bit up to a level where these positive factors are fully reflected in the [Music] price hello before we dive into the video be sure to click that subscribe button so you never miss an episode show us some love by giving a thumbs up and sharing your thoughts in the comments your support really means everything to us today I'll be digging through the (00:58) video lectures of legendary investor Jo greenblat from his time as a professor at Columbia greenblat 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 green blad's track record is largely unrivaled from 1985 to 205 he earned better returns than even Buffett did across much of his career compounding at 48. (01:24) 5% 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 produced while also having high Returns on Capital he would essentially rank Stocks by their cheapness and returns in 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. (01:48) 8% from 1988 to 2009 versus the 99.6% yearly return from the S&P 500 over that period in 1981 at just 24 years old greenblat 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 greenl 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 possibly do so for more than the current market value of the stock these situations are abnormal but (02:19) they've been observed to happen and greenblat 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 greenblat reviews three of the best pitches to the value investors club that he's ever seen all from the same investor 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 green blats (02:48) class which I'll link to in the show notes in June 2001 an investor with the username Charlie 479 submitted n VR 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 in short nr'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 (03:15) Charlie 479 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 Builders with the most debt typically fall into bankruptcy while the home builders that survive endure ential wrate Downs of their assets yet NVR is or at least was different rather than purchasing land outright for development like most Builders MVR would acquire the rights to use land through options contracts which (03:42) gave them the right to buy Lots but doesn't obligate them to do so they'd put up 5 to 7% 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 the lower Capital requirements of this method translate into lower inventory risk and greater Returns on Capital and (04:13) secondly what differentiated NVR according to Charlie 479 at the time was that the company pre-sold 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 with this Superior business model indr traded at a surprisingly low price earnings ratio of just eight 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 (04:41) only a small percentage of its shares actually trading on the stock exchange it was particularly vulnerable to Big swings from large shareholders uping 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 green reviewed with his class I actually looked up the stock out of curiosity to see how it's doing today and well it's (05:05) up 163% in the past 5 years and trades at a price 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 in the 23 years since it was first published nvr's stock price per share has compounded at an impressive 20% per year versus only 7% per year for the S&P 500 over that same period so with hindsight we can say pretty safely that Charlie 479 nailed it with NVR even with the great financial crisis lurking just a few years on the horizon (05:38) 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 greenblat 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 to begin the exercise greenblat likes to (06:06) condense down any given investment thesis into just two to three sentences which is what he asks his students to do with this one greenblat works through his thinking on the idea suggesting that he' 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 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 (06:32) 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 tracks of land that other firms may not be able to afford the students throw out a bunch of questions and concerns at him and take a stab at describing the thesis but I love tell green blat simply is able to distill everything down being able to reduce nuanced points into their most (07:00) understandable form without sacrificing any key information is really a superpower in my opinion and the mark of a truly great investor greenblat exemplifies this by outlining that the Crux of the thesis here is that this is a company that's priced cheaply at just eight times earnings yet they put little capital in the business comparatively since they use options agreements instead of buying land outright and they pre-sell their inventory beforehand which gives them a big cash flow Advantage as he puts it since NVR is (07:28) taking little Financial Risk there will probably be a temporary hit to their business and 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 on the stock at the time it was originally pitched meanwhile the upside was considerable assuming the company could leverage its advantages further and continue to compound Capital at the rates it had (07:53) already proven it could in previous years these are exactly the sorts of companies that made greenl Rich over the course of his career highquality companies that for at times inexplicable reasons traded at Ultra cheap prices 2001 was a long time ago but it wasn't that long ago 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 in upside relative to the downside is (08:23) that NVR had gone into bankruptcy in 1991 under a different and more conventional homebuilder business model back then green proposes that the market essentially hadn't learned to trust in VR 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 and capitalizing on it would have required an appreciation for how (08:49) the business had changed I really love a point that greenblat 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 is greenl 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 nine out of 10 years and in the 10th (09:17) year it earns a profit of zero 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 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 greenblat turns to a company called nii Holdings which was also pitched on the value investors club by Charlie 479 this time in (09:47) November 2002 which was honestly a good time to buy a lot of stocks given how beaten down the market was after the dotcom bubble 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 this is a company that was (10:16) formed in 1996 to hold all of Nexel Communications International Wireless assets and over six years Nexel invested over $500 million in nii while Bond holders lent an additional $2 billion 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 8 months later it emerged from bankruptcy restructuring with a new plan to payback creditors that was less burdensome after converting $2.4 billion of outstanding (10:49) bonds into Equity Charlie 479 argues a few key points in nii's favor namely because nii had recently come out of bankruptcy the stock was largely for Goten 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 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 (11:22) stock traded on a major Stock Exchange again it was expected to trade at a more normalized valuation similar to its parent company this normalization of Ni stock price alone plausibly offered upside of two to three times the current stock price according to Charlie 479 and talking about the pitch for nii greenblat 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 people who used to track the company might have stopped doing so (11:51) During the period it was restructuring and others will find the odds of the company slipping back into bankruptcy court to off-putting as he explains too because some 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 he sort of continues to go over why the situation was so right for the stock to be potentially misvalued and he (12:17) deconstructs how an investor like Charlie 479 might have found this perspective opportunity personally they realized that because the company had recently