These class notes and supplemental materials are written by an investor who audited Joel Greenblatt’s Special Situation Class at Columbia’s Graduate Business Program from 2002 through 2006.   Different years may have an overlap of material and concepts covered by the prior year’s notes but the repetition and supplemental material may improve retention.  Any errors, omissions or faulty premises are the notetaker’s fault and not implied or committed by the speakers or persons presented.   Please use these notes as a spur to your own efforts and thinking in how to become a more effective investor.  I hope this help. Comments welcome at aldridge56@aol.com

Below are in depth notes just from class #1 stay tuned for notes from classes 2-9 and more (over 250 pages, we kid you not) enjoy!

UPDATE: Find part II of the class here!

We will be posting many more articles throughout the week from Greenblatt’s class notes so make sure to check back at least daily or subscribe on Twitter, Facebook,  Google+, Linkedin,   RSS (or Feedly specifically),  or best of all sign up for our new and enhanced newsletter (make sure to select value investing and daily under the options).

Joel Greenblatt of You Can Be a Stock Market Genius (which focuses on special situations) and The Little Book That Beats the Market below (both are discussed in detail).

Greenblatt Class #1  

                                                                                                                                                    Sept. 07, 2005

A Story Selling Gum

My goal is to teach you the course that I never had and that I wish I had.   I started in business school 25 years ago.  What I know about investing other than reading financial statements, I learned on my own reading and making mistakes.  Hopefully, I can give you the benefit of my experience.

A number of years ago I was trying to explain to my son what I did for a living.  He is 11 years old.   I spoke about selling gum. Jason, a boy in my son’s class, sold gum each day at school.  He would buy a pack of gum for 25 cents and he would sell sticks of gum for 25 cents each.  He sells 4 packs a day, 5 days a week, 36 weeks or about $4,000 a year.   What if Jason offered to sell you half the business today?  What would you pay?

My son replied, “Well, he may only sell three packs a day so he would make $3000 a year.  Would you pay $1,500 now?   Why would I do that if I have to wait several years for the $1,500?

Would you pay a $1?  Yes, of course!  But not $1,500.  I would pay $450 now to collect $1,500 over the next few years, which would be fair.   Now, you understand what I do for a living, I told my son.

I sit around trying to figure out what businesses are worth, and then I try to pay a lot less for them.    I think you get the point.

The Skills I Will Teach You

I really don’t think the skills that I am going to teach you are very valuable. It is not that you can’t make a lot of money from what I am going to teach you.  There are fundamentally better things you can do with your time.  My view is that the social value of investing in the stock market as being similar to being good at handicapping horses.  There is a benefit to having markets for raising capital; they just really don’t need you.

I think what I am going to teach you this semester is really how to make money and so whatever social benefits there are to society, it is not very large.   So if you do end up following my advice and it works for you, I would ask that you find some way to give back.   I am one iteration removed so what I am doing?

I truly wish that I had the chance to have this course to help out in some way.

Divergence between Prices and Values:

Prices fluctuate more than values—so therein lies opportunity.

Why are prices of each company so variable and volatile compared to the value of companies?

If I take out the newspaper and I pick out any large cap stock like IBM, Cisco, EBay, KKD, Google, why are the prices all over the place?   Look at the wide divergence between the 52 week high/low.   Here is a business that hasn’t changed much but the price has gone from $35 to $70.   $7 to $30 and right now to $20.  Look at ANF and INTL.

Questions:

These are all pretty good companies and this has been the least volatile period in many years, and there have been 100% moves over one to two year periods—why the huge disparity?

Are markets efficient?

Why do MBAs and other smart people not do well in money management?

People invest with their emotions.   They process information differently.

Does it make sense that these prices fluctuate so much while the values of the underlying companies do not move around in a short period of time?  (Price diverges from value).

Joel Greenblatt (JG): It is very clear—pick any company you want–the price is very volatile over short periods of time.  It does not make sense to me that the values are nearly as volatile as the prices and therein lies what should be a great opportunity.  All these companies which have fairly established businesses (Disney, Boeing, Wal-Mart) the values are not fluctuating nearly as widely as the prices.   There should be great opportunity, yet there are not many winners in the market.

The reason why that is…….in the final analysis……why do the price fluctuate so widely when values can’t possibly?   I will tell you the answer I have come up with: The answer is I don’t know and I don’t care. We could waste a lot of time about psychology but it always happens and it continues to happen.

I don’t know and I don’t care. I just want to take advantage of it.   We could sit there and figure it all out, but I like to keep it simple.  It happens; it continues to happen; the opportunities are there.  I don’t know why it happens and I don’t care—I just want to take advantage of prices away from value.

In this course, I am going to teach you how to take advantage of that.   I will make a guarantee now:  If you do good valuation work and you are right, Mr. Market will pay you back.  In the short term, one to two years, the market is inefficient.  But in the long-term, the market has to get it right—it will pay you back in two to three years. Keep that in mind when you do your analysis.   You don’t have to look at the next quarter, the next six months, if you do good valuation work—and we will describe what that means—what the best metrics to use, Mr. Market will pay you.  In the long-term Mr. Market eventually gets it right; he is very rational.  That is very powerful.  That is the context in which you should think this semester.

The big picture:

There are lots of smart guys on Wall Street yet most of them go out and basically fail for many reasons—they are unable to contribute value.   I have a firm, Gotham Capital; we have averaged 40% per year for 20 years.  $1,000 would now be $836,683. There are lots of smarter people who can do better spread sheets than I can; there are lots of smarter analysts than me.  I think the difference to how we have been able to do it is that we think simply and a little bit differently.

The context in which we put our analysis—not that our analysis is any better than anybody else’s.  We are not experts in any particular industry, we are not smarter than anybody else, and we are not doing better analysis.  The fact that you are here means you can do the analysis.  It is the context in which you put that analysis that makes the difference to you.

Simplify, place valuation into context, practice.

That should be encouraging to you that you don’t have to be smart, or have to do a million hours of work or tricky analysis, but you have to be good.  You have to know what you know—Your Circle of Competence.  You don’t have to be the best in the world at figuring stuff out.   It is the context which I will teach you those simple things and then we will do a lot of practicing–practice of doing valuation while keeping the simple context in mind.  Even I have to remind myself to remember what is important.  You must be able to cut through all the noise.   The Wall Street Journal has more info in it in one day than the entire world had 700 years ago.

How to Beat the Market

Many people don’t beat the market, so name some ways that you can do it.

Focus on small caps where the markets are more inefficient.  There is less analyst coverage so less information flow.   You have the chance to find prices more above or below value.   Small caps have more opportunity to find mis-priced stocks.

Small Caps: Another secret, when money managers learn their valuation work and focus on small caps, they make a lot of money, and they graduate from small caps.   For a guy starting out there is always an opportunity to do original work.  There is turnover in the ranks.

Activist Investing:   JG won a proxy fight and eventually made money but it was not worth the pain.   His first and last foray into activist investing.

Special situations:  A corollary to small cap investing.  You go where other people aren’t. A more inefficient area of the market.   Value investing with a catalyst.

Student: Superior knowledge in an industry.  Linda Greenblatt focuses in retail (stay tuned for that).

Concentrate your investments. 

How Gotham generated great returns:

Gotham Capital stayed small.  We returned outside capital, so we could invest in as many situations as possible (not constrained by size).   We are very concentrated.  We invest in 5 to 8 securities.   Know your companies very well.   Why that is more safe than diversifying?   You pick your spots.  So if your holding period is three to five years and you only have 4 to 6 securities, then you only need one or two ideas a year.  That is why I have time to teach this class.   It is more fun and it works.

Why Value Investing Works

Richard Pzena:

Value investing works, but it tends to work in cycles.   Pzena lost 70% of his investors.  Now of the $14 billion he manages he only has 4 (Joel G. is one of them) of his original investors.

Joel G: I was down 5% in 1998-1999 but worried about a bubble breaking in 1999 (a macro worry), but I could find cheap companies—look how cheap Brk.a got in 1999.  They kept doing what they were doing. He was up 130% in 2000.  The markets came back.

Read: What Works on Wall Street by James P O’Shaughnessy.  He started a fund in 1996-1997 but he underperformed the market by 25% and after three years in business of underperforming he sold his company at the bottom of the cycle.   The guy who wrote the book quit his system!   It seems like it is easy to do, but it is not easy to do.

This book, What Works on Wall Street, has born out its wisdom. The two funds that are patented that fool his strategy have been phenomenal. HFCGX is the patented fund based on his top idea of Cornerstone Growth; over the last 5 years it has had an average return of 13.44% per year vs. the Vanguard 500′s -2.01% per year (6/1/00 through 5/31/05). HFCVX is the patented fund based on his 2nd to best idea of Cornerstone Value; over the last 5 years it has had an average return of 6.47% per year vs. the Vanguard 500′s -2.01% per year (6/1/00 through 5/31/05).

The most interesting point is that the author points out those investors often are to emotionally involved to have the discipline to see the strategy through. Not only did the first reviewer bash the book because he did like the returns strategy one year after the book came out, but Mr. O’Shaughnessy sold the funds to Hennessy Funds at the end of 1999 after it failed to surpass the returns of the bubble that soon after collapsed. Seven years after it was published an investor would be much wealthier had they followed the books top strategy instead of the investors who dog-piled onto the stocks of the market’s bubble.

We are going to try to understand why it works. Why it has to work over time.  That is the only way you can stick it out.

The math never changes: 2 + 2 = 4.   That is the level of your understanding I want you to have by the time we are done.  If I get that right, forget all this other stuff and noise, I will get my money.  No genius required.  Concepts will make you great.

There is a lot of experience involved in valuation work, but it doesn’t take a genius or high IQ points to know the basic concepts.  The basic concepts are what will make you the money in the long run.   We are all capable of doing the valuation work.

Overview of the course.

His book,You Can Be a Stock Market Genius was written for the general public but he learned that it was written more at an MBA level.

Brian Gains was one of our analysts at Gotham.  He will be one of the speakers in this class.

The Value Investor’s Club:

Six years ago, we found one of our best investments that was trading at ½ cash value and it had a very good business attached.  We found it because of the very complicated capital structure.  We thought we were the only ones to find it.  We found another person on Yahoo.com who had analyzed the situation correctly.   Hey, there is intelligent life out there.   Get together these smart people and share ideas.

If you get A+ in this class you could get in.

This is the application procedure.  You have to know certain metrics that Yahoo members don’t know.

I am not vouching for any write-up in particular.   Read the reviews above 5.7 with many reviewers.  You can search by rating or person.    Usually 5.5 and above is pretty good.   You can look at example after example and see what happened years later.  You see smart investors asking questions.   There is a lot to choose from here.  It is a great learning tool.   A great research archive to build an investment thesis.   I can’t recommend this highly enough.    Do not share your ID for the VIC with anyone.   This is a great learning resource for you.

You can search by investor and see what makes for a good write-up.  We have found a number of superior investors.   A simple and clear thesis.

Review

• Stocks bounce around a lot.
• Mr.  Market eventually figures it out over three years.
• The market closes the gap.
• We seek a margin of safety.

Valuation:

What are the different Valuation Methodologies?

DCF: Discounted Cash Flow (problems) you have to make projections.  The terminal value can change drastically due to small changes in assumptions.   What earnings does the price imply?  What growth rate and what discount rate am I using to get to that valuation three years from now?  What would justify that future price?  I sort of work backwards and throw in a bunch of numbers like growth rate.  What is this price I am expecting it to be worth imply?   I use it as a reality check to decide and see if my assumptions can be justified.   What it tends to do is force me to use conservative numbers.

How do you know if you are conservative?

What if you can’t figure this out—like growth rate or discount rate?  Pass on it.  If it is hard for me to figure it out, I go onto the next one.

Relative value: look at similar businesses and what they are trading at. Problems: the businesses are not really similar.  It might be tough to find a good comparable.  Everything might be overvalued in a sector, so you are comparing one overvalued asset with another.   Comparables might be over or under valued.

Replicating value—I don’t usually do that.   The communists made square wheels because they cost the same to make as round wheels.

Break-up value: A company has two divisions one is making $3 and the other is losing $1 (EPS = $3 – $1 = $2).  The stock trades at $34 so PE = $34/$2 = 17x but if you close down the bad business, it really trades at 11 times or $34/$3.

Where the stock has traded in the past is noise.   What is it worth?  Where is it today (Price).

Acquisition value: You have a discount brokerage account with 100,000 accounts that acquires Brown Co’s 50,000 customers, so they can pay more that company due to just adding customers to thei5r infrastructure.

The acquisition value might be much higher than the DCF value.

I don’t like to see values per subscriber or x hospital beds.   I still want to see the cash flows translated from the hospital beds.  I don’t like to see relative value.

Summary: Valuing a Company

We have four ways to value a company:

1. DCF or intrinsic value,
2. Relative value,
3. Break-up value, and
4. Acquisition value

Balance Sheets, Income Statements and Cash Flow Statements

A company trades at $6 per share and it has $5 per share in cash.

Current Assets: (CA) First we look at CASH.   We have often found companies are trading at close to its cash per share.   Technology stocks in 2002.   $5 per share in cash and

You can value the $5 in the company’s pocket but it is not in your pocket.  What will the company do with that cash?  How will they redeploy the cash?

Will they dissipate the cash or use it wisely like returning it to shareholders?  Look at management and decide if they are capital destroyers.  How is their bread buttered, do they own a lot of stock or are they paid mostly in salaries.

Look at where the business is—is it earning money, is it earning $ in other businesses?  Is management doing good things with the money?  If management is doing good things, I may put full value on that cash.  Or I won’t take it at face value if the business is losing money.   Make sure it is net cash.

They may need more working capital so I may have to haircut the cash figure.   I usually give a discount to the cash on the balance sheet.   Generally capitalism works.  Are these guys’ losers.   People running a business are generally more entrepreneurial.  Are these guys treating it like their own money or somebody else’s money?  There always nuances.  If I am not sure, I will put a very conservative value on the cash to take care of that uncertainty.  You may say you know what; this $5 should only be worth $3.  Do I still want to buy the company with what is left?

That $5 really is worth $3.00.  Something as simple as cash on the balance sheet, there are many iterations of how do I look at cash?  A lot of people just look and accept the cash value, but I analyze it. I will value that $5 at $4 or $3.   Usually this won’t keep me from investing; I will just put a big discount on it (the cash).  Probably when the company makes a big acquisition that is the time to sell.

Accounts Receivables:

What are the considerations there?  Does the receivable number make sense?  If A/R is rising quickly, then they are pumping out sales and extending credit—that may be good, it may be bad.

Inventories:

There are ways to look at that.

Current Assets, prepaid assets.

WC: Accounts Payable, short term portion of long-term debt.

Assets:  PP&E, Real Estate (how much have those assets appreciated).

Intangibles: goodwill—the excess paid for assets above the book value of those assets.

A little secret: Operating profit.  Usually I use a 40% tax rate.  The number I like to use is operating profit—a pre-tax number so comparisons are easier.

D&A are not cash expenses.  Now you don’t amortize goodwill unless you write it off.

EBITDA—don’t show this in your reports.  You have to subtract out the maintenance capital expenditures (MCX).  Now, if the company is growing and you want to figure out “normalized earnings.”   Capital spending is the number to use.  Capex is a cash expense but depreciation is a book entry not cash.

Let us say you are opening 10 new stores in addition the 10 stores you already have, the capex would include keeping up the ten stores you already have making capex on those stores and the cost of opening the ten (10) new stores but you won’t get the benefit of those new stores in that year.  For normalized earnings what you really want for normalized earnings is maintenance capex.  How is this number reported?  Ask the management.  Break out growth vs. maint. Capex.

I ask for an explanation for mcx and how do they get there.  Usually the company understates mcx. When EBITDA, DA = capex, then EBIT = EBITDA – Capex.   A quick and dirty when you use EBIT. I try to get at EBITDA – maint. Capex.

Discussion of maint. capex vs. growth capex.

The Cable Industry is in a continual upgrade cycle.

Look at EV/Sales, EBIT/EV.   EV/EBIT is pre-tax earnings yield.

Why you use Enterprise Value (EV)?

COMPANY A

$10 EBIT

40% tax rate

$6 in Net Income

P/E 10

$60 million Market Cap. or EV = $60

COMPANY B

$10 EBIT

-$5 Interest Expense

=$5 million in pre-tax operating

$3 mil. in int. expenses.

$15 mil in market cap + $50 mil in debt = $65 in EV

A is cheaper with a PE of 10 while Company B has a P/E of 5.  The price of the EV is lower for A at $60 vs. $65 for B.

I look at EV to sales not P/S.  The point of this exercise is that when you show me your comparables and you say the average P/E–every analyst report shows the industry ratios where they say the industry is trading at 13x and this company is trading at 12x so it is cheap–it doesn’t take into account market capitalizations, differences in tax rates and things of that nature.   And looking at things through an EV/EBIT basis does.

To make apples to apples comparison we will use EBIT/EV.

The Importance of ROIC vs. ROE

Do I care about the ROE?  I care about the return on capital (ROIC).

The first thing I look at ROIC = EBIT/ (NWC + Net Equipment). How good a business is this?

Pre-tax return/Net Tangible Capital.   What capital the company needs to use to be in business–NWC + Equipt.   Net Working Capital (NWC): Use financial A/R and eliminate the excess cash.  Subtract Accounts Payable NIB debt.

Why eliminate goodwill?  Because it states historical costs.  It doesn’t matter what I paid.  You want to know going forward what type of business you are looking at.

EBIT/EV Earnings yield.  What price am I paying relative to earnings?

Avoid value traps (low return businesses).

Hotel Capex:

Spend $1,000 for a hotel. Then spend $25 per year for MCX, but then in year 5, I need to refurbish the hotel for $400 to stay competitive.   So I would add ($400/5 or $80 per year to the $25 per year and deduct $105 per year in true maint. capex).

Summary of What Joel teaches

in the Little Book That Beats the Market

You will learn:

• How to view the stock market.
• Why success eludes almost all individual and professional investors.
• How to find good companies at bargain prices.
• How you can beat the market all by yourself.

The key is to understand the simple concepts in this book

Most academics and professionals can’t help you to beat the market. YOU must do it yourself.

You have to believe that the story is true.   Most professional investors have learned wrong and very few people believe or else there would be many more successful investors.  They aren’t.

Compare Our investment alternatives

We want to compare how much we can earn from a safe bet like a U.S. government bond with our other long-term investment choices.  We want to make sure we earn a lot more from our other investments than we could earn without taking any risk.

Buying a share in a business

Buying a share in a business means you are purchasing a portion (or percentage interest) of that business.  You are then entitled to a portion of that business’s future earnings.

• We have to estimate what the business will earn in the future.
• How confident are we in our prediction?
• Nest year is only one year.  What about all the years after that?  Will earnings keep growing every year?
• The earnings from your share of the profits must give you more money than you would receive by placing that same amount of money in a risk free 10-year U.S. government bond.

Figuring What A Business Is Really Worth?

Why do the prices of all these businesses move around so much each year if the values of their businesses can’t possibly change that much?

Why are people willing to buy and sell shares of most companies at wildly different prices over very short periods of time?  I just have to know that they do!