come out of bankruptcy but didn't guarantee the stock was misvalued but that increased the odd of markets being wrong about it from there Charlie 479 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 Charlie 479 was able to piece (12:45) together that the company was trading at an incredibly cheap valuation relative to various measures of its profitability after reconstructing nii's financials that was not laid out Simply for anyone else to see and thus made it even more likely that the stock wasn't being accurate priced as greenblat 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 between the messy financials that concealed the company's operating profits selling (13:14) 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 which represented a buying opportunity to anyone willing to come in and hold the stock for a year or two what I love about green bl's teaching here is the focus on what could have been known at the time hindsight is 2020 (13:41) 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 to some extent we have to sort through luck and skill and that's what greenbot 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 (14:06) which factors are being overlooked by markets why that's so and determine how to act accordingly and at the time greenblat 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 wish he had bought more and paid even closer (14:34) attention since it worked out so well in hindsight in the ensuing two years nii went from $10 per share to $240 per share that's just a massive 24 times increase but greenblat apparently knows the investor behind the Charlie 479 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 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 (15:06) you're right about something let yourself be right big I'm sure Charlie 479 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 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 Charlie 479 for cashing in with (15:35) both nii and NVR green blat 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 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 bit 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 beting advantage that an investor could earn by (16:02) simply buying a company with an attractive business model that has a stock valuation that more than reflects that quality 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 under appreciation 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 (16:30) and Discerning investors these case studies are just so fun to me because as I've said these are investments that greenblat 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 and small to micr crap 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 (16:56) have to invest in bigger and bigger market cap companies to move the needle for them 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 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 the point being great (17:23) investors cut their teeth with bets like nii and NVR and graduate to larger market capital ization stocks as they begin to manage more money which then leaves these companies underf followed and creates an opportunity for the next generation of investors to get rich on special situations and undervalued micro caps so with that I want to go over another of these investment case studies from Green blad as pitched by Charly 479 on the value investors Club forum just to see what we can learn the third case study is on a (17:54) company called Sportsman's Guide ticker sgde which no longer trades public public L after being acquired by a private Equity Firm 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 Charlie 479 was premise on the fact that the company was earning a very impressive 35% return on Equity while having very little debt despite those impressive results sgde traded at (18:27) less than five 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 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 (18:55) remain flat then it would take 20 years to earn back that inv 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 and retained earnings 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 five times fre cash flows the company was offering what I'd say was an unusually large amount of upside with relatively (19:25) less risk as the 2003 pitch on the value inv 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 the catalog was earning around $180 million of Revenue per year and a partnership with buyer 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. (19:52) 2 million customers where they knew their customers well because 85% of sales came from recurring Shoppers on to top of that it's competitive Advantage lied in offering 25 to 60% 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 1,200 suppliers all that sounds pretty good and the most exciting part was that the company could save millions of dollars a year from Printing and shipping its (20:21) cataloges by migrating its offerings to being solely shown online this was obviously the early days of online retailing but in five years Sportsman Guides Online sales went from just $1 million per year to $53 million thanks to the internet a major source of sgd's operating costs were being phased out and the Catalyst for these stocks price as it often is was a recently announced share repurchase program where the company planned to buy back 10% of its outstanding stock presumably because management also recognized that the (20:52) stocks market price didn't reflect its value 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 the time for free on the Vic Forum it just still sounds too good to be true however as greenblat frames it the thesis is pretty straightforward and it doesn't take a genius to see the opportunity here (21:23) sometimes it's really as simple as just saying that coming out of the do bubble this is a time when there were a ton of cheap stocks to buy which means some will slip through the cracks longer than others given it was such a small business with two 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 in a level that seems like a no-brainer in hindsight from the time it (21:50) was pitched SGD stock Rose about four times over the next few years which is a pretty nice return on investment that I'd be more than satisfied with Buy Low sell High Buy Low sell high it's a simple concept but not necessarily an easy concept right now High interest rates have crushed the real estate market prices are falling and properties are available at a discount which means fundrise believes now is the time to expand the fundrise flagship funds billion doll real estate portfolio you can add the fundrise flagship fund to (22:24) your portfolio in minutes by visiting fundrise.com millennial that's f n d r i.com Millennial carefully consider the investment objectives risks charges and expenses of the fundrise flagship fund before investing this and other information can be found in the funds perspectus at fundrise.com Flagship this is a paid advertisement in reflecting on the three case studies we've gone over so far greenblat tells the students that what matters is UN seeeing what management is going to do with the earnings they've generated from a shareholder perspective (23:02) companies can earn as much income as they want but if management Wast it away then it was all for nothing at least from a shareholders 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 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 (23:30) 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 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 (23:55) stocks here's a little snippet from Green blad selection to make the point do some basic valuation 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 and if I'm not right it's going to be hard for me to lose money so that that's under those are all underlying them themes to this and I um the whole construct of you know what's been taught generally in Business Schools over the last four years about (24:30) efficient markets and beta I know you 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 and speaking of the same guy um you know second part of the class where you get to win your uh Warren Buffett cartoon book um 