Who knows and who cares?  Maybe people just go nuts a lot.

Ben Graham figured out that always using the margin of safety principle when deciding to purchase shares of a business from a crazy partner like Mr. Market was the secret to making safe and reliable investment profits.

Valuation

How are you supposed to know what a business is worth?  If you can’t place a fair value on a company, then you can’t divide that number by the number of shares that exist, and you can’t figure out what the fair value of a share of stock is.

In the process of figuring out the value of a business, all you do is make a bunch of guesses and estimates.  Those estimates involve predicting earnings for a business for many years into the future.  Even experts (whatever that means) have a tough time doing that.

Learning the Concepts

You must make a willing suspension of disbelief.

It is hard to predict the future.  If we can’t predict the future earnings of a business, then it is hard to place a value on that business.

If you just stick to buying good companies—ones that have a high return on capital—and to buying those companies only at bargain prices—at prices that give you a high earnings yield—you end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away.

Buying good businesses at bargain prices is the secret to making money.

Graham’s Formula:

His formula involved purchasing companies whose stock prices were so low that the purchase price was actually lower than the proceeds that would be received from simply shutting down the business and selling off the company’s assets in a fire sale.  He called these stocks by various names: bargain issues, net-current-asset stocks, or stocks selling below liquidation value).

Graham stated that it seems “ridiculously simple to say that if one could buy a group of 20 or 30 companies that were cheap enoughto meet the strict requirements of his formula, without doing any further analysis, the “results should be quite satisfactory.” In fact Graham used this formula with much success for over 30 years.

Graham showed that a simple system for finding obviously cheap stocks could lead to safe and consistently good investment returns.   Graham suggested that by buying a group of these bargain stocks, investors could safely earn a high return without worrying about a few bad purchases and without doing complicated analysis of individual stocks.

Magic Formula Results

Over the seventeen years, owning a portfolio of approximately 30 stocks that had the best combination of a high return on capitaland a high earnings yield could have returned 30.8 percent per year.   $11,000 would have turned into $1 million before taxes and transaction costs.

To make the Magic Formula Work:

It will be your belief in the overwhelming logic of the magic formula that will make the formula work for you in the long run.

How the Formula Works:

The formula looks for the best combination of those two factors out of a 3,500 company database.   Getting excellent rankings in both categories (though not top ranked in either) would be better under this ranking system than being the top-ranked in one category with only a pretty good ranking in the other.

No Size Effect

The Magic Formula Results for the top largest 1,000 companies: 22.9% vs. 12.4% for the S&P 500 over 17 years.  The formula works for companies large and small.

The Magic Formula seems to work in order of Deciles.  There should always be plenty of highly ranked stocks to choose from

How does the Magic Formula fare vs. the market?

The formula fared poorly 5 out of every 12 months tested. Annually the formula failed to beat the market once every four years.

If the magic formula worked all the time, everyone would use it. If everyone used it, it would probably stop working.   The formula doesn’t work all the time.

For the magic formula to work for you, you must believe that it will work and maintain a long-term investment horizon.

Timeless Principles

In order for the magic formula to make us money in the long run, the principles behind itr must appear not only sensible and logical, but timeless. Otherwise, there is no way we will be able to “hang on” when our short-term results turn against us.

We are buying on average above-average companies that we can on average buy at below-average prices.

The opportunity to invest profits at high rates of return is very valuable because it can contribute to a very high rate of earnings growth!

To earn a high return on capital even for one year, it’s likely that, at least temporarily, there’s something special about that company’s business.  Otherwise, competition would already have driven down returns on capital to lower levels.

In short, companies that achieve a high return on capital are likely to have a special advantage of some kind.  That special advantage keeps competitors from destroying the ability to earn above-average profits.

So by eliminating companies that earn ordinary or poor ROC, the magic formula starts with a group of companies that have a high ROC.

“If you took our top fifteen decisions out, we’d have a pretty average record. It wasn’t hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor.”

- Charlie Munger, Vice Chairman,  Berkshire Hathaway

Via CSinvesting

Joel Greenblatt Columbia Class notes on special situations, this is part II. Please see part I and the disclaimer there.

We will be posting many more articles throughout the week from Greenblatt’s class notes so make sure to check back at least daily or subscribe on Twitter, Facebook,  Google+, Linkedin,   RSS (or Feedly specifically),  or best of all sign up for our new and enhanced newsletter (make sure to select value investing and daily under the options).

Joel Greenblatt wrote one of the best books ever on investing (with one of the worst titles ever) You Can Be a Stock Market Genius (which focuses on special situations) and The Little Book That Beats the Market (on the magic formula); both are referenced extensively below. So if for some reason you have not read them make sure to check them out.

Joel Greenblatt Class #2

                                                                                                                           Sept. 14, 2005

Some definitions of Free Cash Flow = EBIT – Maintenance Capital Expenditures (MCX) – annual changes in working capital.  Changes in annual working capital (WC) are due to working capital changes needed for growth.

I can’t emphasize enough my recommendation to study the Value Investor’s Club because you can obtain more experience and learn from other’s mistakes.

Classes Oct. 5^th & 12^th rescheduled for Friday Oct. 7^th and 14^th from 9 am to 12 pm URIS Room #329 for a make up class. No class Oct. 19^th.

I downloaded all the Buffett Letters from Berkshire’s Web-site and then used Google Desktop to search through for any topic.

Assignment:

I left you with the magic formula last week.   Next Week Richard Pzena will talk about (Lear Corporation) and read Haugen book—focus on the concepts.   Prepare Lear Corp.

An updated chart from last week’s class.  Cycles of Value Investing Aug. 2005

Aug. 95 to Feb. 2000: a very tough time for value investors; you remember the Internet phase.  Even if you had a great company with excellent prospects, the market didn’t pay for it.  S&P 500 up 163% cumulatively vs. up 91% for Value Investors—72% underperformance. If you are running a fund and you beat the value index, the lowest 20% in BV, you would have underperformed by 70% to 60% over five years. If that happens, people leave.   Even Richard Pzena, whose firm runs $50 billion dollars, in March 2000, most of his investors had left.  His performance since that time has been so phenomenal.

From March of 2000 until today, value has outperformed the S&P 500 by 175% and Pzena did much better than that.   People left at the wrong time as usual. If you stick to your guns and your clients don’t you can understand the pressures on a manager?  You are looking at a chart through four years and say you will stick it out through the value cycle, but that is an awfully long time and many don’t survive.  Some value managers cheated with a value tilt to the S&P, and they got clobbered.  They were cheating to hang in there.   Even surviving long term with this simple value model is tough.

This may seem like a minor point, but this is the whole story.  Really what I am always doing is valuing the company when I can.

What happens if it is very difficult to value a company?  Do something else.  That is a very powerful concept if you have the luxury of looking at something else.

The guarantee I made last week is that if your valuation is right, it will usually only take Mr. Market two or three years at most—sometimes a lot faster–to get it right.   Do good valuation work.

They way I define value is not low price to book or P/E but intrinsic value.  You can see price/book has gotten a little less robust over time from out performing at 6% to 3.1% CAGR.

We are talking about the disparity in performance.

The lesser importance of assets with service businesses as in the past industrial period—perhaps a reason why book value losing its importance.

I analyze each company from the bottom up.  I am very value driven

I don’t predict under or out performance of the value cycle.

MAGIC FORMULAS

1. WHAT YOU PAY: “Normalized” EBIT/Enterprise Value (What I pay or pre-tax earnings yield).   You would value EBIT higher if tax revenues are lower due to a permanent tax change.  Take the after-tax yield and see what the differences are.  Is EBIT representative of true cash flow.  EBIT is a short hand for EBITDA – Maint. Capex.   Different capitalization can skew net income. Differences in tax rates.   Using EBIT is a way to compare apples to apples.

2. WHAT YOU EARN: EBIT/(NWC + NFA)  the denominator shows what I need to invest in the business to get that EBIT.  Don’t forget to normalize investment capital over the course of a year. What I earn.

I told you about my “magic” formula as my starting point for looking at companies.

JG: You bring up a very important point.  These are totally two different things.

This is how much I earn based on what I paid for it (EBIT/EV).

This is what I earn based on what the company paid for the assets that created those earnings (EBIT/IC or (NWC + NFA).  Those are two totally separate concepts.

Return on the capital they made on the past.  So what?  Incremental dollars will make good returns but not as high as they made in the past.  I may earn 60% ROIC on the new store versus 70% previously in the old store, but there are no other places to earn as high a return so I will still build that store. But if my pretax returns are between 15% and 20%, it doesn’t take too much to tip the balance.

Use normalized EBIT.  Look at the normal environment.  This is the art part.   What I think a normal environment might be.  There is nothing special going on in regards to the company or the economy.   Obviously it is an assessment now we are into the art part of determining “normalized”.

Here is normalized EBIT over capital invested in the business. This is my best guestimate of what type of business do I have?

When I ran a defense business I had a lot of contact with investment bankers who were pitching acquisitions.  They would say, “Well, you can add 20 cents to earnings and make a non-dilutive acquisition by acquiring a business at 9 x EBIT earning 11% pre-tax and that is about flat in growth while borrowing 9.5% partly fixed and partly variable.  The spread is 1.5%.   Is this worth it for a crappy business?  No.

They slapped on the same multiple we had before even though we would be a lot more levered.   The investment bankers had a 400 page report with a nice cover on it, but when you get down to it, this is the bet you are taking.  It looks like a bad bet.

Boil the analysis all down to its essence—is it a good business at a good price?  Is the bet worth it?

Don’t throw out logic.  Ask one simple question.  How much do I have to pay?  How much am I earning?

If you have to continually make acquisitions to grow, then it is a different animal.

You are earning 50% on tangible capital ($2/$4) unless you have to add acquisitions to get future growth.   All you have to replace is fixed assets.  Your capital spending will be confined to replacing fixed assets. You don’t have to keep replacing Goodwill.  Goodwill is a past cost.   (See Warren Buffett’s writing in the 1983 Annual Report of Berkshire Hathaway on amortization and intangible assets).

This took me a long time to learn, but if I had read Buffett’s letter in 1983, then I would have learned this sooner.

Forget how the company got there.  If the company made bad acquisitions so debt is in the EV.    Goodwill is a sunk cost in past acquisitions.   If management is a serial acquirer that makes bad acquisitions then the future earnings won’t be what they say it will be.  Adjust.

I care about what I have to pay today to generate returns today and in the future.  EBIT/EV takes into account for what I paid for it.

If they have land where their factory could be moved and the land used for a higher and better use, don’t just take the value of the land without considering the cost of moving the factory.  Do the difference between the industrial land and the value of the land.

Why are we taking Net Fixed Assets (NFA)?   It is not always right.  Say we buy a hotel for $10 and it is going to last 10 years and we write it down over 5 years and now it is at $5. But if this goes down to zero, I might half to invest another $10.  This would give me ($5) a skewed return (being too high) because of not considering replacement and reinvestment into the fixed assets.

Say you have 100 hotels and they are all on different cycles, then on average, you will be correct in using NFA.   10% of your hotels will be refurbished each year over a 10 year normal cycle.    That is my quick and dirty for an ongoing business.

Do I have to adjust any numbers based on the unique circumstances of the business.   Beware of overstating returns on capital.

Hooke, author of Security Analysis and Business Valuation on Wall Street, said that you don’t control the company so you take the capitalization as is so use P/E.  It is the hand you drew.   JG: I strongly disagree with this—reasonable minds differ—because I have been doing this a long time and EV to EBIT works better than P/E because if management doesn’t optimally use optimal capitalization then someone will come in and do it for you.  Using EV/EBIT is the way to go.

Acquisition value is not the same as P/E multiple.

If there are big blips in capex then there will be a hybrid between gross and net.

“Roll-ups mean lose money.”

You spent the money on the stores but you don’t receive the EBIT yet, so you must normalize the number for EBIT.

If you are earning 50% to 60% vs. 15% to 20% then we are looking at two different animals.  Then what are their growth prospects, what is there growth rate, bargain price, good business?

20% pretax = 12% after tax.  The average for business is 12%.

I don’t make money because I am really smart, I make money because I have a big picture in mind for what I am looking to do.   The big picture in mind—is the difference between 50% to 60% vs. 15% to 20%.

Capital Cost: Opportunity cost for my capital

How JG compares investments.

For a $1 of earnings per share after tax what P/E for a non-leveraged company?

Now I have alternatives for my money, the risk-free return is the 10-year bond is less than 6%, I use 6%.  Never lower than 6% even if the rates are 4.5%.   You know Buffett confirmed that when rates are below 6%, I use 6%.

Now if the 10 year bonds are 7%, then I use 7% as my bogie.

$1 at a 16.66 price earnings ratio is equivalent to 6% yield (risk free rate).  If my $1 is going to grow to $1.40 EPs in two years, then I prefer growth vs. a static 6%.

How do you justify 20x or 5% yield on $1?  If it is growing and I am confident of that growth.

10% pre-tax = 10% x (1- 40% tax rate) = 6% after-tax.

Compare the opportunities here versus my other choices.   I compare a growing 5% yield to a 6% risk-free rate.

When I get the money it is after-tax from the company compared to the after tax stream from the bond.

EBIT/EV portion.  Then I look at the ROIC portion.

Two businesses:

Jason’s Gum Store: $400,000 to build and $200,000 in operating profit so 50% ROIC.

Jimbo’s Just Broccoli: $400,000 earnings $10,000 = 2.5% ROIC.  But compared to the 6% government bond yield, Jimbo is actually losing (2.5% – 6%) 3.5% a year.  This is crazy unless he thinks the profits will grow tremendously.  Though it seems he is making a little bit of money (2.5%), he is actually throwing money away (-3.5%).

This is how I evaluate each business—what are they doing.  I won’t pay for a value destroyer. Stay out of Value Traps of just buying low P/E stocks. WEB calls them “cigar butts.”

–

I want to look at two things:

Am I getting a good return based on what I am paying and what are the incremental returns (MROIC) on capital?   What kind of capital do I have to put in to earn that type of return?

What am I paying and is this a good business?  I want to stay out of the value traps.  I am really looking at normalized EBIT three or four years out vs. last year’s EBIT.

How much of the money that I earn can I reinvest at the same rate. The incremental return on capital will affect my growth rate. It will affect how much my dollar will grow over time, then it will what normalized growth rates and earnings will be.

Generally, the way I solve any issues like that are…I look for what things in three years will be worth $50 and I pay $25 for them.  If it is $45 or $55, I don’t care; I am not smart enough to fine tune it over time.  I am picking my spots.  There are not that many companies are trading at that discount.  It is $38 going to $58 in three years—24% per year.  Depending upon how confident I am in that return that may be a great rate of return.   Some times I need a higher rate of return depending upon my confidence.  I may take a 15% to 20% rate of return despite I like to make more than that.  If I am wrong how much can I lose?  If I have a lot of room to be wrong and still not lose money.  The risk is low.

If the cost of hanging in there is dead money for three years and the $25 goes to $30 or wherever, I get an OK return.  Generally, if I am good and I get 4 out of 6 right or how many I get.  I look out three years.  I take my best shot; I look for a wide disparity.  I always looking for a catalyst or the market will realize what I see.   What will make people see what I see?

This is a special situations class so I would love to have a catalyst on everything I do.  Eventually, in three years or more you don’t even need a catalyst.  There are a lot of things that can happen.  The efficient market people are right but only long term.  But eventually the facts come out.  Whatever people were uncertain about now over the next two or three years, they find the answer to.   There are a lot of people out there trying to figure out what something is worth.

So I think the flaw with the efficient market theory is that it often takes a lot more time.  There is often a lot of emotion in the short term and there is much more uncertainty involved, and people take the discounts for uncertainty but there is more opportunity if you have a longer term horizon.  In the short term I don’t think a stock can trade at $20 and $35 and nothing happens and they both can’t be right.   The economy doesn’t change that much.  In the short term, the market may not be efficient, but in the long term the market eventually gets it right.

Other times a company may buy back stock if they think it is cheap.  These little pieces of paper represent the whole company.   Eventually all those things work together to get the right price.

We will talk about Duff & Phelps.  I learned from that.

Break………

(See case study material on Duff & Phelps before reading this section)

EXERCISE: Duff & Phelps….Buy, hold or sell?  Students reviewed the annual report of Duff & Phelps without looking at the subsequent price.

The best section is to look at the front section where they summarized five years of financial and operating history.

This is a great business, it is growing, and it requires low capital intensity.   Every dollar they make is spent to buy back shares.

You want to see how the management’s bread buttered.  How much of their salary vs. share ownership?  If they are giving themselves egregious option packages then I will take that into account.

Income grew but total assets did not grow.  Their incremental return on capital is infinite.  They can grow without reinvesting their capital.

Did anyone attempt to value this?

Duff & Phelps  was spun off at $7.

EBITDA is 31.25 and EBIT is $28.8.

EBITDA of $31.25 minus capex of $2.5 = $29.535

EV/(Ebitda – capex).

There are negative working capital businesses like MacDonald’s.

Anyone see a problem with using a normalized earnings?  Look at the fast growth rate of earnings.  Do you think that is sustainable?

I took a normal growth rate over five years.

Three different EBIT growth rates: 8%, 13%, 20%.  I chose a conservative 8% growth rate.

EBIT of $43.72 x .6 for taxes = $26.23 x 13 P/E = $341.  I shrank the number of shares due to the buy backs down to 3.5 million outstanding shares.   I assumed that they were buying back shares with the shares increasing in price by 8% a year.   Don’t forget to make assumptions about what they would do with their excess cash.

$341/3.5 = about $95 to $100 per share.

So at $52 today at 8% the stock price was $99; at 13% the price was $122 and at 20% the price was $164.  If I go out five years expecting to earn 20% per year, how could I earn the return sooner?  Time compressed?

How could I make 50% in a year?  The market figures it out sooner.   I make 76% if pension funds wake up and discount the earnings at 9%.

Duff & Phelps was a small cap stock with low liquidity.

I am always looking at value and where it is now.

This spin off was a good learning tool for (Joel’s interest and work to analyze and invest in) Moody’s.  

Duff & Phelps was taken over by Fitch at $100.

Compare the multiple to the bond rate.  I will take a 5% earnings yield with a great business and with growth vs. 6% bond yield that is flat.

Quality of Earnings Example: Commodore.   Work in Process Inventory (WIP) growing faster than Sales.

Sunbeam Article in Barron’s.   Chain Saw Al stuffed the channels with inventory.   Another trick is to write down inventory to 0.  490 million to $0. If there are any sales in future periods then sales will be inflated and there will be extra profits.

$92 million in PP&E removes D&A so earnings are overstated.

Drop in allowance for doubtful accounts is less conservative accounting.   Sunbeam still lost money after all these adjustments.

Each mistake leads to better insights and subtleties.   

–

Joel Greenblatt Columbia Class notes on special situations, Please see part I and the disclaimer there (he mentions this topic.

We will be posting many more articles throughout the week from JOEL Greenblatt’s class notes so make sure to check back at least daily or subscribe on Twitter, Facebook,  Google+, Linkedin,   RSS (or Feedly specifically),  or best of all sign up for our new and enhanced newsletter (make sure to select value investing and daily under the options).