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 (25:02) that he's looking for that that can make you money 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 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 and I've been doing this for you know unfortunately a long time well fortunately whatever greenblat continues his lecture by Leading students through an exercise (25:35) where he role plays as Warren Buffett as they throw questions at him related to the case studies on NVR nii and sgde he discusses the importance of management and how Management's actions will speak for themselves with the home builder NVR that we went over greenblood says it was clear that management was thinking with the shareholders best interest in mind because they were shareholders too with large stakes in the company especially after they overseen the company's Buybacks in the past 5 years that repurchased more than half of nvr's (26:03) 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 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 (26:32) a grain of salt compared to what the numbers are telling you if a CEO says their company is the best in the business but you can tell from looking at the numbers that they've wagged their competitors and generating returns and 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 then you can really just use (26:54) the numbers again to call their Bluff every situation is different but again greenblat loves to find no-brainer Investments where you don't have to debate the merits of investment ad nauseum because it's sitting in some great 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 he continues into a really (27:20) interesting conversation on how to think about earning back returns which we've discussed a bit already a lot of times people look for specific catalysts who 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 and the market catching up to your outlook for example if you expected Walmart's earnings to grow at 15% per year for the next 5 years you might expected stock to follow the same trajectory and also grow at 15% per year (27:50) 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 fiveyear period though to double your investment because markets are forward-looking those higher earnings would eventually get priced in and 30 to 50% of the 100% returns to be earned over 5 years might come in the first 12 months 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 (28:19) message here which I think really bear is repeating is not only that markets can correct sharply to price in new information but that when they do correct that pulls forward return returns from the future which means anyone buying in after that upward correction would be implicitly accepting a lower rate of expected return if a stock you expect to go from $10 today to $20 after 5 years sees a 35% return in the first year as the market catches up to a higher earnings growth Outlook expected returns fall from 15% per year (28:50) initially to 10% 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 % gain after 12 months and look elsewhere since 10% expected returns per year going forward doesn't really offer enough upside this is how Legend investors like greenblat 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 (29:19) and how Market fluctuations change those expected returns 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 green blad'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 desiles according to their cheapness and that directly corresponds to the ranking for their returns over a (29:48) certain following period so the top desile of cheapest stocks sorted by their price earnings ratio end up with the best Returns the second desile 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 greenblat explains to his students that before he even started as a professional investor in the 1970s he saw studies on cheap stocks out performing and even so buying them continued to work for him (30:17) throughout his career although it would seem that as a teacher and author greenblat 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 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 (30:43) firstly cheapness is relative and there will always be a desis of the cheapest stocks to invest in secondly cheap stocks exist because there are real reasons to dislike them if you filter down the US Stock Market down to the companies with the lowest PE 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 (31:11) quarters 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 green BL has shown you can do well from Simply buying the cheapest death STS 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 cheap stocks come from people owning them when they were well not (31:37) 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 greenblat to check them out further to make this point even more in a talk before the CFA Society of Chicago in 2019 greenblat explains how he taught the shortcomings of the stock market to a group of teenagers in Harlem he filled up a jar with jelly beans and asked the students on their own to calculate how many they thought were in the jar and then submit (32:04) 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 changed their answer based on what others had said when these students thought critically on their own their average answer was 1,771 jelly beans which was actually just five away from the correct answer yet when these students gave answers allowed and were biased by what others had said the average answer fell to 870 (32:32) jelly beans as greenblat 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 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 jelly beans in the jar what I love love about greenblat is that while he acknowledges the nuances and difficulty of investing (33:03) he's also open about the fact that it doesn't have to be rocket science simple principles like buying the cheapest Des out of 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 home builder 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 when everyone is telling you that Intel is imploding and Irrelevant in the age of AI can you really disregard that (33:31) 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% and the opportunity is mostly gone it 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 after we followed green through three separate (33:59) case studies originally pitched by this Charlie 479 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 after becoming something of a legend on the value investors Club forum for his post the pseudonymous Charlie 479 last post was an early 2009 so unfortunately he's not still posting winning ideas (34:31) that we can study or clone but we do know that he was and probably still is closed Trends with Joel greenblat and reportedly earned returns of 38% per year from 1994 through 2003 as a money manager 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 Charlie 479 and his firm punch card capital in the show notes I'll link to (35:03) his only public interview ever from 2011 for you to check out the name punch card capital is inspired by Warren Buffett's punch card analogy quoting Buffett 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 life lifetime they're going to get five or three or seven and you can get rich (35:32) off five or three or seven 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 Burkshire hathway but also Ali Financial Winnebago Industries and Smith and Wesson because Charlie 479 has already contributed so much to this episode and obviously thinks about investing similar to greenblat I want to share a passage from another of his posts addressing the tension between buying cheap stocks and (36:01) buying highquality Compounders which is something I've covered at length in last week's episode and in the week before he's referencing his 2001 pitch on Windmill and Company ticker wmla 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 the these types of opportunities are known as cigar butt stocks because (36:31) 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 greenl made a living on especially in their early days Charlie 479 writes quote it is always amazing to me how many people will turn down the chance to buy $1 of cash for 40 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 (36:59) until they think they have the scoop that the company is about to be sold 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'm 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 as long as I know that I have more than $2 of net cash behind each $1 I put up that there are certain Clues as to a potential (37:27) payoff off it's not a terrible proposition Charlie continues by saying wmla is a cigar butt cigar butts are inferior to Great operating companies with defensible Market positions generating 25% Returns on invested capital and selling at 8xp like NVR however there are extremely few of these high quality companies that are trading for such low values Koch is a great company but fully priced they ow for Moody's American Express Etc the companies that don't have high multiples are usually average businesses that will (38:00) produce average long-term rates of return on Capital look at the value investors Club board it is littered with low PE stocks with either unexciting Returns on Equity or very high leverage I'd say that the W nmla cigar but types of stocks have better risk reward than both of these two types of low PE 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 rate shows Charlie's comments here shed light on how he (38:31) thought about the balance between cheap cigar but stocks like w nmla 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 ndr and WN MLA which you can see if you're watching this podcast on YouTube to summarize it briefly it is up and to the right for NVR outpacing the S&P 500 well the cigar butut St W nmla offered periods of upside but otherwise mostly preserved value with flat Returns the (39:04) stock prices correspond to intrinsic value over time and over time NVR has compounded intrinsic value while W nmla has not but that doesn't mean that at 45 cents on the dollar which is effectively what an investor in wmla in 2001 would have gotten was a bad investment basically Charlie 479 says he likes great businesses at low prices but those are hard to find so in the meantime if can invest in a money market fund cigar butt stock with a possible 100% upside he's more than happy to do it while many of the investors on the value investors (39:36) Club are quite Savvy and Charlie 479 is probably one of the best to 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 these aren't always bad ideas but the majority of them will lead to just average results the real outstanding Returns come from identifying the relatively you truly undervalued situations whether from an average business selling for half of net cash like wmla or an exceptional business (40:06) selling at a single digigit earnings multile like ndr so we 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 greenl told his students was his worst investment ever as so many terrible Investments do everything looked good on paper for what it's worth the company was growing had impressive returns in capital and he was wooed by management after an executive painted a Rosy but (40:33) seemingly realistic picture of the future in a nutshell it was a company that hosted trade shows in Las Vegas 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, square fet of space on the Vegas Strip for around $2 per square foot and then turn around and rent out the space for (41:00) the trade show at a cost of $60 per square foot 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 and as more and more computer hardware and software companies arose to take advantage of the internet boom the trade shows would (41:27) would probably only grow bigger and bigger each year especially now that the former head of Ticket Master 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 at least that was the idea for greenbots thesis here it seemed like a no-brainer the company was an intermediary seemingly best position to benefit from the secular rise in the internet with the business being immensely profitable and having plenty of space in Las Vegas to expand (41:55) 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 obviously that's not what happened and as greenblat points out operating leverage can work both ways boosting profitability as the business expands and cutting profits quickly if the size of the trade shows 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 (42:22) it's similar to the concept of economies of scale 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 back to the story here after hype around the internet peaked interest and trade shows fell off and they got smaller and (42:51) smaller until the company finally went bankrupt as greenblat puts it for every foot the trade show 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 his position in the company fell from $12 per share to $1 per share before greenbot 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 greenlite says there were (43:22) many times along the way where we could have gotten out with a profit 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 blats lectures available on YouTube and I'll link to a playlist of them so you can watch them for free if you're interested greenblat has the rare combination of investing brilliant interest in sharing his learnings and an intuitive ability to distill complicated financial information into digestible insights I would of course also (43:52) recommend his books to learn more about the magic formula in addition to checking out our interview directly with green black 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 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 (44:19) today's theme in the episode with one last quote from Joel greenblat 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 (44:47) today's episode and I'll see you again next week hey guys this is your Millennial investing host Shan Ali when I first started learning as a value investor I I had no idea what direction to go in there's just so much to try and wrap your head around but it's never too late to get smarter about Stock Investing from the ground up after spending years interviewing and studying the best stock investors as a company at the investors podcast Network I've worked to distill those learnings into a simple course for you why did I do that so I can help you (45:19) master the principles of excellent lifelong investing I was a fan of the investors podcast for years before I joined the team and I always wanted to course that broke down the most important insights from a decade of interviews with leading investors the course is great for both beginners and pros from studying what the Legends actually do to small practical ways to build your wealth over time I'll take you through 10 different sections covering the basics of what a stock actually is and how stock markets work (45:47) to strategies to optimize your retirement savings picking great companies what to look for in ETFs how much you should invest and how to monitor your Investments plus so much more by the time you're done you'll be ready to invest in the stock market learning plenty of tricks from the pros along the way to access the course and begin learning how to invest like the Legends just visit the investors podcast. (46:11) com SLG getstarted with stocks that's the investors podcast.com SLG getstarted with stocks and for a limited time you can use code mi15 for a 15% discount at checkout that's mi15 when checking out a good long-term investor is one who even if they own just a single share in a company tends to think like they own the entire company or like Venture capitalists actively investing in a private business diversification is only a substitute for intimate knowledge about a company and a quote damn poor one according to Whitman he ads quote (46:47) for us markets are taken as given something investors take advantage of because they understand a business in Whitman's view diversification is far less necessary despite the teaching of mainstream Business Schools when someone is truly an expert on a company and has learned to think as if they own the entire business
Joel Greenblatt: Behind the Magic Formula w/ Shawn O’Malley (MI381)
Summary
Transcript