Joel Greenblatt wrote one of the best books ever on investing (with one of the worst titles ever) You Can Be a Stock Market Genius (which focuses on special situations) and The Little Book That Beats the Market (on the magic formula); both are referenced extensively below. So if for some reason you have not read them make sure to check them out.

Joel Greenblatt (“JG”): Before she speaks, just to give you a context, Linda sticks to one area: consumer products and retail.  She has been in that area for 10 years and has averaged high 20’s percent returns staying in that little niche that she knows well.  She finds enough opportunities in that one area.  Her returns have been no more volatile than other concentrated investors.  She has phenomenal returns focusing on what she knows.  There is a great lesson for you.  It doesn’t have to be retail but an industry that you understand.  She picked something she really enjoys–that is a very important lesson.

A number of people have come up to me before class and said they will join a big firm and they are afraid they will be pigeon holed.   That may be true but to really learn an area very well and still be very profitable.  As you invest over a long period of time you will come to know more areas.  Knowing one area well is tremendous.

She will talk about areas she is working on…….

What is a girl from Long Island doing in retail?

Linda Greenblatt (“LG”): So what is a girl from Long Island doing in retail? Pick an area that you can know and that you can understand well and that you enjoy. I like shopping. It is definitely an area I have to come to know well.  You start to see patterns. Over a ten-year period you learn how a particular industry group trades that gives you a big advantage over people who are first looking at the stock and coming in cold and not having the background.

I like retail because you are constantly getting information.  You get it on a monthly basis and sometimes on a weekly basis.  Retailers put out same store sales numbers-Comparable sales in stores for a year-over-year period.   Monthly basis but most industry groups you normally get quarterly numbers.   The more information you have, the more people try to trade on the information before, after and during.  You get a tremendous volatility in this sector.  A lot of people don’t like volatility. As far as I am concerned, I can live with volatility if there is a good opportunity over the long term.  And if I am taking a two years time horizon that is actually my greatest opportunity–are these monthly numbers.

Inevitably these companies are going to miss because of their fault or no fault of their own due to the macro environment. There will be a missed number and the market tends to have no mercy.  So the market kills these stocks.  One day it is trading at 20 times and the next day it is trading 10 times (earnings) but nothing has fundamentally has changed. That fundamentally is your opportunity.  So you must live with a little bit the anxiety.  Believe me when these stocks are down 30% to 40% it is hard to pull the trigger, but that is usually the best time to buy.  Volatility is your friend.

I don’t know how to pick the next trend.  I really don’t know fashion.   I say this: nobody can predict fashion. It is really is not about hitting the next trend on a continuous basis.  Are these companies running a good business over the long-term?  Are they running a business that can weather the ups and downs?

The best time to get in is when they missed a season of merchandise because if you look at the fundamentals of the company and it is well-run and the stock gets crushed because they miss a season of merchandise, then it is an opportunity to own for the long term. It is really irrelevant if they pick the hot trends or not.

It is very interesting because the Street misses the point on retail.  Most analyst reports focus on how this company will do in Oct?  How will this company be affected by Katrina or higher heating prices for Christmas?  These are all relevant questions, but not relevant if this is a good business.  Fundamentally it will be around. If you buy it at the right price it really doesn’t matter what is happening to the customer today because they will be around and they will continue to buy.

A quote from Fortune last year from a Hedge Fund manager who often invests in retail, “I have my people visit stores to see how much the items are marked down or if there are long lines at the register and I buy if this company will beat numbers and short it if it misses numbers.  It is that simple.

He really misses the point.  It is not that simple. If I had to invest that way, I would lose sleep over whether I could consistently do that.  Maybe I would get it right only 50% of the time.  I would have a lot of anxiety in between. If you can take a longer time horizon for one to two years.  You have to buy these things when people hate it because that, obviously, is when your opportunities are available. So you have to be a contrarian.

Can you see my slide:  This is a price chart of AEOS, American Outfitters.

Here is the two year price chart, it was up then down.  So the first thing you notice there is a lot of money to make in this stock.   Two years ago it traded at $7.5.  Here at $10, they had $3 to $4 dollars of cash on the balance sheet, you knew they were not going under.  Yes, they missed sales—is anybody familiar with this story?

Basically they were off-trend for a while.  They were not sure how to position themselves in the marketplace.  They tried to compete against (Abercrombie, ANF but they didn’t have the cache.  Back in 2004 they were not addressing their customer—the fickle teenager.  Back in 2003/2004 they were missing the boat with their customer; they were not meeting their needs.

Fast forward six months, they got their inventory under control and they turned their merchandise around.   Comparable store sales turned around that was key. Back in 2004 it wasn’t that their earnings potential was any less than six months later, it was the fact that comps (comparable same store sales) were negative.  This company doesn’t deserve this multiple because they are showing negative comps so it should trade at six times potential earnings net of cash.   To me this is a company that will be around.  They have a healthy balance sheet. Yes, they have merchandise misses; yes their same stores sales are down.  But they are making changes to their management team; they are on top of their inventories.  They got hit on inventories in 2004.   Certainly there is potential there.

As soon as people as people saw comps stabilizing and they recognize that they could get back to more normalized earnings and margins, the stock basically tripled. This is one example how you can make money in retail if you get in at the right time.

Next Chart: ANF:

Does anyone know the story here?  Basically the same thing happened. Comps were negative for awhile; there were merchandise misses, they tweaked their management team.  Back in their 2003/2004 area, despite the fact that they had a strong balance sheet and strong customer base, the stock was depressed.  ANF has a loyal following and they were not going away.  If  they could just stabilize their margins.  Again, they had the highest margins in the business; they had the best ROC in the business—a solidly run business.  The one caveat was that their comps were negative. That is why people knocked the stock down to those levels.  The stock was basically a triple from December of 2003 to July of 2005—the stock went from $25 to $75.

JG: By the way, Linda was here in class touting these stocks at the lower prices.

Aeropostale

Anybody know a little bit about this company?   Anyone been into an ARO store?  Have you ever not bought something on sale? If they mark something at $30 it immediately has 20% off.  You immediately feel like you are getting a bargain. That is certainly different from what ANF is trying to do.   Most retailers are only taking their mark downs when they have too.   If you see people not buying, I am not going to buy too.

We want our customers to feel like they are getting a bargain.  Their price points are about 30% lower than Eagle and Eagle is about 30% lower than ANR.  It positions them very well in the marketplace.  There is certainly a place for them in the marketplace so they are not going head to head with the other guys.  This is a one year stock chart.  The stock was as low at $18.5 last week and as high as $35 a few months ago.   Perhaps there is an opportunity here.   Around $18 was where we were buying it.

We are going to build out their store base and figure out what we think it is worth in a three-to-five year period.   We want to figure out a price target of our own.

So obviously, what got me interested was the precipitous fall in the stock price. It certainly made me take a second look.  And I knew estimates had been in the two dollar earnings range with $3 in cash so $15 and potential for $2 EPS gives you 7.5 xs.  The stock seems pretty interesting; I want to do more work.

What happened for the decline to have occurred: They missed their comp sales, their merchandise was slightly off; inventories were up 33% per sq foot while same store sales were down 2% so they were over inventoried, it will probably take them a few months (not a one quarter problem) to clear out the inventory.  So they were having big sales to get rid of stale inventories to bring in fresh inventories so margins get crushed in the interim fire sales.  It is a very stable company. They will get their merchandise back on track. They just needed time to weather the storm.  A company with heavy debt that misses several merchandising seasons could go bust.  The wheels are in motion, management issues–if there are any–are being addressed and inventory issues are addressed.  I would rather see you take a hit and get your inventory problems behind you rather than stretch their problems out over a year.

They started to have these issues and everyone piles onto the band wagon (investors sell immediately; all the analysts downgrade the stock).   You can’t own it here because the problems will carry over into the next quarter.  The majority of analysts either have holds on it or sales on it.   Nobody wants to get ahead of themselves.   They see that this will be a problem for a quarter or two so they don’t want to go out on a limb and predict a turnaround no matter how cheap the company becomes. They can’t predict over the next few months, but as you know, it is irrelevant what same store sales are going to be. Because what is relevant is if this company gets past these issues, can the company be back to normalized margins and earnings and when they do, what is this company worth?

JG: Stop Linda right here and look at that chart and say isn’t it great that the world works like that.  (Stock chart shows a collapse from $35 to $18).   Linda has been making money all these years and that is what the chart looks like every time.

LG: You don’t want to listen to the sell-side analysts.    Analyst: At $19 we are underweighting ARO because they will continue to miss estimates (“sell” it at the lows or buy high and sell low) because they have too much inventory (no kidding).  Those trends will likely continue into spring (Jan-Feb).  Maybe so, but we are taking a one to two year time horizon.  We don’t care what happens into spring, we care about what happens when they get through these issues.

“We think it makes sense to underweight stocks with earnings momentum slowing.”  I think that is exactly the wrong way to think.  Downside earnings miss.  It is the wrong way to think about things.  The time to buy is when everybody knows they are missing comps, have inv issues, etc.   You know what, if she knows it, then everyone knows it.  This is the time you have to be looking at it and thinking like a contrarian.

JG:  She has always has done it that way, she is going to keep doing it that way.

LG: Pulled off the Bloomberg. Earnings were supposed to be $1.65 range and the number for next year was supposed to be in the $2 range.  This is now: earnings came down to $1.36 for the year and they took earning down to $1.70 for the following year.  Why did they take the following year’s earnings down?  It makes no sense.  They can’t keep their estimates for next year the same if they lower this year’s earnings.   They automatically bring next year’s estimate down regardless of the business.   Could the business do $2 next year?  Of course, they could.  I think there is a really good chance to make $2. Per share once they get through their inventory issues.

The fact that they numbers come down means that you shouldn’t be fooled that something has fundamentally changed with the business that is causing numbers to come down for next year.

Student: What do you do to differentiate among management teams?

LG: Management–I like to see someone who has been around for awhile.  I like to see a proven management team.   As I do more research, I look at: Who is their customer base?  Who are their competitors?  Is there a reason for their being?  Is there a reason people shop at this store vs. their competitors?   Yes, because of price. ARO will win on price.  There is a reason for their being.  They are competing with the discounters and there are not many other specialty store concepts in the malls that are competing directly with them.   This is the price point they are looking to.

Student:  Why didn’t you look at American Eagle as an investment?  They both are way off of their highs, they both are well run and they have a reason for being.

LG:  It is interesting because those are exactly the two companies I was looking at to add to the portfolio.  I looked at Eagle and you are right on all counts but the one major difference was that ARO is a six hundred store chain and they have more potential to grow to 1000 to 1200 store with their concepts like Jimmy’s.  The growth potential is tremendous.  I look at that an American Eagle that is fully saturated at 900 stores.  Perhaps they can open another 100 stores.  I believe growth will be better with ARO.   It will be a few years before Eagle has any growth potential. AEOS can open a new concept but it will take a year for a test phase and a few more years to get momentum.   I like ARO primarily for that.   ARO was a little bit less a fashion concept than a fashion follower.   I like that position a little better.   ARO doesn’t have to be in the lead on fashions, they can be a step behind.

Student:  What about falling same store sales?

LG: Same store sales falling and growth in stores?  It really depends upon the issues.  They didn’t have much top line growth but margin growth, then that might be of interest.  I don’t necessarily have to see 15% to 20% top line growth depending upon the situation.

You want to understand why the SSS are declining.  Ask how the company is addressing the problem or if they are addressing it.  If management is blaming it on the weather, oil prices etc.   I like companies that take the blame and take responsibility to fix the problem.  You know what, there are some macro issues but we have a plan to fix our issues.

Student: How do you know when a retail concept is reaching saturation?

LG:  It depends upon whom they are catering to: what malls are they in: ABC Malls.    You could see an AEOS in an A or B or C mall.   A 1000 to 1200 is max saturation for a retailer to go into all three mall types.  An ANF will max out at 400 malls because they are only in A type malls. You won’t see them in a C mall.  That is why they launched the Hollister concept which was for lower quality malls: B and C.

Student: Whom do you talk to when doing your research?

JG: I will talk to anyone who will talk to me.  I will talk to store managers because they often know a lot.  I try to talk to senior managers.  You will get different information from a senior merchandising manager than a CFO.

We talk to people who come out of the store with or without bags.  We speak to store employees.  It depends upon what we are trying to find out at the time.  When looking into ARO we wanted to see a loyal customer base.   Are customers coming in and not buying?  What do they think of the merchandise?   Are the customers still coming in despite the weak merchandise?  One of the basic things we try to understand is what is happening to their customer base during this period of time when they have these merchandising missteps.  You go in with a thesis on the stock. Why is the stock cheap?   You go in and try to delve further.

The nice thing about retailers is that you have more access to their customers.   Again, the more information the better.   I go the malls, my partner and a person in her twenties who spends a lot of time in the malls—we all go to the malls to check out stores.

I send my mother or anyone who I know is a potential customer to the store.   Everybody has a valid opinion when it comes to retail.  We are based on the East Coast so certainly we have a very warped perspective of the world.  It is important to be careful not to extrapolate from the East Coast to the whole country.  If you are out doing that qualitative research you focus on the entire area not just one area.

Student: What about macro issues that can hurt retailers?

LG: When it is a cheap retailer like this, this is the customer who will be hit the hardest because of the high oil prices, but on the other side, the customer who used to shop at Eagle will now shop at ARO because they have less money.   I do not spend too much time on spending trends.

I try to avoid the macro stuff.   Do I think the news of the Macro economy is out there already in the market.  Do I think that every article I have read for the past four months is already in the market?  Yes.

I ask whether this is a cheap stock today and do I think over the next two years there will there be a normal environment.

Student: Do you short stocks?

LG:  Sometimes I short.  I prefer to short more of a basket than a particular stock.   These stocks can go to even more ridiculous valuations on the upside.  I don’t have the two-year stomach to wait for a stock to drop like I do for the long side.

If I do see a company posting double digit comps for several months in a row and it is trading at 50 times earnings, do I think it is sustainable?  No.  I don’t know when it is going to turn but I know it is unsustainable.   You know the day will come.   Reversion to the mean.

Student: How do you value growth?

LG: Here is a quick look at the numbers to say this stock looks cheap, so perhaps we want to do more work on it.   If you notice it’s EV to EBIT is 8 times but this is year coming off of depressed margins because they messed up on merchandise.  So that 8.5 EV/EBIT is not that relevant.  You really want to look out a year. That EV to EBIT is not really that relevant either.  People took down their numbers not because the business is changed but because they got hurt this year.

I like to put together my own numbers for next year. My own numbers show EV to EBIT of 6 times so it looks pretty cheap so I want to do more work.

Slides:

This slide is on store potential:   It looks pretty exciting for ARO.   Just some Easy numbers to calculate for why the stock looks pretty cheap to me.   Those P/Es are not net of cash so net of cash they are even cheaper so that is interesting.   You asked about growth.

ARO with the potential for another 400 stores and the other, Jimmy concept could be 800 stores.  I was more conserve with 600 stores, but there is a lot of store potential there.

Here is a situation where people are looking at this year’s numbers and they are really focusing on that operating margin number of 10.8%–under pressure.  The analysts write that the margins are really under pressure; we hesitate to recommend it until the get back to better margins (investing in the rear view mirror). It wasn’t that long ago that the company did north of 14% in margins.  It wasn’t that long ago the company did north of 14%.  I believe the company can do 13% while the street is at 11.5%.  Is it difficult for them to get back to 14% op margins considering nothing in their business has changed in the way they run their business?  This says to me, Wow, there is 400 basis point of operating margin improvement in operating margin here.

They have big room for improvement 11.5% to 14%.  You need to look at normalized margins not depressed margins.  If I look at norm in the 13% area because they did 14.5% last year.  That This leads me to a valuation of the stock.  But the point being is that I see 10.7% operating margin with potential to go to 14%, so there is upside here.  I get excited.   Most people say, “the stock is 10.7% margins, I am going to knock it down.”

There is huge potential upside here from 10.5 margin to 14.5 margin.

LG: You like to see that has experience opening a large number of stores in a year.  Typically you don’t want to see a company go from 100 to 500 stores in a year, the risk is high.  You want to be sure that they have a good model, they can format the store, they know what their customer is looking for, and they are earning attractive ROICs.   As they gain confidence then the store opening can accelerate.

JG: A new store may not do as well as a more mature store.  If the company has poor merchandising then it doesn’t matter if they open many stores or not to help ROC.   Ask if there are too many stores opening (saturation) or something else is going on.

I always want to discount their expansion.   What is a fair discount for growth?

I try to be very conservative on my terminal value.

Be aware that the quality of merchandising may affect same store sales more than the number of stores opening or the company being close to a saturation point.

New Slide:

JG: This slide is a little confusing, but it helps you come up with a thesis as to when the stock is cheap; where you want to buy.  I try to take a look out over a five year period and place a terminal valuation on the stock over that five year period

2.2 billion for arrow with pot for 400 another 1.4 billion Sq ft  Jimmy’s currently only has 8 stores, Now, this is a sit where they are in a test mode and they will continuye to test for another 6 mos.   When I make may assumptions, I want to be very conservative.  So I assume they test for another two years, then they slowly open 50 stores a year.

If you look at how Arrow opened their store base, once they has their concept down, they opened 100 stores a year.  These are conservative estimates.  My assumptions are not aggressive in terms of how I do my valuation.

Over next five years they have 2.2 billion Sq. and 2 bil sq fot potential. Arrow doing $525 a square foot.  That is the number I am using for the additional store openings.  I am not assuming big things for comps again.

Jimmy’s not as prod as Arrow.   They are doing $400 per sq ft for their category which is more in line with retailers that compete in their category.  Jimmy’s is catering to 18 to 25 year old customer.  You can take a look at competitors to get the numbers.

What is the potent earnings power over that five year period?  Normal margins—peak margins were 14.6%.  Mind you that the company believes it has the pot to do north of that.  I assume a 13% margin which I believe is a normalized margin, certainly in line with other retailers and well below what the company thinks it can do.

They are earning $1.63 on 13% margin and $1.42 with additional margins.   If the Arrow can do a 13% margins and Jimmy’s doing a higher margins- Earnings over that five years is $3.05 and place a low 12 multiple (based on conservative assumptions).  Jimmy has the potential to open 800 stores but they will only have 150 stores opened by the end of five years.

Then the build up of cash over the five years.  $110 then adds back depreciation and subtracts maintenance capex and it gets you to $8 per share in cash and there is $3 in cash today for a total of $11 per share in cash.  I am assuming that management does not pay dividend or buy back stock, they just sit on their cash.   Here you have $37 plus $11 gets you to $45 stock price at the end of a 5 year period.  If you remember Arrow’s stock chart, basically you had a month and a half to buy at $20 or under to buy this stock.   If you had done these calculations, you have a return of 19% over the next five years.  That is one way to look at it.

JG:  Right.  The way we talk about is that when everyone figures out what Arrow will earn and it could be a $48 stock, you could have the stock revalued faster and within two years you could have a $48 stock.  Other investors could discount that back at 10% since that is a normal return of what you expect to get from a stock.  The stock could be at $36 within two years which is an 80% return.  Though Linda presents the return as 19% annualized over five years, when most people start to figure it out, you could get a big chunk of your upside in the next two or three years.