(00:00) 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 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 greenblat 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 there are (00:27) 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 bit up to a level where these positive factors are fully reflected in the [Music] price hello before we dive into the video be sure to click that subscribe button so you never miss an episode show us some love by giving a thumbs up and sharing your thoughts in the comments your support really means everything to us today I'll be digging through the (00:58) video lectures of legendary investor Jo greenblat from his time as a professor at Columbia greenblat 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 green blad's track record is largely unrivaled from 1985 to 205 he earned better returns than even Buffett did across much of his career compounding at 48. (01:24) 5% 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 produced while also having high Returns on Capital he would essentially rank Stocks by their cheapness and returns in 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. (01:48) 8% from 1988 to 2009 versus the 99.6% yearly return from the S&P 500 over that period in 1981 at just 24 years old greenblat 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 greenl 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 possibly do so for more than the current market value of the stock these situations are abnormal but (02:19) they've been observed to happen and greenblat 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 greenblat reviews three of the best pitches to the value investors club that he's ever seen all from the same investor 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 green blats (02:48) class which I'll link to in the show notes in June 2001 an investor with the username Charlie 479 submitted n VR 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 in short nr'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 (03:15) Charlie 479 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 Builders with the most debt typically fall into bankruptcy while the home builders that survive endure ential wrate Downs of their assets yet NVR is or at least was different rather than purchasing land outright for development like most Builders MVR would acquire the rights to use land through options contracts which (03:42) gave them the right to buy Lots but doesn't obligate them to do so they'd put up 5 to 7% 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 the lower Capital requirements of this method translate into lower inventory risk and greater Returns on Capital and (04:13) secondly what differentiated NVR according to Charlie 479 at the time was that the company pre-sold 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 with this Superior business model indr traded at a surprisingly low price earnings ratio of just eight 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 (04:41) only a small percentage of its shares actually trading on the stock exchange it was particularly vulnerable to Big swings from large shareholders uping 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 green reviewed with his class I actually looked up the stock out of curiosity to see how it's doing today and well it's (05:05) up 163% in the past 5 years and trades at a price 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 in the 23 years since it was first published nvr's stock price per share has compounded at an impressive 20% per year versus only 7% per year for the S&P 500 over that same period so with hindsight we can say pretty safely that Charlie 479 nailed it with NVR even with the great financial crisis lurking just a few years on the horizon (05:38) 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 greenblat 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 to begin the exercise greenblat likes to (06:06) condense down any given investment thesis into just two to three sentences which is what he asks his students to do with this one greenblat works through his thinking on the idea suggesting that he' 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 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 (06:32) 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 tracks of land that other firms may not be able to afford the students throw out a bunch of questions and concerns at him and take a stab at describing the thesis but I love tell green blat simply is able to distill everything down being able to reduce nuanced points into their most (07:00) understandable form without sacrificing any key information is really a superpower in my opinion and the mark of a truly great investor greenblat exemplifies this by outlining that the Crux of the thesis here is that this is a company that's priced cheaply at just eight times earnings yet they put little capital in the business comparatively since they use options agreements instead of buying land outright and they pre-sell their inventory beforehand which gives them a big cash flow Advantage as he puts it since NVR is (07:28) taking little Financial Risk there will probably be a temporary hit to their business and 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 on the stock at the time it was originally pitched meanwhile the upside was considerable assuming the company could leverage its advantages further and continue to compound Capital at the rates it had (07:53) already proven it could in previous years these are exactly the sorts of companies that made greenl Rich over the course of his career highquality companies that for at times inexplicable reasons traded at Ultra cheap prices 2001 was a long time ago but it wasn't that long ago 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 in upside relative to the downside is (08:23) that NVR had gone into bankruptcy in 1991 under a different and more conventional homebuilder business model back then green proposes that the market essentially hadn't learned to trust in VR 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 and capitalizing on it would have required an appreciation for how (08:49) the business had changed I really love a point that greenblat 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 is greenl 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 nine out of 10 years and in the 10th (09:17) year it earns a profit of zero 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 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 greenblat turns to a company called nii Holdings which was also pitched on the value investors club by Charlie 479 this time in (09:47) November 2002 which was honestly a good time to buy a lot of stocks given how beaten down the market was after the dotcom bubble 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 this is a company that was (10:16) formed in 1996 to hold all of Nexel Communications International Wireless assets and over six years Nexel invested over $500 million in nii while Bond holders lent an additional $2 billion 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 8 months later it emerged from bankruptcy restructuring with a new plan to payback creditors that was less burdensome after converting $2.4 billion of outstanding (10:49) bonds into Equity Charlie 479 argues a few key points in nii's favor namely because nii had recently come out of bankruptcy the stock was largely for Goten 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 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 (11:22) stock traded on a major Stock Exchange again it was expected to trade at a more normalized valuation similar to its parent company this normalization of Ni stock price alone plausibly offered upside of two to three times the current stock price according to Charlie 479 and talking about the pitch for nii greenblat 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 people who used to track the company might have stopped doing so (11:51) During the period it was restructuring and others will find the odds of the company slipping back into bankruptcy court to off-putting as he explains too because some 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 he sort of continues to go over why the situation was so right for the stock to be potentially misvalued and he (12:17) deconstructs how an investor like Charlie 479 might have found this perspective opportunity personally they realized that because the company had recently come out of bankruptcy but didn't guarantee the stock was misvalued but that increased the odd of markets being wrong about it from there Charlie 479 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 Charlie 479 was able to piece (12:45) together that the company was trading at an incredibly cheap valuation relative to various measures of its profitability after reconstructing nii's financials that was not laid out Simply for anyone else to see and thus made it even more likely that the stock wasn't being accurate priced as greenblat 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 between the messy financials that concealed the company's operating profits selling (13:14) 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 which represented a buying opportunity to anyone willing to come in and hold the stock for a year or two what I love about green bl's teaching here is the focus on what could have been known at the time hindsight is 2020 (13:41) 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 to some extent we have to sort through luck and skill and that's what greenbot 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 (14:06) which factors are being overlooked by markets why that's so and determine how to act accordingly and at the time greenblat 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 wish he had bought more and paid even closer (14:34) attention since it worked out so well in hindsight in the ensuing two years nii went from $10 per share to $240 per share that's just a massive 24 times increase but greenblat apparently knows the investor behind the Charlie 479 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 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 (15:06) you're right about something let yourself be right big I'm sure Charlie 479 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 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 Charlie 479 for cashing in with (15:35) both nii and NVR green blat 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 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 bit 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 beting advantage that an investor could earn by (16:02) simply buying a company with an attractive business model that has a stock valuation that more than reflects that quality 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 under appreciation 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 (16:30) and Discerning investors these case studies are just so fun to me because as I've said these are investments that greenblat 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 and small to micr crap 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 (16:56) have to invest in bigger and bigger market cap companies to move the needle for them 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 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 the point being great (17:23) investors cut their teeth with bets like nii and NVR and graduate to larger market capital ization stocks as they begin to manage more money which then leaves these companies underf followed and creates an opportunity for the next generation of investors to get rich on special situations and undervalued micro caps so with that I want to go over another of these investment case studies from Green blad as pitched by Charly 479 on the value investors Club forum just to see what we can learn the third case study is on a (17:54) company called Sportsman's Guide ticker sgde which no longer trades public public L after being acquired by a private Equity Firm 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 Charlie 479 was premise on the fact that the company was earning a very impressive 35% return on Equity while having very little debt despite those impressive results sgde traded at (18:27) less than five 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 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 (18:55) remain flat then it would take 20 years to earn back that inv 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 and retained earnings 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 five times fre cash flows the company was offering what I'd say was an unusually large amount of upside with relatively (19:25) less risk as the 2003 pitch on the value inv 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 the catalog was earning around $180 million of Revenue per year and a partnership with buyer 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. (19:52) 2 million customers where they knew their customers well because 85% of sales came from recurring Shoppers on to top of that it's competitive Advantage lied in offering 25 to 60% 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 1,200 suppliers all that sounds pretty good and the most exciting part was that the company could save millions of dollars a year from Printing and shipping its (20:21) cataloges by migrating its offerings to being solely shown online this was obviously the early days of online retailing but in five years Sportsman Guides Online sales went from just $1 million per year to $53 million thanks to the internet a major source of sgd's operating costs were being phased out and the Catalyst for these stocks price as it often is was a recently announced share repurchase program where the company planned to buy back 10% of its outstanding stock presumably because management also recognized that the (20:52) stocks market price didn't reflect its value 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 the time for free on the Vic Forum it just still sounds too good to be true however as greenblat frames it the thesis is pretty straightforward and it doesn't take a genius to see the opportunity here (21:23) sometimes it's really as simple as just saying that coming out of the do bubble this is a time when there were a ton of cheap stocks to buy which means some will slip through the cracks longer than others given it was such a small business with two 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 in a level that seems like a no-brainer in hindsight from the time it (21:50) was pitched SGD stock Rose about four times over the next few years which is a pretty nice return on investment that I'd be more than satisfied with Buy Low sell High Buy Low sell high it's a simple concept but not necessarily an easy concept right now High interest rates have crushed the real estate market prices are falling and properties are available at a discount which means fundrise believes now is the time to expand the fundrise flagship funds billion doll real estate portfolio you can add the fundrise flagship fund to (22:24) your portfolio in minutes by visiting fundrise.com millennial that's f n d r i.com Millennial carefully consider the investment objectives risks charges and expenses of the fundrise flagship fund before investing this and other information can be found in the funds perspectus at fundrise.com Flagship this is a paid advertisement in reflecting on the three case studies we've gone over so far greenblat tells the students that what matters is UN seeeing what management is going to do with the earnings they've generated from a shareholder perspective (23:02) companies can earn as much income as they want but if management Wast it away then it was all for nothing at least from a shareholders 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 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 (23:30) 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 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 (23:55) stocks here's a little snippet from Green blad selection to make the point do some basic valuation 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 and if I'm not right it's going to be hard for me to lose money so that that's under those are all underlying them themes to this and I um the whole construct of you know what's been taught generally in Business Schools over the last four years about (24:30) efficient markets and beta I know you 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 