I just want to make another important point that Linda made—she built out her store base.  In other words, most people say, “Well, they are growing their stores at X percent and it deserves that P/E or that P/E—people just pick numbers out of the sky based on a growth rate that will be short-term.   Whatever the growth rate may be, people just pick—I don’t know what they do.  But what Linda does is just so logical.  She builds out the whole concept; it makes sense.   She used conservative margins and store openings.  She built up the new concept by only 20% of the potential but she still comes up with huge numbers.   So this exercise is figuring out what it is worth and being super conservative. If there is a big gap between what it is worth and what you are paying, then you have something that is pretty good.

LG: Another way I look at it is that if the company can get to that $2 in earnings run rate over the next couple of years, then other investors once they get off same store sales and onto earnings and then they look at square footage growth and say, “Oh, they are growing at 15% to 20% so this company deserves a 15x to 20x multiple, so you have a $30 to $40 stock over the next two years.   The bottom line is that I am not including what I could have put in additional assumptions which would imply a more aggressive upside for the new concept of Jimmy’s which includes a more aggressive roll-out of the stores.   They could have 500 stores at the end of the five years not just 150 stores like I mentioned in my assumptions. I am assuming a flattish pick-up of same store sales, but they could do better. They do a stock buy back and the margin performance is doing better than that 13%.  The company takes steps to improve the margins beyond 14%.

Student: What are the ROIC’s on the stores?  What type of return do mall based stores typically have?

JG: You probably should figure out what the inventory will be.

LG: This has 20% after tax ROIC, so it is very good.

Student: How did you figure out $20 million per year for capex?

JG: They break out the capex for stores then I multiply by the new stores they open per year—that is how I reach that number.  In terms of MCX, it varies.

What are the assumptions or the things that could happen in a good way which I am not including?  I am very conservative.

Student: Mr. Market rewarding you faster, then so you sell?

LG: I would exit if the price was revalued much faster than my five year estimates.   I have yet to sell a stock at its peak.

END

Next week you have your 2^nd project due.

Assume we are in the 1^st qtr of 1996 for Munsingwear.

Class #9 November 16, 2005

Skip Benewitz (SP) from Kirkwood Capital is here to ask you questions about your presentations.

Your assignment is to read my book (The “Little Book”) for next class.

The exam will be a test of your valuation skills.  The one thing about the final is that I generally keep them so when someone asks me about you; I can see the results of your exam.

STUDENT PRESENTATIONS

Student Presentation on Timberland (TBL):

Students: A $2 billion Mkt. Cap Company manufacturing and selling active wear and footwear.   7.7 EV/EBIT and 59% ROIC.

Joel Greenblatt (JG): Did you use EBITA minus MCX for your proxy for EBIT?

Student: We see it cheap for a number of reasons: Negative sentiment. Miscues in product rollouts

We believe there is a 25% upside today and 50% in two years.   On a net basis for 24% and if you hold it more than two years you have a 50% return.

Take the current multiple ….

They have no debt and strong cash flow.  They have profitable investment opportunities.  They are growing.  Every dollar they put back into the business, they earn 40% on capital.

The management team is solid.  They are fully vested.  They have announced a stock buy back.  How many shares outstanding?  $68 million.    Shareholder friendly management.    Corporate responsibility is good.  Human rights are one of their concerns.

Risks: Not getting the fashion trends right.  Risk is mostly in the US business.

Calculating Enterprise Value (EV): Timberland has no debt and $100 million in cash.

Calculating Excess Cash for Enterprise Value (EV)

JG: One of the points that always come out is do you subtract (all) cash?  The answer is no; you subtract “excess” cash (cash that is not needed to run their business on a yearly basis).  You have to decide whether any of that cash is needed.  Negative working capital businesses (like McDonald’s Restaurants where customers pay cash or credit card while payables are 30//60/90 days) usually have the total amount of excess cash on the balance sheet excepting, of course, for petty cash in the registers.

Remember that retailers need to keep cash in their registers all the time, so do not subtract the full amount of cash on the balance sheet.

Competitors: Wolverine.

They have a loyal following of customers—construction workers.

The multiples and the margins—we took them down from where they have been.   There peer group is trading at 11x EV/EBIT.  This is trading at 10 x EV/EBIT.   50% return if you hold it for two years and you get 10x EV/EBIT on an exit or sale.

JG: How about on an absolute basis?  How do you justify that?

Students: This is a great company over a long period of time.

JG: Did you factor in how much room they have to expand—grow their store base?  How much more expansion do they have?

10x pre-tax (EV/EBIT)?  Usually I would take off 40% for taxes so you would have a 6% return (10% – 4%).   If the tax rate is lower due to overseas operations, sometimes they can’t repatriate the money.  Ask why that tax rate is lower or if that tax rate is sustainable?

Student: Timberland is growing abroad so we do not see repatriation as an issue.  We also discounted back two years in our valuation.

Analyst: How does the business break out between domestic and international operations regarding operation margins?  What are international competitors doing? Since you say their international division is growing 20% to 22% overseas.

How much of their business comes from the work boot area versus their entire sales because you said their strong margins are due to their strong customer loyalty in foot wear.

Student: Timberland messed up on apparel in the US so earnings for 2006 are depressed (temporarily we believe). EBIT margin of 2005 is 11%.

Analyst: Did you break out their licensing revenue from other revenue?  Licensing revenue is very high margin revenue.

Student: No, but it is very small.

Footlocker, Inc. (FL).

There are three main reason to buy FL as it sits at $20 with our price target of $26 which is a 35% upside.

Three (3) main reasons to buy FL:

Increase in operating margins.   The management is shutting down over-size big store concepts in early 2000 and improving their operating margins.   15% average over the last 4 years and mgt. stated a target of 10% with it currently at 7.4%. Op. margins.

Domestic growth is uncontested in Footwear for teens.  Growth in mall space across the US.

They have Strong portfolio of business with different footlocker products and Chance with an 11% EBIT margin.

Valuation:

Average store size 300 square feet.  Year-by-year growth in sq. footage.  CAGR is 2.5% over the last five years. Sales per Sq. Ft. is $529.

JG: They have been closing some of their stores and that will stop, so using net square footage number may be misleading.  So I would look inside that number to see what was the growth of the smaller stores ex-the closing of the big-store concept.

What you said is that they are closing the big store concept while their square footage is growing 2.5% per year.   Look at growth with just the small store concept.  Break out the concepts!

EBIT margin for whole company is 10%.  $50 million in EBIT.  Using a 7% EBIT margin you get $350 in EBIT to be conservative.   The best case is 10% margin.  We do think there will be competition from Finish Line.   We put an 8 multiple on that since the business is not growing.  Then you add $400 million for the online business and build up of cash.

Analyst: Pension (debt) in regards to Enterprise Value?  (Did you adjust the Pension liabilities if needed and add to your EV?)

Student: We did a standard EV/EBIT analysis.  We expect per share appreciation of 27% for the base case.

JG: Did you break out the domestic and international divisions?  They have different margins and margin opportunities.  The market went way down in Europe (margins collapsed from 18% to 10%).  Their margins used to be 18% so the question is do they normalize at 10% or higher. But if Linda (Greenblatt) were here she would probably say the margins probably normalize around 12% margins that would be her best guess.

I think you have the big picture, and you did a nice job with not much time.  I am trying to point out what I would do.

The more you can break it (the Company) apart the better.  In some businesses the different parts feed on each other.  But in FL there is enough disparity in the growth opportunities, the margins and the competitive landscape in Europe vs. the US where you need to pick apart the different businesses separately.   There is extreme margin contraction from 18% to 10%.  There is a lot of room there.  The question is where it lands.

Management believes that their margins can be double digits. I am trying to bring up issues as how I would approach it.  Their competitive position is very strong since their nearest competitor is five times smaller?

Student: Yes, it is.

Analyst: This applies to both presentations–operating margins are the value investors’ growth number. The scariest thing to get into earnings is that you feel the urge to go to a reversion to the mean thesis or management estimate thesis like FL.  Often those are the best answers you can come to, but the best you can do in all cases is to try to get as bottom up to that number as you can.  Do what Joel suggested which is to separate the businesses.   You did that with operating leases and how they made progress at FL.

Student: How do you treat operating leases?

Analyst: In most cases it doesn’t matter.   In some cases where rent is different than market rates, it can matter so you have to adjust for market rates to figure out normalized.

Pensions. The most important time to add pension debt to the EV is when the company is not funding expense through the income statement.  Say you have $300 million in pension assets and you are really paying $30 million a year into that pension for employees that are already retired and those that are in service. Sometimes pensions get screwed up because it is done on a lagged smoothed basis.  So you must make sure you add back the pension debt on an adjusted present value basis if it is under funded.

JG: If management is using an unrealistic assumption of 9% returns for their pension plan but you think the returns should be 5% or 7%, then I would adjust the pension liability and use your adjusted number.

Claire Stores:

Students: A mall based Store.   $2.71 billion market cap. They have 2800 stores.  The stock is $27 and we get to a valuation of $27 to $34 depending upon your assumptions going out five years.

We use a 22% margin for the US and international is 17% margin in EBIT so we used

JG: What type of growth do you use for them?  Is there inflation growth?

Students: We use 5% annual growth.

JG: Why are they not growing now?  So you are assuming mature growth in five to ten years?  What did you do with the cash?

Students: We built up cash of $7 per share.

Students:  Their (gross?) margins are 55%.

JG: Why are their margins so high—they can source their goods very cheaply?

Students: They have an efficient operating model.

JG: Buy one; steal one—a store that had small, cheap jewelry for teenagers.

Analyst: What are their ROIC in their stores?  You gave it a low multiple of 12, but this company has profitable growth—perhaps it deserves a higher multiple—especially where the market is currently trading at.

Students: 27%.

Cross Checking Your Multiple

JG:

Did you do a discounted cash flow analysis to determine an appropriate multiple?

Student: No we did not.

JG:   A DCF analysis would help you determine a proper multiple as a cross check.  A 5% growth in perpetuity will blow out most growth models and gets you a very high multiple.   So the question is what happens at 3% or 5% growth in perpetuity?  It might be interesting to have a matrix of various growth rates to judge the multiple.  What multiple theoretically is 5% growth in perpetuity?  Where does your 12 multiple fit into that?

You figured a 15x multiple (6.6% yield) after tax was a reasonable price for Claire Stores.   I say use a minimum 6% hurdle rate. At best what we will get out of here is that it is a great business, it won’t lose much money and at some point it will get a higher multiple.   You are probably being too conservative which is OK because you are trying to buy it at a huge discount.

COCO

The company takes six or seven years to integrate an acquisition of a new campus.   They have made 80 acquisitions in the past four years.   We think the company is worth $22 while it is currently trading at $12.   We assume improvement in operating margins.

JG: Do you trust these guys?  Explain the big picture thing.  Don’t they get funding from the government for the tuition and aren’t there claims of fraud against the company?

There are no convictions but I’m a great guy?  Are they goosing the numbers, are they too aggressive, why is the operating margins dropping—what did they do in the past that is different now?

Analyst: 72% upside?  You think it will be worth $22 in 2010?  Why do you think it will get there quicker?

Explain what you mean by campuses.

Student: ROIC regarding acquisitions? Would goodwill be a good proxy for capital—a decent proxy for capex since they are constantly buying campuses?  If they didn’t acquire campuses then they would have to build the schools?

JG: They are buying these campuses for their earnings power not the cost of their assets to be able to put the schools together.   Wouldn’t it cost them to expand?  Basically you have to use logic on each one.

Simplify everything—what is it worth now if they just stopped and grow?  Then if they take some of their incremental dollars capital and buy stuff what kinds of incremental returns do I think they are going to get on that?  So I break things into two pieces generally. They have what they have now. Incrementally if they stop growing what is that worth?  If they can generate this much cash, so what will they do with that cash?  They can distribute cash (pay a dividend), buy back stock or acquire stuff.  I have to make an assumption of what will they do with that cash.  If they start acquiring stuff, I have to ask, “Will that be a good use of the cash or not?” And value it that way.  It gets to be too amorphous if you start assuming if they are going to buy these many at this time or at this price?  If that all changes it mucks up the whole works.

I take what I have and then if they are going to spend some cash do I think is it going to be a good thing or a bad thing (the company which is making acquisitions). And then I ask, “How much do I think they are going to earn on that?”  That is the way I take apart your question and try to attack it.

Quantify Growth Mathematically—Growth Matrix of New and Maturing Schools

Joel Greenblatt Columbia Class notes on special situations, this is part III. Please see part I and part II and the disclaimer there (also massive archive of videos and text here).

We will be posting many more articles throughout the week from Greenblatt’s class notes so make sure to check back at least daily or subscribe on Twitter, Facebook,  Google+, Linkedin,   RSS (or Feedly specifically),  or best of all sign up for our new and enhanced newsletter (make sure to select value investing and daily under the options).

Joel Greenblatt wrote one of the best books ever on investing (with one of the worst titles ever) You Can Be a Stock Market Genius (which focuses on special situations) and The Little Book That Beats the Market (on the magic formula); both are referenced extensively below. So if for some reason you have not read them make sure to check them out.

Joel Greenblatt Class #3

Sept. 21, 2006

Three objectives:

(1) I want to talk about value investing in general: why does it works, what are the characteristics that might make you believe there is value, and what makes them (the stocks or the companies) cheap.

(2) How do you actually analyze a business?  First generically—what makes a good business?  I will spend a little bit of time talking about the difference between a good business vs. a bad business.

(3) Then I will use an example, Lear Corporation (NYSE:LEA), as something that might be a value investment. We will try to understand whether it is or is not a value investment.

Feel free to interrupt with questions any time.

1. Let me start with value investing.

I assume you have all read the same things, the academic studies on value investing, They all say basically the same thing that if you do invest and you are sensitive to the price you pay relative to some metric of value like book value, sales, earnings, cash-flow, you tend to naively do well.  Fama & French studies show price relative to book value metrics outperforming an index as long as they have a pretty long period to work with.

Those studies are repeated over and over again.  In fact, I don’t believe you can find a single 20-year period of buying the lowest deciles P/E, P/S or P/Book stocks where you wouldn’t do better than buying an index. There are none. But over the long term it is a strategy that works.  I don’t have to use book value, the same thing works with sales, cash flow and earnings–any tangible metric of the size of the business. If you buy a stock at a low price relative to that metric, you outperform the market.  Note the large out-performance of the value metrics, however there are periods of underperformance (shaded areas).

So why doesn’t everyone just do it, if it is so simple?  That is the dilemma for me.  Even recently where you could study this data for decades.  In the late nineties, you had the rare ten-year period that showed that value investing didn’t work.  We were in a “new world”.  Now we are in another “mini-new” world thesis where we will be perpetually short of industrial commodities and energy and those prices will stay high forever.  Almost certainly that will end the same way (badly with price declines).  You never know when, but this is what happens in the world.  People love things; people hate things.

Now, if I were today to look at stocks that were the cheapest on the basis of price to book value, you would probably get a list that not one of you in this room would want to invest in. It would be the airlines, the auto manufacturers, and the insurance companies insured against hurricane losses.  It would be a list of companies that you would look at and pass on.

That is why psychotics make better investors (Inside Joke.  Joel Greenblatt placed a NY Times article on the board which had the headline, “Psychopaths make better investors.” before introducing Mr. Richard Pzena).

Because normal people look at this and read the newspaper and say that is crazy.  So value investing continues to work.

What really is the mechanism that is going on that creates the opportunity in value?  I want to lay out some data for you that demonstrate what goes on and what lies behind the efficacy of this strategy.

On this axis I will measure time and the other axis will be ROE.  If I divide the S&P 500 (INDEXSP:.INX) today into five quintiles based on ROE where the highest ones are in the top left hand corner dropping down in each quintile.

If I could trace out over time what would I see?  The companies with the highest profitability decline while the lowest rise–convergence to a mean.  You would find that (the mean reversion process) in any market cap, any market in the world, any geographic.  Any time period you use, it always looks like this.

I do not think it is very surprising.  If you have a company in the left-hand corner up here making lots and lots of money (high ROE), then competitors want to enter that business to make those profits as well.  So they try and over time they drive down returns.

Someone has a unique retail concept like Wal-Mart Stores, Inc. (NYSE:WMT) 25 years ago, or you execute it better than everybody else, then as you grow you start with the best locations and then you place new stores into less attractive locations.  You don’t know when to stop building Wal-Marts until the ROE begins to decline.  There is no formula as to how many to build.

On the opposite side, what do you think these people are doing?  They are not jumping off bridges; they are trying to fix things.   The low profitability (Low ROE—lower left corner of graph) could be caused by over-capacity in an industry so they take out capacity. The cost structure is too high, they change the cost structure; the sales force orientation is not working, so they change the sales force orientation; the product portfolio may not be working, so they change the product portfolio. Everybody not in the upper left quadrant (high ROE) is trying to get there and everyone down in the lower left quadrant (Low ROE) is trying to move up there. Most of them succeed.

What is interesting is that this data is not adjusted for survivorship bias.  This is including the ones that go out of business.  On average companies do not go out of business.  On average, poor companies do better and on average great companies that are doing wonderfully, don’t do as well.  That is why value investing works because the markets extrapolate the same trends of high ROE companies continuing with the same or higher ROE while low ROE companies have lower to same trends extrapolated into the future.  People just don’t get it (reversion to the mean) despite many years of evidence.

The people who are buying high growth companies are trying to pick the high growth companies that will not revert to the mean. Some will be great growth or high quality franchise-kind of investors, but you are betting against the odds when you do that. People investing with the low ROE companies with low expectations should be able to outperform the market.

From The New Finance: The Case Against the Efficient Markets, 2^nd Edition by Robert A Haugen, “Investors tend to mistakenly project a continuation of abnormal profit levels for long periods into the future.  Because of this, successful firms become overvalued.  Unsuccessful becomes undervalued.  Then as the process of competitive entry and exit drives performance to the mean faster than expected, investors in the formerly expensive stocks become disappointed with reported earnings and investors in the formerly cheap stocks are pleasantly surprised.”  Page 21.

All you have to do to better than mediocre is to say that you can make some judgment to eliminate the ones, which will go out of business.  It is just easier because you don’t do anything; just play the odds by buying low P/E or Price to Book.  And I will not do any research and over time history shows me that I will win.  Then you can try to be more creative by doing better than that, which is what we all spend our time trying to do.

The academic rational is very, very clear for value investing.  It is also clear for other types of investing like momentum investing where price trends tend to persist. There is evidence, which suggests businesses doing well, keep doing well.  This short-term data contradicts the other long-term data.  People who are momentum investors will be sitting on the edge of their chair trying to figure that out when to get out.  I think that is hard or harder, but it is valid method backed up by academic data. There is not a whole lot of academic data as you would see going through the Haugen book.

We are doing the opposite by buying companies having problems.  There is another book, What Works on Wall Street by Shaughnessy, which is a composite of trying any possible financial statistics and seeing if it worked. Things like buying high growth companies, but it didn’t have price in the variable. I would buy a great company, with great management, good growth rate and dominant market position and all of these characteristics that everyone wants in their portfolio.  It is the one thing where there is no academic evidence that it works.