and speaking of the same guy um you know second part of the class where you get to win your uh Warren Buffett cartoon book um 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 (25:02) that he's looking for that that can make you money 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 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 and I've been doing this for you know unfortunately a long time well fortunately whatever greenblat continues his lecture by Leading students through an exercise (25:35) where he role plays as Warren Buffett as they throw questions at him related to the case studies on NVR nii and sgde he discusses the importance of management and how Management's actions will speak for themselves with the home builder NVR that we went over greenblood says it was clear that management was thinking with the shareholders best interest in mind because they were shareholders too with large stakes in the company especially after they overseen the company's Buybacks in the past 5 years that repurchased more than half of nvr's (26:03) 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 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 (26:32) a grain of salt compared to what the numbers are telling you if a CEO says their company is the best in the business but you can tell from looking at the numbers that they've wagged their competitors and generating returns and 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 then you can really just use (26:54) the numbers again to call their Bluff every situation is different but again greenblat loves to find no-brainer Investments where you don't have to debate the merits of investment ad nauseum because it's sitting in some great 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 he continues into a really (27:20) interesting conversation on how to think about earning back returns which we've discussed a bit already a lot of times people look for specific catalysts who 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 and the market catching up to your outlook for example if you expected Walmart's earnings to grow at 15% per year for the next 5 years you might expected stock to follow the same trajectory and also grow at 15% per year (27:50) 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 fiveyear period though to double your investment because markets are forward-looking those higher earnings would eventually get priced in and 30 to 50% of the 100% returns to be earned over 5 years might come in the first 12 months 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 (28:19) message here which I think really bear is repeating is not only that markets can correct sharply to price in new information but that when they do correct that pulls forward return returns from the future which means anyone buying in after that upward correction would be implicitly accepting a lower rate of expected return if a stock you expect to go from $10 today to $20 after 5 years sees a 35% return in the first year as the market catches up to a higher earnings growth Outlook expected returns fall from 15% per year (28:50) initially to 10% 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 % gain after 12 months and look elsewhere since 10% expected returns per year going forward doesn't really offer enough upside this is how Legend investors like greenblat 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 (29:19) and how Market fluctuations change those expected returns 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 green blad'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 desiles according to their cheapness and that directly corresponds to the ranking for their returns over a (29:48) certain following period so the top desile of cheapest stocks sorted by their price earnings ratio end up with the best Returns the second desile 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 greenblat explains to his students that before he even started as a professional investor in the 1970s he saw studies on cheap stocks out performing and even so buying them continued to work for him (30:17) throughout his career although it would seem that as a teacher and author greenblat 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 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 (30:43) firstly cheapness is relative and there will always be a desis of the cheapest stocks to invest in secondly cheap stocks exist because there are real reasons to dislike them if you filter down the US Stock Market down to the companies with the lowest PE 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 (31:11) quarters 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 green BL has shown you can do well from Simply buying the cheapest death STS 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 cheap stocks come from people owning them when they were well not (31:37) 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 greenblat to check them out further to make this point even more in a talk before the CFA Society of Chicago in 2019 greenblat explains how he taught the shortcomings of the stock market to a group of teenagers in Harlem he filled up a jar with jelly beans and asked the students on their own to calculate how many they thought were in the jar and then submit (32:04) 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 changed their answer based on what others had said when these students thought critically on their own their average answer was 1,771 jelly beans which was actually just five away from the correct answer yet when these students gave answers allowed and were biased by what others had said the average answer fell to 870 (32:32) jelly beans as greenblat 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 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 jelly beans in the jar what I love love about greenblat is that while he acknowledges the nuances and difficulty of investing (33:03) he's also open about the fact that it doesn't have to be rocket science simple principles like buying the cheapest Des out of 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 home builder 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 when everyone is telling you that Intel is imploding and Irrelevant in the age of AI can you really disregard that (33:31) 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% and the opportunity is mostly gone it 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 after we followed green through three separate (33:59) case studies originally pitched by this Charlie 479 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 after becoming something of a legend on the value investors Club forum for his post the pseudonymous Charlie 479 last post was an early 2009 so unfortunately he's not still posting winning ideas (34:31) that we can study or clone but we do know that he was and probably still is closed Trends with Joel greenblat and reportedly earned returns of 38% per year from 1994 through 2003 as a money manager 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 Charlie 479 and his firm punch card capital in the show notes I'll link to (35:03) his only public interview ever from 2011 for you to check out the name punch card capital is inspired by Warren Buffett's punch card analogy quoting Buffett 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 life lifetime they're going to get five or three or seven and you can get rich (35:32) off five or three or seven 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 Burkshire hathway but also Ali Financial Winnebago Industries and Smith and Wesson because Charlie 479 has already contributed so much to this episode and obviously thinks about investing similar to greenblat I want to share a passage from another of his posts addressing the tension between buying cheap stocks and (36:01) buying highquality Compounders which is something I've covered at length in last week's episode and in the week before he's referencing his 2001 pitch on Windmill and Company ticker wmla 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 the these types of opportunities are known as cigar butt stocks because (36:31) 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 greenl made a living on especially in their early days Charlie 479 writes quote it is always amazing to me how many people will turn down the chance to buy $1 of cash for 40 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 (36:59) until they think they have the scoop that the company is about to be sold 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'm 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 as long as I know that I have more than $2 of net cash behind each $1 I put up that there are certain Clues as to a potential (37:27) payoff off it's not a terrible proposition Charlie continues by saying wmla is a cigar butt cigar butts are inferior to Great operating companies with defensible Market positions generating 25% Returns on invested capital and selling at 8xp like NVR however there are extremely few of these high quality companies that are trading for such low values Koch is a great company but fully priced they ow for Moody's American Express Etc the companies that don't have high multiples are usually average businesses that will (38:00) produce average long-term rates of return on Capital look at the value investors Club board it is littered with low PE stocks with either unexciting Returns on Equity or very high leverage I'd say that the W nmla cigar but types of stocks have better risk reward than both of these two types of low PE 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 rate shows Charlie's comments here shed light on how he (38:31) thought about the balance between cheap cigar but stocks like w nmla 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 ndr and WN MLA which you can see if you're watching this podcast on YouTube to summarize it briefly it is up and to the right for NVR outpacing the S&P 500 well the cigar butut St W nmla offered periods of upside but otherwise mostly preserved value with flat Returns the (39:04) stock prices correspond to intrinsic value over time and over time NVR has compounded intrinsic value while W nmla has not but that doesn't mean that at 45 cents on the dollar which is effectively what an investor in wmla in 2001 would have gotten was a bad investment basically Charlie 479 says he likes great businesses at low prices but those are hard to find so in the meantime if can invest in a money market fund cigar butt stock with a possible 100% upside he's more than happy to do it while many of the investors on the value investors (39:36) Club are quite Savvy and Charlie 479 is probably one of the best to 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 these aren't always bad ideas but the majority of them will lead to just average results the real outstanding Returns come from identifying the relatively you truly undervalued situations whether from an average business selling for half of net cash like wmla or an exceptional business (40:06) selling at a single digigit earnings multile like ndr so we 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 greenl told his students was his worst investment ever as so many terrible Investments do everything looked good on paper for what it's worth the company was growing had impressive returns in capital and he was wooed by management after an executive painted a Rosy but (40:33) seemingly realistic picture of the future in a nutshell it was a company that hosted trade shows in Las Vegas 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, square fet of space on the Vegas Strip for around $2 per square foot and then turn around and rent out the space for (41:00) the trade show at a cost of $60 per square foot 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 and as more and more computer hardware and software companies arose to take advantage of the internet boom the trade shows would (41:27) would probably only grow bigger and bigger each year especially now that the former head of Ticket Master 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 at least that was the idea for greenbots thesis here it seemed like a no-brainer the company was an intermediary seemingly best position to benefit from the secular rise in the internet with the business being immensely profitable and having plenty of space in Las Vegas to expand (41:55) 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 obviously that's not what happened and as greenblat points out operating leverage can work both ways boosting profitability as the business expands and cutting profits quickly if the size of the trade shows 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 (42:22) it's similar to the concept of economies of scale 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 back to the story here after hype around the internet peaked interest and trade shows fell off and they got smaller and (42:51) smaller until the company finally went bankrupt as greenblat puts it for every foot the trade show 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 his position in the company fell from $12 per share to $1 per share before greenbot 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 greenlite says there were (43:22) many times along the way where we could have gotten out with a profit 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 blats lectures available on YouTube and I'll link to a playlist of them so you can watch them for free if you're interested greenblat has the rare combination of investing brilliant interest in sharing his learnings and an intuitive ability to distill complicated financial information into digestible insights I would of course also (43:52) recommend his books to learn more about the magic formula in addition to checking out our interview directly with green black 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 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 (44:19) today's theme in the episode with one last quote from Joel greenblat 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 (44:47) today's episode and I'll see you again next week hey guys this is your Millennial investing host Shan Ali when I first started learning as a value investor I I had no idea what direction to go in there's just so much to try and wrap your head around but it's never too late to get smarter about Stock Investing from the ground up after spending years interviewing and studying the best stock investors as a company at the investors podcast Network I've worked to distill those learnings into a simple course for you why did I do that so I can help you (45:19) master the principles of excellent lifelong investing I was a fan of the investors podcast for years before I joined the team and I always wanted to course that broke down the most important insights from a decade of interviews with leading investors the course is great for both beginners and pros from studying what the Legends actually do to small practical ways to build your wealth over time I'll take you through 10 different sections covering the basics of what a stock actually is and how stock markets work (45:47) to strategies to optimize your retirement savings picking great companies what to look for in ETFs how much you should invest and how to monitor your Investments plus so much more by the time you're done you'll be ready to invest in the stock market learning plenty of tricks from the pros along the way to access the course and begin learning how to invest like the Legends just visit the investors podcast. (46:11) com SLG getstarted with stocks that's the investors podcast.com SLG getstarted with stocks and for a limited time you can use code mi15 for a 15% discount at checkout that's mi15 when checking out a good long-term investor is one who even if they own just a single share in a company tends to think like they own the entire company or like Venture capitalists actively investing in a private business diversification is only a substitute for intimate knowledge about a company and a quote damn poor one according to Whitman he ads quote (46:47) for us markets are taken as given something investors take advantage of because they understand a business in Whitman's view diversification is far less necessary despite the teaching of mainstream Business Schools when someone is truly an expert on a company and has learned to think as if they own the entire business