The premise we use is of deep value investing because in the end all of these academic studies are using the cheapest quintile or the cheapest deciles of their universe.  They are not using what the index is using.  If you are familiar with the indexes that institutions use to evaluate money managers, the Russell Value Index and the Russell Growth Index which takes the 1000 largest companies and breaks them into: are they either value or are they growth and puts equal market caps in both.  And these consultants conclude that over time that they both do the same, so a smart strategy is to have your portfolio diversified into value and growth.  This is the premise of the advice given by lots of consulting firms to institutions.  One will work while the other doesn’t.

Of course, the Russell Value Index is not a value index. It is not a value index in the academic sense.  It is just a bunch of stocks that have some characteristics of value, but you are not capturing deep value or the academic version of value.  I am trying to distinguish here between a value approach that can buy companies that are low ROE companies and accept that they are not probably going to stay there (move to higher or improving ROE) and ignore the high ROE companies.

When I make a presentation to value investors or when I receive a call from my investors, the single most common question from them is: “Don’t you read the papers?”   Because if you did then how could you be buying…..didn’t you see that their earnings were terrible or they just lost a big account or their customers are bankrupt and on and on and on…..

That is why these things are cheap.  They are cheap for a reason.  The point that I am making is that you never, never find things that are cheap for no reason.  I hope to find one some day but it doesn’t happen.  You have to accept that you don’t get the best businesses with great management teams with high margins, with great growth rates and high market share selling at low prices. You don’t get those.  But good businesses can sell for low prices generally when one or more of those things listed above are missing. When there is some blood on the table.

A basis for contrarian investing: There is some evidence that suggests that markets do overreact to both good and bad news, especially in the long term, and that stocks that have done exceptionally well or badly in a period tend to reverse course in the following period, but only if the period is defined in terms of years rather then weeks or months (Source DeBondt & Thaler).

2. Businesses in General

Let us talk about businesses in general.

Student: What time horizon are you speaking about regarding the ROE change and decline for high ROE Companies?

Richard Pzena (RP): About five years.  On average their economics deteriorate while the low ROE companies improve.

If you can combine a company that has a low valuation and should have a sustainable edge, but may, in the present, may not be experiencing it for some–and it may be temporary–reason, then you have this unbelievably powerful combination.  If you can buy a good business at a low price, then you have nirvana.

Characteristics of good businesses

• High Barriers to Entry
• High Margins
• Good management
• Pricing Power

Low capital intensity–RP: but doesn’t a company with low cap intensity have low barriers to entry? (Sees Candy is a counter example).  I think capital is a barrier.  Would you pursue competing against Boeing with enough capital and find a good person to do that?  Is there a barrier to entry?  Clearly if no capital is required then there is easier entry.

Why is it that The Boeing Company (NYSE:BA) over time produces good profit margins but Sprint or Verizon Wireless doesn’t–they are both equally capital intensive?  Answer: High switching costs.  Concentration of the marketplace–wouldn’t you say an industry with two players vs. eight players has a higher chance for rational behavior?  (Boeing and Airbus make up the two major air plane manufacturers in the world, so the structure of the market is an oligopoly with more rational pricing and high barriers to entry).

Will JetBlue Airways Corporation (NASDAQ:JBLU) sustain its high profit margins?  Would you want to bet that?  Does jetBlue have a sustainable competitive advantage for the long term?  What is that?  Better quality of service.  How do you account for the fact that the (Airline) industry has been unbelievably unprofitable its entire life?  Last cycle Southwest Airlines Co. (NYSE:LUV) was the JetBlue. Now SWA is history.  How does JetBlue all of a sudden appear?  And if JetBlue can appear all of a sudden, why would you be confident that another JetBlue doesn’t all of a sudden appear? (The Airline Industry has easy entry with no incumbent competitive advantages).

JetBlue Airways Corporation (NASDAQ:JBLU) has a no barriers to entry model.  There may someday be barriers to entry unless there is a slot restricted type of markets.  JetBlue could go to an airplane leasing company so capital was not a barrier.  An airplane holds its value. If lease financing was not available and airplane values were highly erratic, then you might have a different outcome.

If one guy is standing out better than everyone else, I would be nervous.  jetBlue probably has a good business model given the industry.  Clearly, the history suggests the industry is a bad business.

What are some barriers to entry?

• High switching costs
• High capital costs
• Brands
• Lower operating costs (airline with 1 low cost fleet, by operating in a certain way, locks you in)
• Tobacco with its addicted customers

Value investing works because it doesn’t always work.  Just naively using value metrics would allow you to outperform the benchmarks.

Barriers to Entry

• Patented technology
• Government regulations  No advertising in chewing tobacco, so SKOL has an advantage
• Brands
• Customer captivity and Economies of Scale: An Airline with same models allows it to operate cheaper than competitors, which causes customer lock-in.

So we have a general view of what makes a good company….I think the important point comes in many forms.  It could be simple like physical location where you have a ten-year concession to sell trinkets at the Statue of Liberty.  You could have natural resources (low cost copper mine), low transport costs (A Rock Quarry) so physical assets and location could be one form of barrier to entry.

Another could be some form of competitive cost advantage like a mining company—a copper deposit that costs 10 cents to extract while everyone else is at 50 cents a pound, I would say that business is nicely protected.  It could be a patent or a technology—you have something that no one else has or will have.

The Coca-Cola Company (NYSE:KO) has a franchise—nobody spoke about franchises– where it has been built over decades which give Coke a competitive advantage of high barriers to entry.  Coke is associated with good things; it has mind share.

I would define a good business where you can identify specifically a reason why it should be able to earn an excess return on its cost of capital. It has to be a simple reason that you can clearly see.

The Auto Industry is the exact opposite where it is actually easy to see why it wouldn’t earn the cost of capital.  It is a commodity business, because it is a high fixed cost business where capacity is relatively fixed and the product has a cyclical sales cycle, so people kill each other because they can’t produce above their fixed costs.  You normally see it with their historical return on capital or ROE over time.  Look at the last 10 or 20 years of the company and say, “Is it (ROIC) high?  Is the ROE high?  If you do this analysis, any company that has been able to earn in excess of 10% to 12% on total capital employed after tax over time, you have to say to yourself, “OK, this looks like a good business.

Now can I identify why it is a good business?  I would say JetBlue Airways Corporation (NASDAQ:JBLU) is earning above its cost of capital and therefore is a good business, but do I understand why?  Yeah, I get it.  I think it is sustainable, then you have a good business.

If I can combine a cheap price with a good business, that is what I am trying to do.

One, I want to talk about: Is it a good business?  Then go through the characteristics of the company and ask if it is a good business or not?

Student: High ROIC, High ROE and you see it is sustainable—it looks like a good business.  How do you ascribe this to your earlier point of regression to the mean?

RP: Typically, good businesses where you are seeing that on a consistent basis, you rarely see them cheap, they are not good stocks to invest in.

What creates value?

What creates value? We talked about how value gets resolved—the bad stops being bad and things don’t stay good forever.   How does value get created? Value gets created for almost the same reason, because something went wrong and because there is deterioration. Something went wrong.

The pattern is almost always the same. If you have a company that is chugging along just fine and something falls off trend–that is what creates value.  The stock price, especially if the price is looking far out into the future for a continuation of earnings growth, the price will fall dramatically if the earnings fall off their trend.

The dilemma that every value investor faces: the academic studies also show that buying a stock in a business that is deteriorating is a bad idea because there is serial correlation in goodness and in badness—which is counter to the ROE example and argument.  Both of those phenomena are happening.  In the short term there is serial correlation and in the long run there is competitive pressure.   They both have an impact.  It is deterioration that creates value.

So if you buy a stock that is deteriorating, you are an idiot.  The problem is that if you wait for the earnings to turn or the catalysts or the revisions from Wall Street, then you will be too late and not get a cheap price.

Student: Would you have a preference for a good business or a low price?

RP: I would invest in only a cheap stock, but I would give credit for a good business to the extent that that good business justifies better earnings power.  For me the issue is price relative to the companies normalized earnings power. So if I had to pay up for The Coca-Cola Company (NYSE:KO) just to feel better because KO has a stable earnings base, I wouldn’t do it.  But if it translates into higher earnings than some other investment and I could quantify that my price is low relative to some future earnings power, then I will (invest).  I have never found KO to be cheap.

What you find is the business deteriorates and management tries to do something and then the business stabilizes at a lower level.  This is where I try to buy—in the trough of stabilization of the business. Most people are unwilling to buy it here because most people don’t know if it is going to go back up here.

You can speculate because it is a good business because of this, this and this but it isn’t going up right now.  But I am going to buy it because I know if it does go up, I am going to make a lot of money and if it doesn’t, I won’t lose a lot of money. There is a better risk/reward trade-off.

Value is created by deterioration. The price drop relates to the deterioration while the value captured is associated with price reverting back to trend or the mean.  You have to accept further price declines when you buy while the business continues deteriorating, and if you wait, you will pay up while recovering and miss a good opportunity.  Once you can see a catalyst, you are late and you are playing partial momentum here.

SUMMARY

You have better odds in the value camp, because you are playing in a better field.  So if I was mediocre, I would beat the market.

But to be great one must distinguish–what this tells you (lowest quintile) is that those companies are experiencing problems; some are experiencing temporary problems.  The way you can add value is to distinguish between temporary and permanent problems.  Getting a good business at a good price is nirvana.  A low price will be associated with problems surrounding the company and its business.

3. LEAR CORPORATION

What does Lear Corporation (NYSE:LEA) do?   They are a supplier of parts to the auto manufacturers.  They make seats.

Is this a good business?  It doesn’t look like a good business?  Why?   They make a commodity—seats and auto parts?

Characteristics of long-term vs. current environment.

Too much capacity is a bad thing, but rationalization of capacity is a good thing.

Let us go back and review which of these characteristics are characteristics of the company and the markets in which they compete in long term and which of these are typical of the current market.

When I am asking about what makes a good business vs. what makes a bad business, I am not talking about current conditions.

Toyota outsource seat supplies so why couldn’t Lear Corporation (NYSE:LEA) supply in the future?

Europe is 65% outsourced while the US is 90% outsourced.  Lear has a flexible, low cost model.  Though Lear has a union work force, they can lay off workers and close down plants.

The auto manufacturer (Ford or GM) puts investment into a model, which will either do well or not.  The cyclicality will average out over time.  Lear Corporation (NYSE:LEA) is in a different fixed cost position than the auto manufacturer.  You can say that is bad because of their concentrated customer base.

Questions:

I think we are mixed about whether this is a good or bad business.

The business has thin margins and a high return on invested capital.  There are low working capital requirements and equipment needed.  Just in time inventory–the time they get the order before the seat is delivered to the auto plant is three hours.   Conflicting signals: thin margins but high ROITC.  How?  Low capital requirements.  This is a bunch of guys in a warehouse throwing things together.  

There are a lot of assets on the balance sheet–goodwill–so when you see their return on capital it is not as good as shown.  We are using tangible capital not including goodwill.

Remember my definition: If the business has a ROC greater than its cost of capital, it is an indication that it is a good business.  Now we have to ask, “Is it luck; is it sustainable? Why is that?”

It is really rare to find that kind of capital return.  If you are generating 30% returns after tax, then you can pay down debt rapidly because of slow growth absent acquisitions.  How do they achieve this?

There are high barriers to entry which are high market share.  They are sole source suppliers on every one of their supply contracts.  Now their customers have the contracts bid out, but there are only one or two competing bids.  Johnson Controls Inc (NYSE:JCI) is their only other major competitor.  Johnson Controls probably has a similar cost structure to Lear Corporation (NYSE:LEA) and would bid rationally.

There have been two sources of growth in this business over the last twenty years (in the industry): 1.) More complex seats with customer controls, etc. or content per vehicle is going up.  Increasing seat content due to two sources: the seats are getting fancier and the cars are getting bigger.  2.) There is more outsourcing.

There has been growth, but still nobody has entered their business.  Why? Customers are locked-in. A customer is likely to say, should I risk a new supplier if there is a chance that they can’t deliver?  The risk for hurting a customers’ processes is too great too risk. The structure of the market is that you bid on the contract for the life of the model, so incremental business comes up rarely.  Another competitor is unlikely to take market share.

What is the ROITC in 2005?  I think they will lose money this year.  Certainly they are running on a negative rate of return so far as of end June 2005.

There are two possibilities:

1.) This really is a crappy business and now we should accept it or

2.) We have a temporary problem going on. We don’t understandwhat it is.

What is causing these problems?

High raw material costs with fixed price contracts–a temporary problem.  Once the contract is over, there is another negotiation.  How does the pricing mechanism work?  Did anyone read up on that?General Motors Company (NYSE:GM)’s only choice is to squeeze suppliers (the Bear Argument).

Ask the guy who is running this business what he will do.  Now, let’s be analysts, and ask.  If you were in charge of Lear Corporation (NYSE:LEA), what would you do? 

Lear Corporation (NYSE:LEA)’s reply, “Our Number One Strategy: Grow our business with others who are not in such bad shape.”

Let me ask a question….did anybody look at the competitor?  Johnson’s Controls earnings went down by the magnitude of their business to General Motors Company (NYSE:GM), which was not nearly the decline in Lear‘s business.  Why?

Lear and Johnson did not contract on the same basis.  Lear Corporation (NYSE:LEA) contracted on a company by company basis while Johnson Controls Inc (NYSE:JCI) contracted on a model by model basis.  So Lear didn’t care if they made money on any particular model.  So when GM said, “You are making all this money on our SUVs, can you give us a break on car seats over here so we don’t show huge losses every time we sell a car.  Lear is happy if the whole contract is profitable, but when SUV sales collapse, then there is a problem.

What does the guy at Lear Corporation (NYSE:LEA) do? 

Let us say you are selling a seat for $500, which costs $600 to make, so you are losing $100, and you are selling a SUV seat for $1,000 that costs you $800 to make so you are netting $200.  This is what Lear was doing.  So what does Lear do?

“Excuse me, but we have to raise prices on this because we are losing money.”   They bring the numbers to GM and ask to raise the price.  They have price adjustment clauses in all the contracts.  That as always meant in the past, General Motors Company (NYSE:GM) saying we need 5% lower prices this year.  Lear Corporation (NYSE:LEA) would say, OK, here is what a 5% lower-priced seat looks like.  Lear gives GM a different seat–1/2 leather and 1/2 plastic.

Will Lear be successful in their renegotiation?  You have no idea.   Look how much steel and plastic costs are, so we pass on the costs to you.  GM says, “You are killing me; you make me break my prices.  I need a break.”  How will it be resolved?

Let us switch gears and jump away from what is going to happen now. 

I want you to forecast what the earnings will be five years from now.  Let’s say the average contract is four years, the average model life is four years.  I want to forecast the earnings of this company.

1. Auto production of 1% increase of top-line growth in the industry.  $16.5 million to $17 million in sales as a starting point.  Cars/unit mix skewed.

2. Market share for market

3. Content per vehicle.  Big Three/Others market share:    65%/35%   55%/45%     60%/40%    55%/25%

Volume will stay the same at 1% growth.  Unit sales will be flat.  Content per vehicle is 5% now, so above trend.   I would argue we scale back the 5% to 2%.  What about profit margins compared to the average of the past two years’ margins?  We will keep at 5% to 5.5%.

$17 billion in sales times 5.3% net margin = $900 million minus $170 million interest expense = $730 million times (1 – 33% tax rate) = $490 million  then divided by 67 million outstanding shares = $7.30 per share.  At today’s $33 share price with EPS of $7/share = less than 5 times earnings.

Now let’s dig down into this.  15% of their business is bad.  The interior products business is selling a commodity-like product, competing against Asian manufacturers.  What do we do about this division?  Shut it down.  8-K came out today where management describes the business:

From 8-K Filed on Sept. 19^th, 2005

Section 2 – Financial Information item 2.06 Material Impairments

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” Lear Corporation (NYSE:LEA) (“Lear” or the “Company”) periodically evaluates the carrying value of its goodwill for indicators of impairment. SFAS No. 142 requires the Company to evaluate the carrying value of its goodwill for potential impairment on an annual basis or on an interim basis if there are indicators of potential impairment.

As previously disclosed, in conjunction with Lear’s restructuring program, the Company is continuing to evaluate strategic alternatives with respect to its Interior segment. This segment continues to experience unfavorable operating results, primarily as a result of higher raw material costs, lower production volumes on key platforms, industry overcapacity, insufficient customer pricing and changes in certain customers’ sourcing strategies. Based on the foregoing, Lear Corporation (NYSE:LEA) concluded on September 19, 2005, that the Interior segment’s goodwill has been materially impaired. At this time, Lear is unable to make a good-faith estimate of the amount or range of amounts of the impairment charge. Such impairment charge will not result in future cash expenditures. Lear will file an amended report on Form 8-K pursuant to this Item 2.06 within four business days after it makes an estimate of such amount or range of amounts. Further, an estimate of the goodwill impairment charge will be recorded in accordance with SFAS No. 142 in the Company’s third quarter 2005 financial results.

I read that as no value.  The Interior Segment should have no value ascribed to it.

We knock 15% off of our earnings forecast. $7.30 knocked down to $6.00.  

Let’s not forget what happens with no growth and 67 million shares.  How many shares outstanding you suppose they will have in five years?  (What do they do with their FCF?).  So $400 million FCF per year or $2 billion after 5 years, then at $33 per share, there is more than enough to buy back the whole company. However, we assume that Lear Corporation (NYSE:LEA) will have $400 mm in FCF next year.  It is better to assume $0 going to $400 mm the next year.  Lear will either pay down debt and lower interest expense to raise earnings or buy back stock and that will raise earnings. If Lear takes two years to reach normalized margins and operating income then let us assume at the end of five years, it has $1 billion to buy back shares (over 30 million shares at $33 per share) or to pay down debt.

Conservative Assumptions

So even with these very conservative assumptions:

No top line growth, average margins, and getting out of the crappy businesses, which by the way probably depressed the margins in the good business so closing that down will raise the average margin going forward. It looks like there will be a lot of earnings.  You have a margin of error here and a good risk & reward.

Management thinks that that they will be making $3.5 per share next year if you ask them.  And what do they know.  They know the status of negotiations with General Motors Company (NYSE:GM) & Ford Motor Company (NYSE:F) and you don’t.  It doesn’t mean that they are the most credible and reliable people in the world but that is what they are saying.

Lear Corporation (NYSE:LEA) could miss earnings this year and next year and you take a bet that steel prices go down.  I have no clue about trading strategy, but I won’t bet that steel prices keep going up.

Lear has $6 earnings power.  $33/6 = 5.5xs about 5^th least expensive in our stock ranking universe.  We rank each company to its earnings power so it is at a 5 P/E vs. 14 P/E for the market.  Fair value is $6 in normalized earnings times 14 P/E equals $84.  It is a big number.  If it took five years to triple your money would you be willing to wait?  I don’t think it is five years.  I wouldn’t sell it unless it ran tomorrow from $33 to $75.  I do think it is one of the cheapest stocks out there, for good reasons.

I never forecast problems.  I say if there is trouble now, I might wait.  Lear Corporation (NYSE:LEA) is renegotiating its contract, it is going to be better.  Always things are going on.   Their margins have to be higher barring a major world catastrophe.  The fundamentals are not deteriorating.  If things get better, the stock will rise a lot, but if conditions don’t improve, then you won’t lose much.

Even if  General Motors Company (NYSE:GM) & Ford Motor Company (NYSE:F) go bankrupt, they will still make cars.  Interest rates go up causing a consumer recession could hurt.  Auto suppliers as proof.  Delphi/Visteon sell little parts–a lot of competition with no barriers to entry.  Big parts like car seats are difficult to import and have barriers to entry.  There are big parts and there are small parts–two different businesses. 

Our screen for Lear:

Our growth rate for Lear Corporation (NYSE:LEA) was 13% because of past acquisitions and then the computer takes the industry growth rate and averages it (13% + 8%)/2.  We have $12 per share in earnings.

There are two reasons for making the margins higher:

1. Closing down the crappy business but sales will go down with it.
2. The European market is not as good as the US market and that will get better structurally in the future.

They are tied to a company, General Motors Company (NYSE:GM) that is losing share.

$1 billion in debt coming due in three years. 

Johnson Controls Inc (NYSE:JCI) bought York—scary!

What is the top feature of seats for commuters–comfortable seats.

The top feature for SUV customers–power seats.

Once you have a large cap company over $1 billion in market cap, the possibility of growth at high rates is very low.

I think the earnings power for Lear Corporation (NYSE:LEA) will rebound rather quickly.

Johnson Controls Inc (NYSE:JCI) overpaid for York.  It is cheap too on the scale of the market as a whole.

Joel Greenblatt Columbia Class notes on special situations, this is part III. Please see part I and part II and part III and part IV the disclaimer there (also massive archive of videos and text here). 

We will be posting many more articles throughout the week from Greenblatt’s class notes so make sure to check back at least daily or subscribe on Twitter, Facebook,  Google+, Linkedin,   RSS (or Feedly specifically),  or best of all sign up for our new and enhanced newsletter (make sure to select value investing and daily under the options).

Joel Greenblatt wrote one of the best books ever on investing (with one of the worst titles ever) You Can Be a Stock Market Genius (which focuses on special situations) and The Little Book That Beats the Market (on the magic formula); both are referenced extensively below. So if for some reason you have not read them make sure to check them out.

Joel Greenblatt Class #8

November 08, 2005

Hopefully you will read the Magic Formula book for next Class

Linda Greenblatt Presentation on investing in retail stocks.

Joel Greenblatt (“JG”): Before she speaks, just to give you a context, Linda sticks to one area: consumer products and retail.  She has been in that area for 10 years and has averaged high 20’s percent returns staying in that little niche that she knows well.  She finds enough opportunities in that one area.  Her returns have been no more volatile than other concentrated investors.  She has phenomenal returns focusing on what she knows.  There is a great lesson for you.  It doesn’t have to be retail but an industry that you understand.  She picked something she really enjoys–that is a very important lesson.

A number of people have come up to me before class and said they will join a big firm and they are afraid they will be pigeon holed.   That may be true but to really learn an area very well and still be very profitable.  As you invest over a long period of time you will come to know more areas.  Knowing one area well is tremendous.

I like retail because you are constantly getting information.  You get it on a monthly basis and sometimes on a weekly basis.  Retailers put out same store sales numbers-Comparable sales in stores for a year-over-year period.   Monthly basis but most industry groups you normally get quarterly numbers.   The more information you have, the more people try to trade on the information before, after and during.  You get a tremendous volatility in this sector.  A lot of people don’t like volatility. As far as I am concerned, I can live with volatility if there is a good opportunity over the long term.  And if I am taking a two years time horizon that is actually my greatest opportunity–are these monthly numbers.

Inevitably these companies are going to miss because of their fault or no fault of their own due to the macro environment. There will be a missed number and the market tends to have no mercy.  So the market kills these stocks.  One day it is trading at 20 times and the next day it is trading 10 times (earnings) but nothing has fundamentally has changed. That fundamentally is your opportunity.  So you must live with a little bit the anxiety.  Believe me when these stocks are down 30% to 40% it is hard to pull the trigger, but that is usually the best time to buy.  Volatility is your friend.

I don’t know how to pick the next trend.  I really don’t know fashion.   I say this: nobody can predict fashion. It is really is not about hitting the next trend on a continuous basis.  Are these companies running a good business over the long-term?  Are they running a business that can weather the ups and downs?

The best time to get in is when they missed a season of merchandise because if you look at the fundamentals of the company and it is well-run and the stock gets crushed because they miss a season of merchandise, then it is an opportunity to own for the long term. It is really irrelevant if they pick the hot trends or not.

It is very interesting because the Street misses the point on retail.  Most analyst reports focus on how this company will do in Oct?  How will this company be affected by Katrina or higher heating prices for Christmas?  These are all relevant questions, but not relevant if this is a good business.  Fundamentally it will be around. If you buy it at the right price it really doesn’t matter what is happening to the customer today because they will be around and they will continue to buy.

A quote from Fortune last year from a Hedge Fund manager who often invests in retail, “I have my people visit stores to see how much the items are marked down or if there are long lines at the register and I buy if this company will beat numbers and short it if it misses numbers.  It is that simple.

He really misses the point.  It is not that simple. If I had to invest that way, I would lose sleep over whether I could consistently do that.  Maybe I would get it right only 50% of the time.  I would have a lot of anxiety in between. If you can take a longer time horizon for one to two years.  You have to buy these things when people hate it because that, obviously, is when your opportunities are available. So you have to be a contrarian.

Can you see my slide:  This is a price chart of AEOS, American Outfitters.

Joel Greenblatt Columbia Class notes on special situations, this is part III. Please see part I and part II and part III and part IV and part V the disclaimer there (also massive archive of videos and text here). 

We will be posting many more articles throughout the week from Greenblatt’s class notes so make sure to check back at least daily or subscribe on Twitter, Facebook,  Google+, Linkedin,   RSS (or Feedly specifically),  or best of all sign up for our new and enhanced newsletter (make sure to select value investing and daily under the options).

Joel Greenblatt wrote one of the best books ever on investing (with one of the worst titles ever) You Can Be a Stock Market Genius (which focuses on special situations) and The Little Book That Beats the Market (on the magic formula); both are referenced extensively below. So if for some reason you have not read them make sure to check them out.

Joel Greenblatt Class #9

November 16, 2005

Skip Benewitz (SP) from Kirkwood Capital is here to ask you questions about your presentations.

Your assignment is to read my book (“The Little Book That Beats the Market ”) for next class.

The exam will be a test of your valuation skills.  The one thing about the final is that I generally keep them so when someone asks me about you; I can see the results of your exam.

Student presentations

Student Presentation on Timberland (TBL):

Students: A $2 billion Mkt. Cap Company manufacturing and selling active wear and footwear.   7.7 EV/EBIT and 59% ROIC.

Joel Greenblatt (JG): Did you use EBITA minus MCX for your proxy for EBIT?

Student: We see it cheap for a number of reasons: Negative sentiment. Miscues in product rollouts

We believe there is a 25% upside today and 50% in two years.   On a net basis for 24% and if you hold it more than two years you have a 50% return.

Take the current multiple ….

They have no debt and strong cash flow.  They have profitable investment opportunities.  They are growing.  Every dollar they put back into the business, they earn 40% on capital.

The management team is solid.  They are fully vested.  They have announced a stock buy back.  How many shares outstanding?  $68 million.    Shareholder friendly management.    Corporate responsibility is good.  Human rights are one of their concerns.

Risks: Not getting the fashion trends right.  Risk is mostly in the US business.

Calculating Enterprise Value (EV): Timberland has no debt and $100 million in cash.

Calculating Excess Cash for Enterprise Value (EV)

JG: One of the points that always come out is do you subtract (all) cash?  The answer is no; you subtract “excess” cash (cash that is not needed to run their business on a yearly basis).  You have to decide whether any of that cash is needed.  Negative working capital businesses (like McDonald’s Restaurants where customers pay cash or credit card while payables are 30//60/90 days) usually have the total amount of excess cash on the balance sheet excepting, of course, for petty cash in the registers.

Remember that retailers need to keep cash in their registers all the time, so do not subtract the full amount of cash on the balance sheet.

Competitors: Wolverine.

They have a loyal following of customers—construction workers.

The multiples and the margins—we took them down from where they have been.   There peer group is trading at 11x EV/EBIT.  This is trading at 10 x EV/EBIT.   50% return if you hold it for two years and you get 10x EV/EBIT on an exit or sale.

JG: How about on an absolute basis?  How do you justify that?

Students: This is a great company over a long period of time.

JG: Did you factor in how much room they have to expand—grow their store base?  How much more expansion do they have?

10x pre-tax (EV/EBIT)?  Usually I would take off 40% for taxes so you would have a 6% return (10% – 4%).   If the tax rate is lower due to overseas operations, sometimes they can’t repatriate the money.  Ask why that tax rate is lower or if that tax rate is sustainable?

Student: Timberland is growing abroad so we do not see repatriation as an issue.  We also discounted back two years in our valuation.

Analyst: How does the business break out between domestic and international operations regarding operation margins?  What are international competitors doing? Since you say their international division is growing 20% to 22% overseas.

How much of their business comes from the work boot area versus their entire sales because you said their strong margins are due to their strong customer loyalty in foot wear.

Student: Timberland messed up on apparel in the US so earnings for 2006 are depressed (temporarily we believe).   EBIT margin of 2005 is 11%.

Analyst: Did you break out their licensing revenue from other revenue?  Licensing revenue is very high margin revenue.

Student: No, but it is very small.

Footlocker, Inc. (FL).

There are three main reason to buy FL as it sits at $20 with our price target of $26 which is a 35% upside.

Three (3) main reasons to buy FL:

Increase in operating margins.   The management is shutting down over-size big store concepts in early 2000 and improving their operating margins.   15% average over the last 4 years and mgt. stated a target of 10% with it currently at 7.4%. Op. margins.

Domestic growth is uncontested in Footwear for teens.  Growth in mall space across the US.

They have Strong portfolio of business with different footlocker products and Chance with an 11% EBIT margin.

Valuation:

Average store size 300 square feet.  Year-by-year growth in sq. footage.  CAGR is 2.5% over the last five years. Sales per Sq. Ft. is $529.

JG: They have been closing some of their stores and that will stop, so using net square footage number may be misleading.  So I would look inside that number to see what was the growth of the smaller stores ex-the closing of the big-store concept.

What you said is that they are closing the big store concept while their square footage is growing 2.5% per year.   Look at growth with just the small store concept.  Break out the concepts!

EBIT margin for whole company is 10%.  $50 million in EBIT.  Using a 7% EBIT margin you get $350 in EBIT to be conservative.   The best case is 10% margin.  We do think there will be competition from Finish Line.   We put an 8 multiple on that since the business is not growing.  Then you add $400 million for the online business and build up of cash.

Analyst: Pension (debt) in regards to Enterprise Value?  (Did you adjust the Pension liabilities if needed and add to your EV?)

Student: We did a standard EV/EBIT analysis.  We expect per share appreciation of 27% for the base case.

JG: Did you break out the domestic and international divisions?  They have different margins and margin opportunities.  The market went way down in Europe (margins collapsed from 18% to 10%).  Their margins used to be 18% so the question is do they normalize at 10% or higher. But if Linda (Greenblatt) were here she would probably say the margins probably normalize around 12% margins that would be her best guess.

I think you have the big picture, and you did a nice job with not much time.  I am trying to point out what I would do.

The more you can break it (the Company) apart the better.  In some businesses the different parts feed on each other.  But in FL there is enough disparity in the growth opportunities, the margins and the competitive landscape in Europe vs. the US where you need to pick apart the different businesses separately.   There is extreme margin contraction from 18% to 10%.  There is a lot of room there.  The question is where it lands.

Management believes that their margins can be double digits. I am trying to bring up issues as how I would approach it.  Their competitive position is very strong since their nearest competitor is five times smaller?

Student: Yes, it is.

Analyst: This applies to both presentations–operating margins are the value investors’ growth number. The scariest thing to get into earnings is that you feel the urge to go to a reversion to the mean thesis or management estimate thesis like FL.  Often those are the best answers you can come to, but the best you can do in all cases is to try to get as bottom up to that number as you can.  Do what Joel suggested which is to separate the businesses.   You did that with operating leases and how they made progress at FL.

Student: How do you treat operating leases?

Analyst: In most cases it doesn’t matter.   In some cases where rent is different than market rates, it can matter so you have to adjust for market rates to figure out normalized.

Pensions. The most important time to add pension debt to the EV is when the company is not funding expense through the income statement.  Say you have $300 million in pension assets and you are really paying $30 million a year into that pension for employees that are already retired and those that are in service. Sometimes pensions get screwed up because it is done on a lagged smoothed basis.  So you must make sure you add back the pension debt on an adjusted present value basis if it is under funded.

JG: If management is using an unrealistic assumption of 9% returns for their pension plan but you think the returns should be 5% or 7%, then I would adjust the pension liability and use your adjusted number.

Claire Stores:

Students: A mall based Store.   $2.71 billion market cap. They have 2800 stores.  The stock is $27 and we get to a valuation of $27 to $34 depending upon your assumptions going out five years.

We use a 22% margin for the US and international is 17% margin in EBIT so we used

JG: What type of growth do you use for them?  Is there inflation growth?

Students: We use 5% annual growth.

JG: Why are they not growing now?  So you are assuming mature growth in five to ten years?  What did you do with the cash?

Students: We built up cash of $7 per share.

Students:  Their (gross?) margins are 55%.

JG: Why are their margins so high—they can source their goods very cheaply?

Students: They have an efficient operating model.

JG: Buy one; steal one—a store that had small, cheap jewelry for teenagers.

Analyst: What are their ROIC in their stores?  You gave it a low multiple of 12, but this company has profitable growth—perhaps it deserves a higher multiple—especially where the market is currently trading at.

Students: 27%.

Cross Checking Your Multiple

JG: Did you do a discounted cash flow analysis to determine an appropriate multiple?

Student: No we did not.

JG:   A DCF analysis would help you determine a proper multiple as a cross check.  A 5% growth in perpetuity will blow out most growth models and gets you a very high multiple.   So the question is what happens at 3% or 5% growth in perpetuity?  It might be interesting to have a matrix of various growth rates to judge the multiple.  What multiple theoretically is 5% growth in perpetuity?  Where does your 12 multiple fit into that?

You figured a 15x multiple (6.6% yield) after tax was a reasonable price for Claire Stores.   I say use a minimum 6% hurdle rate. At best what we will get out of here is that it is a great business, it won’t lose much money and at some point it will get a higher multiple.   You are probably being too conservative which is OK because you are trying to buy it at a huge discount.

Joel Greenblatt Columbia Class notes on special situations. Please see part I, part II, part III, part IV,  part V  and Part VI the disclaimer there (also massive archive of videos and text here). 

We will be posting many more articles throughout the week from Greenblatt’s class notes so make sure to check back at least daily or subscribe on Twitter, Facebook,  Google+, Linkedin,   RSS (or Feedly specifically),  or best of all sign up for our new and enhanced newsletter (make sure to select value investing and daily under the options).

APPENDICES:

1. Buffett Writing on ROIC
2. Magic Formula Slide Presentation by Joel Greenblatt
3. Article on Joel Greenblatt

Goodwill and its Amortization: The Rules and The Realities (BERKSHIRE’S 1983 Annual Report)

(Discussion of using tangible return on capital as a judge of businesses)

Book Value vs. Intrinsic Value

We report our progress in terms of book value because in our case (though not, by any means, in all cases) it is a conservative but reasonably adequate proxy for growth in intrinsic business value - the measurement that really counts.  Book value’s virtue as a score-keeping measure is that it is easy to calculate and doesn’t involve the subjective (but important) judgments employed in calculation of intrinsic business value.  It is important to understand, however, that the two terms - book value and intrinsic business value - have very different meanings.

Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings.  Intrinsic business value is an economic concept, estimating future cash output discounted to present value.  Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

An analogy will suggest the difference.  Assume you spend identical amounts putting each of two children through college.  The book value (measured by financial input) of each child’s education would be the same.  But the present value of the future payoff (the intrinsic business value) might vary enormously -

from zero to many times the cost of the education.  So, also, do businesses having equal financial input end up with wide variations in value?

At Berkshire, at the beginning of fiscal 1965 when the present management took over, the $19.46 per share book value considerably overstated intrinsic business value.  All of that book value consisted of textile assets that could not earn, on average, anything close to an appropriate rate of return.  In the terms of our analogy, the investment in textile assets resembled investment in a largely-wasted education.

Now, however, our intrinsic business value considerably exceeds book value.  There are two major reasons:

(1)     Standard accounting principles require that common stocks held by our insurance subsidiaries be

       stated on our books at market value, but that other stocks we own be carried at the lower of

       aggregate cost or market.  At the end of 1983, the market value of this latter group exceeded

       carrying value by $70 million pre-tax or about $50 million after tax.  This excess belongs in our

       intrinsic business value, but is not included in the calculation of book value;

(2)     More important, we own several businesses that possess economic Goodwill (which is properly

        includable in intrinsic business value) far larger than the accounting Goodwill that is carried on our

        balance sheet and reflected in book value.

Goodwill, both economic and accounting, is an arcane subject and requires more explanation than is appropriate here.  The appendix that follows this letter - “Goodwill and its Amortization: The Rules and The Realities” - explains why economic and accounting Goodwill can, and usually do, differ enormously.

You can live a full and rewarding life without ever thinking about Goodwill and its amortization.  But students of investment and management should understand the nuances of the subject.  My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill.  This bias caused me to make many important business mistakes of omission, although relatively few of commission.

Keynes identified my problem: “The difficulty lies not in the new ideas but in escaping from the old ones.” My escape was long delayed, in part because most of what I had been taught by the same teacher had been (and continues to be) so extraordinarily valuable.  Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring Goodwill and

that utilize a minimum of tangible assets.

Goodwill and its Amortization: The Rules and The Realities

This appendix deals only with economic and accounting Goodwill – not the goodwill of everyday usage. For example, a business may be well liked, even loved, by most of its customers but possess no economic goodwill. (AT&T, before the breakup, was generally well thought of, but possessed not a dime of economic Goodwill.) And, regrettably, a business may be disliked by its customers but possess substantial, and growing, economic Goodwill. So, just for the moment, forget emotions and focus only on economics and accounting.

When a business is purchased, accounting principles require that the purchase price first be assigned to the fair value of the identifiable assets that are acquired. Frequently the sum of the fair values put on the assets (after the deduction of liabilities) is less than the total purchase price of the business. In that case, the difference is assigned to an asset account entitled “excess of cost over equity in net assets acquired”. To avoid constant repetition of this mouthful, we will substitute “Goodwill”.

Accounting Goodwill arising from businesses purchased before November 1970 has a special standing. Except under rare circumstances, it can remain an asset on the balance sheet as long as the business bought is retained. That means no amortization charges to gradually extinguish that asset need be made against earnings.

The case is different, however, with purchases made from November 1970 on. When these create Goodwill, it must be amortized over not more than 40 years through charges – of equal amount in every year – to the earnings account. Since 40 years is the maximum period allowed, 40 years is what managements (including us) usually elect. This annual charge to earnings is not allowed as a tax deduction and, thus, has an effect on after-tax income that is roughly double that of most other expenses.

That’s how accounting Goodwill works. To see how it differs from economic reality, let’s look at an example close at hand. We’ll round some figures, and greatly oversimplify, to make the example easier to follow. We’ll also mention some implications for investors and managers.

Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about $8 million of net tangible assets. (Throughout this discussion, accounts receivable will be classified as tangible assets, a definition proper for business analysis.) This level of tangible assets was adequate to conduct the business without use of debt, except for short periods seasonally. See’s was earning about $2 million after tax at the time, and such earnings seemed conservatively representative of future earning power in constant 1972 dollars.

Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.

In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.

Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry.

Let’s return to the accounting in the See’s example. Blue Chip’s purchase of See’s at $17 million over net tangible assets required that a Goodwill account of this amount be established as an asset on Blue Chip’s books and that $425,000 be charged to income annually for 40 years to amortize that asset. By 1983, after 11 years of such charges, the $17 million had been reduced to about $12.5 million. Berkshire, meanwhile, owned 60% of Blue Chip and, therefore, also 60% of See’s. This ownership meant that Berkshire’s balance sheet reflected 60% of See’s Goodwill, or about $7.5 million.

In 1983 Berkshire acquired the rest of Blue Chip in a merger that required purchase accounting as contrasted to the “pooling” treatment allowed for some mergers. Under purchase accounting, the “fair value” of the shares we gave to (or “paid”) Blue Chip holders had to be spread over the net assets acquired from Blue Chip. This “fair value” was measured, as it almost always is when public companies use their shares to make acquisitions, by the market value of the shares given up.

The assets “purchased” consisted of 40% of everything owned by Blue Chip (as noted, Berkshire already owned the other 60%). What Berkshire “paid” was more than the net identifiable assets we received by $51.7 million, and was assigned to two pieces of Goodwill: $28.4 million to See’s and $23.3 million to Buffalo Evening News?

After the merger, therefore, Berkshire was left with a Goodwill asset for See’s that had two components: the $7.5 million remaining from the 1971 purchase, and $28.4 million newly created by the 40% “purchased” in 1983. Our amortization charge now will be about $1.0 million for the next 28 years, and $.7 million for the following 12 years, 2002 through 2013.

In other words, different purchase dates and prices have given us vastly different asset values and amortization charges for two pieces of the same asset. (We repeat our usual disclaimer: we have no better accounting system to suggest. The problems to be dealt with are mind boggling and require arbitrary rules.)

But what are the economic realities? One reality is that the amortization charges that have been deducted as costs in the earnings statement each year since acquisition of See’s were not true economic costs. We know that because See’s last year earned $13 million after taxes on about $20 million of net tangible assets – a performance indicating the existence of economic Goodwill far larger than the total original cost of our accounting Goodwill. In other words, while accounting Goodwill regularly decreased from the moment of purchase, economic Goodwill increased in irregular but very substantial fashion.

Another reality is that annual amortization charges in the future will not correspond to economic costs. It is possible, of course, that See’s economic Goodwill will disappear. But it won’t shrink in even decrements or anything remotely resembling them. What is more likely is that the Goodwill will increase – in current, if not in constant, dollars – because of inflation.

That probability exists because true economic Goodwill tends to rise in nominal value proportionally with inflation. To illustrate how this works, let’s contrast a See’s kind of business with a more mundane business. When we purchased See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets (25% ROIC). Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic Goodwill.

A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast, we paid $25 million for See’s, even though it had no more in earnings and less than half as much in “honest-to-God” assets. Could less really have been more, as our purchase price implied? The answer is “yes” – even if both businesses were expected to have flat unit volume – as long as you anticipated, as we did in 1972, a world of continuous inflation.

To understand why, imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.

But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.

Remember, however, that See’s had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large – a need for $18 million of additional capital.

After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)

See’s, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.

Remember, even so, that the owners of the See’s kind of business were forced by inflation to ante up $8 million in additional capital just to stay even in real profits. Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets (“In Goods We Trust”). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment – yet its franchises have endured. During inflation, Goodwill is the gift that keeps giving.

But that statement applies, naturally, only to true economic Goodwill. Spurious accounting Goodwill – and there is plenty of it around – is another matter. When an overexcited management purchases a business at a silly price, the same accounting niceties described earlier are observed. Because it can’t go anywhere else, the silliness ends up in the Goodwill account. Considering the lack of managerial discipline that created the account, under such circumstances it might better be labeled “No-Will”. Whatever the term, the 40-year ritual typically is observed and the adrenalin so capitalized remains on the books as an “asset” just as if the acquisition had been a sensible one.

* * * * *

If you cling to any belief that accounting treatment of Goodwill is the best measure of economic reality, I suggest one final item to ponder.

Assume a company with $20 per share of net worth, all tangible assets. Further assume the company has internally developed some magnificent consumer franchise, or that it was fortunate enough to obtain some important television stations by original FCC grant. Therefore, it earns a great deal on tangible assets, say $5 per share, or 25%.

With such economics, it might sell for $100 per share or more, and it might well also bring that price in a negotiated sale of the entire business.

Assume an investor buys the stock at $100 per share, paying in effect $80 per share for Goodwill (just as would a corporate purchaser buying the whole company). Should the investor impute a $2 per share amortization charge annually ($80 divided by 40 years) to calculate “true” earnings per share? And, if so, should the new “true” earnings of $3 per share cause him to rethink his purchase price?

* * * * *

We believe managers and investors alike should view intangible assets from two perspectives:

1. In analysis of operating results – that is, in evaluating the underlying economics of a business unit – amortization charges should be ignored. What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic attractiveness of the operation. It is also the best guide to the current value of the operation’s economic Goodwill.

2. In evaluating the wisdom of business acquisitions, amortization charges should be ignored also. They should be deducted neither from earnings nor from the cost of the business. This means forever viewing purchased Goodwill at its full cost, before any amortization. Furthermore, cost should be defined as including the full intrinsic business value – not just the recorded accounting value – of all consideration given, irrespective of market prices of the securities involved at the time of merger and irrespective of whether pooling treatment was allowed. For example, what we truly paid in the Blue Chip merger for 40% of the Goodwill of See’s and the News was considerably more than the $51.7 million entered on our books. This disparity exists because the market value of the Berkshire shares given up in the merger was less than their intrinsic business value, which is the value that defines the true cost to us.

Operations that appear to be winners based upon perspective (1) may pale when viewed from perspective (2). A good business is not always a good purchase – although it’s a good place to look for one.

We will try to acquire businesses that have excellent operating economics measured by (1) and that provide reasonable returns measured by (2). Accounting consequences will be totally ignored.

Joel Greenblatt’s Slide Presentation: Graham’s Value Formula – Updated

Slide 1:  Value investing isn’t dead.

Five years ago, at the height of the Internet Bubble, we ran this ad in Barron’s:

Value investing isn’t dead. It is alive and well at Valueinvestorsclub.com

Slide 2: The Key to Successful Investing: Invest in Good Companies Whose Stocks are Cheap

             Good companies have high returns on capital (ROIC)

n  Defined as operating profit (EBIT or EBITDA – MCX (Maintenance Capital Expenditures)) divided by working capital plus net fixed assets

Cheap stocks have high earnings yields

n  Defined as pre-tax operating earnings divided by enterprise value

Slide 3: Magic Formula Results

Slide 4:

Million-Dollar Magic by James Boric

Joel Greenblatt is not famous…He is merely rich.

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

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

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

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

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

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

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

But earnings yield is only one half of the magic formula. Investors must also ask a second question: Is the business a solid one? The last thing you want to do is to buy stock in a company that is cheap for a good reason – because it stinks.

Greenblatt determines whether a company is “good” or not by looking at its return on invested capital. In other words, is it investing its capital wisely – adding to its earnings power? Or is it wasting its cash on frivolous investments that will create no (or even negative) value for shareholders moving forward? For instance…

If a company spends $1 million on a new factory and it is able to crank out an additional $500,000 in profits the next year, the result is a 50% annual return on capital. That’s outstanding. It says management knows how to spend YOUR shareholder money to create added value. Clearly, companies with high returns on capital will grow more quickly than companies with low returns.

[Editor's Note: By the way, Greenblatt has authored a terrific book about his magic formula entitled, "The Little Book that Beats the Market." He has also created a Website dedicated to the process, which may be found at www.magicformulainvesting.com. For the record, we have no business association whatsoever with Greenblatt. We are merely providing this information as a courtesy to you].

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

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

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

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

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

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

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

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

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

Joel Greenblatt Columbia Class notes on special situations. Please see part I, part II, part III, part IV,  part V , Part VI, Part IIX and the disclaimer there (also massive archive of videos and text here). 

We will be posting many more articles throughout the week from Greenblatt’s class notes so make sure to check back at least daily or subscribe on Twitter, Facebook,  Google+, Linkedin,   RSS (or Feedly specifically),  or best of all sign up for our new and enhanced newsletter (make sure to select value investing and daily under the options).

Note: Readers can print this (or any) article, convert it into PDF by scrolling to the very bottom. Enjoy!

November 30, 2005 Review Class

The test next week will be closed book.

The purpose of today’s class is:

• We will do some review for the exam

• We will discuss portfolio management which we haven’t talked much about it.

• We will then discuss anything from the book—I assume you have read it.

I. Questions about the book, The Little Book that Beats the Market.

Student: Does Ebit = Ebitda – Maintenance Capital Expenditures (MCX) used in the book?

JG: Right, I put a little note in there for the MBA Students in the book.  I assumed MCX = D&A for simplicity purposes.  Figuring out MCX for a lot of these companies is pretty hard.  On average it (using EBIT) is pretty close to being right for simplistic purposes.  If I were doing it myself, I would check to see the true MCX and subtract that number from EBITDA.  You might use EBIT as a check to see if you are close.

Student: When your sister, Linda Greenblatt was here she said that retailers were great to invest in due to their price swings (high price volatility allows for advantageous purchases).  Real Estate swings.  Were there any other consistent sectors in your database that kept showing up?

JG: There was no particular exposure, but there were a lot of consumer exposure in general because those businesses depending upon whom was doing the categorizing do not require a lot of capital to earn their returns (A low capital return model).

The big picture here is the not trying very hard model, right?  You sort of use last year’s earnings and you do not make heroic assumptions, and you do not use very many factors.  It shows how powerful the basic concept is.  

I had fun with this because I read a lot of the academic journals (on finance) because I am a wild and crazy guy.  Four years ago they took some firms in efficient markets.  Everything has to be laid out in that context (of efficient market theory).  They (academics) have never really gotten off that. It is pretty amazing how you can argue in the face of so much information that you can beat the market doing something this simple. (Though ships will sail around the world for centuries, the Flat Earth Society prevails- Warren Buffett).

I wrote the book for the masses—that was the audience for this book.  If you can really insert your estimates of normalized earnings that would be so much better. The fact is that some of you will find some companies that you feel confident in doing that means that if it works this well doing nothing, to work well actually thinking about it as long as you don’t get messed up with the emotions when it is not working out for you.

Student: How do you compile the stocks every year?  How are stocks added or eliminated?  How does that change from year to year?

JG: How is the portfolio purposely constructed?  I left that purposely nebulous because it was complicated.  The basic idea is that there is always a 30 stock portfolio, and you accumulate that portfolio over time so that each stock was held for a year.  We started in Jan. 1988 and although we assumed we started buying stocks in Jan 1987 with some stocks held for 6 months and some held for nine months etc, as I described in the book, I suggested that you bought six stocks every two months until there were 30 stocks accumulated in the portfolio over the year by Jan. 1988.

As I described in the book we used a step-by-step process. We had stocks held for three, six, nine months, etc.  In year two you will have 30 stocks, starting in year two you have thirty stocks in the portfolio then you sell six stocks and bought 6 new stocks.  What I described in the book for a thirty stock portfolio you would be buying 6 stocks every two months.  Then you would sell stocks held for more than a year. Think of starting in year two and that is how we started measuring the 30 stock portfolio.

Student: Was there any reason you picked 1988 for the starting year?

JG: Yes, we used a database called Compustat point-in-time database which was the exact data that someone would see back then.   I said in the back of the book these were the reasons things get attacked and one of them is survivorship bias where they just take bankrupt companies out of the index so you have a bias to do well because you got rid of the loser.  Here this was the exact data the Compustat customer had at that point in time and it only goes back until then (1987).  So we went to the beginning of the database. You could argue that it might not have worked, but we didn’t want to have any argument and this is the easiest database to use because the data is very uniform.

There are many, many problems, and the reason we set up the www.MagicFormulaInvesting.com. Website was because I didn’t want to write the book and then we didn’t want people to use crummy databases and people have to plug in all the formulas.  People would be trying to program tangible capital and all those kinds of things.  So I had planned to use Business Week’s data base but it doesn’t use Compustat data (though it is owned by S&P).  So I felt kind of obligated to do this because the readers would not have accurate or easily obtained data to use the Magic Formula and then they go buy the wrong stock.  We tried to make it as simple as possible.

Student: Did you think of using two year’s data?

JG: That is a good question. In other words, I say it is a good long term strategy and I say to turn it (the portfolio) over ever year—one, a year was simple and two, to take losses in less than a year for short term losses and two, to take profits after holding the stock for a year for a long term gains especially if you were an individual.  It works well using two year old data as well.

We are using last year’s data instead of using projections.  After a year you have fresher data than a year ago and that always makes more sense than using two year old data.  We thought a year was as good as anything else for tax reasons and for turnover costs it was a compromise to a longer term (two years or more) strategy.  And we wanted to keep it simple.

Student:  The lowest deciles were the most risky?  Did you notice a number of companies going bankrupt in the lowest deciles?  Are the lowest deciles the most risky?  Some stocks in those deciles tripled and some went bankrupt?

JG: No.  We are buying high ROIC stocks earning a lot of money, companies that are earning money.  We are not choosing low price to book stocks.  Their argument goes out the window.  We didn’t see much.  (Academics might say Magic Formula Investing Stocks will do better because of the higher risks inherent in the stocks).  And there isn’t much in the low price to book results as well. (Academics say) “It (risk) doesn’t come out in volatility where they (Academics in finance) measure risk everywhere else so it must be some other risk because our theory can’t be wrong.  It is patently ridiculous.  At the end of class I will tell you what I really think. (Laughter).  One thing I did slip in the appendix is that if we are valuing stocks based on future earnings, discounted back….why would low price to book stocks be important…..(garbled)

Low price to book stocks are a subset of stocks that are super cheap and are already out of favor.  A subset of stocks that are cheap will trade close to book value but that is not why they are cheap.   They just happen to be cheap—it is an indication they may be cheap.  So a more direct way to test whether a company is cheap: Does it earn a lot relative to what I am paying and is it in a good business?   This should work a lot better than low price to book stocks.

Low price to book is just a subset that you would tend to get and actually the Trosky Study show less than half of the low price to book stocks beat the market but the ones that do beat it by a lot.  So what he tried to do is throw out some of the worse low price books stocks to see if he improved which he did. But his methodology did not work for large cap stocks.  I think that is the beauty of this (Magic Formula) one. That was why we did the large cap stock study which worked well for us—22% average annual returns for large cap stocks over 1988 to 2003 testing period).

Student: Do you remove cyclical (stocks) from your study?  Couldn’t you be buying cyclical stocks at the worst time because their earnings would be peak earnings, giving you a high earnings yield?

JG: I wouldn’t say that.  I wouldn’t say that.  In most cases…..What we try to do here rather than…. This is the thing that we tested first and it worked.   We didn’t test many things to pick the one that worked, which is comforting because it shows that logic works.  This is the not trying method.

You don’t want to put too many factors in there.  I actually got an email from O’Shaughnessy who wrote, What Works on Wall Street.”  I beat up on him in my book. The only one left on the list is Haugen who has a 72 factor model (requiring monthly turnover!) that doesn’t work as well as the two factor model.   So one down and one left.

Student Did you consider leverage?

JG: No I didn’t, but EV/EBIT includes leverage.  All the studies done in the past—the low P/E studies–are not low EV/EBIT.  When I gave you those passages to read and that guy (Hooke, the author of Security Analysis on Wall Street) said take what you get regarding capital structure so use P/E as opposed to EV/EBIT.   I said that I didn’t agree with that.  I think it is very clear through statistics that on average, this is much better.  So that helps in that analysis.

I try to explain why this works in the book but I have to be frank, I was quite amazed at how well it worked.

JG: Who thinks I was an idiot to write this book in the first place?

Student: Laughter.  Will the Magic Formula diminish over time?

Investing is like dieting.  It is easier to know what to do than actually do it?   There is a pretty strong argument that not many people will be able to follow this. It probably might diminish somewhat.

JG: Low P/E hasn’t (diminished as a value metric) but low price to book (P/B) has.  But low P/B really didn’t make much sense to me.  I think one reason low price to book has diminished over the years is that the economy has been less asset based earned and more services industry oriented over the last 15 or 20 years.  So that the companies that are trading closer to book value with a lot of assets to generate earnings are some of the worse companies to invest in.  Negative results from low P/BV.  That is one of the things that I am banking on.  This method like the low P/E strategy won’t diminish and hasn’t diminished over the past 40 years.  The strategy to buy high earnings yield (Low EV/high Ebit) companies which have high ROIC (high EBIT/Low Invested Capital) should remain robust.

The other thing I am banking on is that if you look at the top of the list (of Magic Formula Stocks) they are hard to own.  How I know why these stocks are trading there—bad near term news abounds.  There are not too many takers to buy.  So I think as long as…..

Even if you look at the Haugen study where he had with 71 factors (of criteria to buy superior performing stocks) and he wrote a trilogy of books–all of them worth reading with various benefits with each. (See shaded segment on page 22).  One of them had to do with his 71 factor model, and he shows you the top ten factors that he used and six of them were low P/E and high ROE.  It is not that quants don’t have this stuff (on what quantifiable criteria outperform the market).  The average guy doesn’t.  Then you have to decide, does it work with the analyst working with big companies who set prices or computer robots?

The reasons that Quants go out of business is because they have to keep reinventing themselves—the quantitative model.  They find anomalies that work for a day, a week a few weeks whatever and they may converge the way they are supposed to go.   And if you look at the results here for the simple model (for the Magic Formula) and in 2002 the model is down 25% and the market is down 22%, but people can’t eat that volatility. If things converge quickly, the people have patience.  If things converge slowly over a year or two years and things go badly in between, people don’t have that patience.  It is very hard for people to adopt that model (of Magic Formula Investing).

People don’t have to patience to wait for convergence.  It is very hard. You can imagine if this doesn’t work this year people will say this (method) doesn’t work either.

For example, my daughter—she–started in August and my son started in March but their results differ because of their starting periods and the stock chosen in that period.

Student: Long term expectation?  What would you think for this to go away?  Or because people are irrational, this will never go away?

JG: That is what I am hoping for. I assume human nature doesn’t change.

Student: What would it take for this to go away that is the real question?

JG:  I think it would be very hard, because like I said it is very, very lumpy (returns) so that…. There will always be things going out of favor.  There are two ways this works.  One of the ways which is what I said in the book.  Good companies at cheap prices.  I think that is certainly true for the first and second deciles and why they outperform the last two deciles.  I think it is very clear on average that is what you are doing.

When you get into the top tier (deciles) of companies, you are working more as an insurance company (so you need a pool of bets to have the odds more in your favor).  Individually it is hard to own them because they are out of favor and they may work out or they may not.  But as a group on average there are enough winners that work out.  So you are really taking an insurance group bet rather than an individual stock bet.  There will always be stuff out of favor and stocks will be priced that way until the quants take over the world.  And when the quants take over the world, it stops working. Then it will work again because the quants will be out of business.

But generally…..If you think about what a quantitative model is—it is just a bunch of numbers to somebody and it blows up at some point and then you don’t know whether it blew up or things had changed or you are doing the wrong thing.  You are actually analyzing companies.   Frankly that is (figuring out normalized earnings) my day job and your day job because you can do it.  This is for the guy not doing any work.  My day job is figuring out what normalized earnings are and plugging it into the model–not looking what happened last year.  This is sort of an easy thing for people to do.   As far as making money in the future, there is always stuff that is in and out of favor.  Human nature doesn’t change.

Student: This can never go out of favor?

JG: In ten years?  I am not expecting it to, no. I think that is a fair assessment.

Evaluating Managements

The main point is not to memorize rules.  Because people ask me about this–evaluating management–throughout the semester, but I am just trying to evaluate how certain people will act in their own best interests.  How is this guy incentivized?  I try to use logic. What is his incentive to do this?  If people are not incentivized to do a good job they generally won’t do it.  There are some great people in the world that will do the right thing regardless of incentives but on average human nature prevails.  You must expect people will act in their best interests and know how they are incentivized.  I would go in expecting that.

What percentage of the company is best to own? It is either a strong point for the company whether management is incentivized well or not.  Do they keep stealing as much as they can and keep blowing it out?  If they are buying back stock over the last five years, I assume it is cheap or they wouldn’t do that. .

Student: Portfolio managers won’t want to hold these types of stocks (Magic Formula Stocks with “bad” near-term news) in their portfolio?

JG:  Richard Pzena, when he is selling to institutions and telling them what he owns, they say to him, “Don’t you read the papers?”  Because there is something wrong with his companies.   For some it is a sale and for others it is a negative.

It is hard to do the stupid thing and lose—that is the hard thing.  If it works, everyone is happy.

Student: You think the majority think that way?

There is too much uncertainty or things will turn down.  There is too much uncertainty.  It is tough.  Things are down.  You say, “Oh, I knew that stunk and now it is down from $33 to $25.  It is not usually the time when guys say let us jump in here.

I do not think about what others are doing or thinking.  Just think about what you should be thinking.  To cut to the chase the idea here is to cut out the extraneous stuff.  It becomes a very simple process.  Forget about what he thinks or what is happening next.  Figure out what the darn thing is worth and buy it for less.  To figure out what it is worth then figure out what are normalized earnings down the road.  Not what happened last year or this year or next year?  Most of the time you won’t be able to do that.  May be the business is too uncertain or too tough or you don’t really know.  But if you can do that in the companies you do know, that is the whole analysis.

It looks cheap enough, and we are getting paid to take our position. Unless the stock bottoms, we have never bottom ticked a stock.   Usually it doesn’t work out so well.

You know you have something great when you are rooting the stock down after you have bought a lot.  That doesn’t happen that often where you have that confidence.

Student: On small amount of money—those transaction costs will add up.

JG: I was thinking about the IRA investor who can put in $4,000 the first year into an IRA so I am figuring that is pretty much the minimum (amount of investment).  There is this site called www. FolioFN.com so you can buy stocks at 19.99 per month.   The cost is 6% in the first year or $240 a year for a $4,000 portfolio which is the smallest suggested beginning portfolio size.

Or you can do Scott Trade which is $7 a trade and you can buy 20 stocks the first year which is $140 per year.   The advantage for you is that you can do small caps.

But you are right, and I was concerned about that.  You can do small caps which have done 18% a year better than the market during the study period (1987 to 2003) and that will take care of a lot of the transaction costs as the account grows.  (Note: Small Caps are not necessarily on average more undervalued but they are subject to more mis-pricing of either being more overvalued or more undervalued).

Right now the first time in 25 years I am finding better bargains in the large cap area.   Though it works great for large caps so that is the best argument.

If you think of other questions………..

I thought one of the most interesting things was on the last page where we talked about the Haugen model which was a 71 factor model and it involved turning over the portfolio every month.   They did comp to the two factor model.  His difference between 1 and 10 was 17% and the difference for the two factor model was 5 percent and change. That was very powerful.  His worst 36 month period was minus 40% and the two factor model was plus 14%. So I thought that was good.

Portfolio Management

I also talked a little about Portfolio Management so I also think we should talk about that a little bit now.

When you guys get out of here (ColumbiaGraduateBusinessSchool) it might be difficult to:

1. have the confidence to own 5 to 8 stocks and
2. Have someone who is crazy enough to let you do that.

I imagine you can do that in:

1. your personal account and
2. where you have control over things

There is an argument to have a very concentrated portfolio.  You really are buying pieces of the business.  The way I look at it.  Think about it as your own business where you own percentages of other good businesses that you researched well and bought at a discount.  And if you can buy it for 50 or 60 cents on the dollar you wouldn’t worry about where people were pricing it all day long.

All the measurements you would get in a traditional MBA in how to do portfolio management would look silly.  What happens in the institutional business?  When they put out money to money managers, they don’t go inside the portfolio (the pension fund managers, for example, don’t know the reason why those particular stocks were purchased by the fund manager).  They don’t have transparency, they don’t know why you bought those stocks, and they only know that your returns bounce around.  If that is all you have-just the numbers-I understand the process could take longer than three years to work out.   If your numbers are no good why should I pick you?   Sort of like Warren E. Buffett (WEB) “I look for 7 foot basketball players.”

It is sort of the same concept.  If someone has not done well for three years, you should ditch them to go with people who have done well.   If it is not working well now, then why will it work now or in the future?

I am on some institutional (investment) boards and that is the thinking.   That is the great thing.  The guy, who doesn’t do well over three years, so he has to sell all his stuff because his money is pulled—so his stocks get even cheaper.  (Ironically usually just before the turnaround).  You can see the institutional reason why this does happen.

The best example, annual volatility then 10 year volatility, it is about equal to the market.  Using trailing 36 months periods, Pzena’s volatility is about half the markets’ volatility.  I am not a big proponent of either (measuring volatility).

Who cares how much it bounces around in the interim if returns are good?  If you look at the statistics what are your draw downs during the course of the year?  All of those measures seem a little silly when you own a share of a business at a good price.

Student: What was the one mistake over the past twenty years, you wish you did a little bit differently?  What was your most common mistake?

JG: I will tell you something encouraging, I have done so many stupid things, and I hate to talk about them and I am not done—it brings up bad emotions.  I have sold too soon and at wrong times.  Yet, if you do enough stuff right you can still get great returns, I think that is encouraging.   Believe me If I go back over the past 30 years and recount my mistakes—it is too embarrassing–but I did sell a stock at 25 cents that is now $15.   There was no logic to selling it. I was raising money.  How much could I raise?   If you knew how many mistakes I have made……not just selling too early though that is one that we often do.

I think I had a contest with Robert Goldstein, my partner.  We made 60% to 70% on our money with Moody’s and it unfolded exactly as we predicted, but the position tripled.  We went back and forth for 30 minutes.  What about all these stocks that tripled after we sold them?  That was certainly one mistake we have made and continue to make.

Another mistake we have made: mis-assessment of a business and being in denial.  But of denial was that we owned so much that we couldn’t get out. It wasn’t so much we couldn’t get out.

We never worry too much about liquidity if I can buy it well.  If I am wrong I should pay for it.  Liquidity constraints in companies that we bought a lot of have more than paid for the ones we couldn’t get out of.  If you have a long enough horizon, over time it works.

Student: You do so much in the small cap area.  How small (are the companies, stocks) do you look at?

JG: Right now the typical investment we own is in the multi billions.  That is another great thing about investing in small caps which I think I mentioned before. The people who get good at this stuff, get wealthy so then they can’t look at the small caps any longer.  They go to the large caps. So there is always a new crop of people. There is always room to start there.  I try to make it clear in the book too. It is not so much that small caps are better.  (Small caps tend to be more mis-priced both on the up and down side).

That is another stupid thing that academics generally do…. They say..”Well, you left out this or you didn’t include that……

I figure I will get attacked eventually because Academics will say, “You did not take out the small cap effect, the low price/book effect.”  They try to take out all these effects–but for that effect you equaled the mkt.  But the point is that the small cap effect if there is one, they are too small to buy. But the small cap effect, if there was one, occurs because the stocks out of favor tend to have smaller caps more than the average stocks because their price is low.

I think a small market cap stock happens because it becomes out of favor.  Same with low price book. The stock happens to have a low price to book because it happens to be out of favor.  It is not cheap because it has a low price to book value.  It is coincidental.  It coexists.  It is not a good buy because it is low price to book.  As opposed to what this is–Rather than what I looked at–which was price relative to what the companies would earn.  It makes more sense to me. It seems silly to me to just use low book value to price.

Student: Theoretically,  the companies we work for will be firms that have billions of dollars of capital where we wouldn’t be allowed to buy companies under $400 – $500 million in market cap.

The Purpose of the Course

JG: The whole point of this course is to give you a context in which to do your valuation work.  All you are doing is valuing companies and trying to buy them for less.  And then understand the context and how the market works over time.   The market may not agree with you in the short term, but you have to stick it out to get right.

All you are doing is valuing companies and buying them for less.  And then what is the global context you are looking at?  If you are valuing large companies, then figure out the cash flows.  It is no different than for small caps. There is no line drawn somewhere. Large caps tend to be better, more established companies, and therefore, they are not one product companies.  They have maybe a stronger market position than small companies but you might look at the same attributes.  It might be a small niche market that the large company has a great share in that market.

It is all about valuing companies no matter how many studies I blabber about.   If you can value companies and buy them cheaper and have the context to know that 2 plus 2 equals 4, then that is all you need—forget the rest.  If you can buy good companies that are making money over time at a discount, you will make money.  That is really what this course is about.

Putting things into context which I am good at and doing the valuation work which I think I am average at.  But I am very picky, and I pick the things I know how to evaluate.   And I think all of you can do that because you are all here.

I might flounder at a big firm because my guess on a particular industry might be no better than anyone else because I don’t understand the dynamics of that industry.  But it is a good process. If you learn three or four industries.  Linda (Greenblatt) has made a good living knowing one industry, retail.  One industry you understand in your bones like manufacturing because that is your background. It is the Warren Buffett circle of competence concept.

Bill Miller (portfolio manager of Legg Mason’s Value Trust) is an extraordinary example is someone who has expanded his circle of competence to companies you generally don’t look at.  He is trying to figure out what a company is worth and buying it for less.  He is trying to understand what people consider very complicated—Google, Amazon, EBay.

Student: What do you look for?

JG:  I am always looking for a disparity between what it is worth and where it is trading. Then what are my alternatives?  Right now because we have some big cap stuff, we are fully invested.   I am worried about the indebted consumer. We were scared in 2000 also.  We owned a lot of companies earning a lot of money. We knew the Internet bubble would burst also.  The S&P 500 dropped in half. There are not many times in your life that will happen, I guarantee it. We were up 100% in 2000 and the market got pummeled.  That is sort of what we are doing now.  We are fully invested.  If we found something else we would sell something else because we don’t use leverage.

Leverage

If you are going to be a very concentrated investor, you should not use leverage.  WEB said you make a lot of money if you only had a 20 card punch card with 20 choices. I will give you a 20-hole punch card for the next ten years to help you be disciplined.

You can’t leverage because you need to live through the downturns and that is incredibly important.

Big picture–the things I look at:  What I have in my portfolio.  This is just practicing now. You have 6 securities in it, and you are 100% invested.  Now if we find something else we like–it has to boot something else out of my portfolio.   We run a fund of funds.  And we found a money manager from the VIC.   He ran a fund with 30 names because he wanted to sleep well.  But he was smart and he had a big staff so he could source a lot of ideas. He had insights we didn’t have.

We came up with a way to work with him.  We said, “Listen we only want your five best ideas not 30.  If you want to add an idea, you have to sell the other.”  What are your five favorite things at a time?   I would recommend to you a 6 to 9 stock portfolio. It is a way to get rich actually. It is a very disciplined strategy to always keeping the best ideas in your portfolio and concentrate. Only keep the best things in your portfolio.  WEB says he has more money than ideas, but I don’t think you will have that problem for a while.   If you do, please look me up.

Student: Is there anything else you look at?

JG:  One thing we did not emphasize enough which is inherent in what we are doing because we are buying stocks cheap.  Look for asymmetrical risk reward investments.  It is inherent in what we do.  Following the margin of safety principle we are looking for good risk reward– a dollar down and five up.  The stock is worth ten and you can buy it $5 but the stock could go down.   You certainly are not going to buy a large cap stock now at a 50 cent dollar.  The way I would look at a 50 cent dollar, “Well I am going to hold this for two or three years and in two or three years with the accumulation of cash it will be worth $10 but I can buy it for $5 or $6 now.” That is a pretty good return.  Sometimes it happens sooner and the market fast forwards those earnings upfront.  Perhaps the market will recognize what I am seeing sooner.

It is interesting because we talk to our portfolio managers a lot. One of the things we bring to the table is that we can help the portfolio manager.   We met a guy who ran $100,000 in 15 years into $25 million (44.5% CAGR for 15 years!) never running outside money.  We convinced him to run money for us.   One day he went through all the metrics of the company and it is worth $10 where the stock is trading at $4.   We said, “Everything you said makes sense, which sounds great. “And one other thing,” He said, “they just put the company up for sale.”  So this sounds really good to me. Right?

Why do you only have 7% of your portfolio in it instead of 20%?  If you were not lucky enough to buy at $2 would you buy a hell of a lot more at $4 if you hadn’t been so lucky?

He said, “I see your point.”  The next day a big block of stock comes up in the stock and he tripled his position.  Three weeks later the company is taken over for $9.

All the stuff I say…People accuse me of trying to make it seem all too easy.  It really is not.  When you look at these results (Magic Formula Stocks up 34% and 22%) over seventeen years, it seems obvious. When you are in the trenches and you are living through the year and a half and it sucks, it doesn’t seem so obvious.  Why am I an idiot?  It is different.  It is much easier to look at an accumulation over time or an average and say that it is obvious and it works.

The same thing in portfolio management.  There is all the psychological things like anchoring, the price you pay. These things naturally go on.  I think the clearer your thought process, the better. Which is: It is worth this it is trading here, I have this much confidence in my opinion.  You just keep going back to basics.  The basics are the market will get it right eventually in three or four years and I have to hang out. If I am wrong, I will be wrong some of the time.  If I am wrong a lot of the time, I have got to find another line of work. Or I have to find some industry that I do know how to value and that is the learning process.

The Hard Part

Student: What is the hard part?

JG: I think the hard part is limiting yourself to those companies that you can figure out the normalized earnings.  I only limit myself to those companies I can figure out–or are easy to figure out–the normalized earnings.

Student: Over time what is the difference in this methodology compared to your first book?

JG: It depends where the opportunities lie over time.   I didn’t get turned on to WEB’s focus on good businesses until the early 1990’s.  I got burned in crummy businesses.   If there is $10 in value and it is going to $12 then great, but if it is going to $8 then your margin of safety is degraded.  Time is against you instead of working for you.

Student: This 20-hole punch card is for the purpose of making great 20 investments?

JG: Put half your portfolio into stocks using your punch card. You put in 10 ideas and you hold them 1 to 3 years.  As I have gotten older, slower and working less hard, I have extended my timeframe and increased my concentration.

I don’t know if you have done the math.  You will use up your twenty picks.  It really is more of a reminder that less is more.  You can only focus on your best ideas. If you don’t think it is great, then pass.  Your opportunity set is not what is in front of you.  The future is unknown. But your opportunity set is not in buying what is the best out there today, but what might come along if you wait.  I am really losing an opportunity to buy when there is a great opportunity.  There are times when there are huge opportunities and it is good to have dry powder.

I am giving you metrics–your hurdle rate should be very high, you should be really confident.  Load up on your best opportunities.  What I consider loading up is more than most people.  We put 20% to 30% of our capital into an idea.  We look at it (an equity position) as owning a piece of a great business.

When we found a great idea is was because we did the work and we found it in an unusual spot.  “Oh, it is trading cheaply because this division could be closed down then the value will be revealed.  It is not like we figured out Google.

Two more questions and then we will take a break.

Student: Are you fully invested?

JG: We have seen a lot of good opportunities in the last six months.

Should I have sat on my hands?   Sometimes we are fully invested and are looking.  The thing you bought goes down and the thing you sold goes up, but I have learned to ignore the pain.

That is the key!  You must think two or three years out when everyone is thinking about the next quarter.

WEB was spoiled by Graham to find only cheap stocks.

JG: To me it took me a long time to get to a long time horizon because there were a lot of neat things to do.  You can make money at both.  You have more weapons in your arsenal. .  It is all the same thing.  You get values coming out of weird situations.

BREAK………..107

Joel Greenblatt Columbia Class notes on special situations. Please see part I, part II, part III, part IV,  part V , Part VI, Part IX and Part IX the disclaimer there (also massive archive of videos and text here). 

We will be posting many more articles throughout the week from Greenblatt’s class notes so make sure to check back at least daily or subscribe on Twitter, Facebook,  Google+, Linkedin,   RSS (or Feedly specifically),  or best of all sign up for our new and enhanced newsletter (make sure to select value investing and daily under the options).

Joel Greenblatt wrote one of the best books ever on investing (with one of the worst titles ever) You Can Be a Stock Market Genius (which focuses on special situations) and The Little Book That Beats the Market (on the magic formula); both are referenced extensively below. So if for some reason you have not read them make sure to check them out.

Note: Readers can print this (or any) article, convert it into PDF by scrolling to the very bottom. Enjoy!

Final Exam

JG: Why don’t we talk about the final?  The final is designed to test your analytical skills. Some questions are a matter of opinion.  The point is to touch on the right points.

I might ask for strategic advice after you have seen the 10-K.  Some general questions about the speakers we had.

You have to figure out an arbitrage spread.  You have an option question.

I am the easiest grader in the school.  I keep your test in my file so I can answer questions about you if anyone asks me.

I like people in interviews to disagree with me. Pick up the issues and argue well.

We saw speakers: Matt Mark, Robert Goldstein, Richard Pzena, Linda Greenblatt, Brian Gains and Bruce Newberg.

Comments on student papers:

In general I thought your papers were very good.  I will tell you your true grade—the grade you should have gotten—versus what I put on your paper.  These are somewhere in between but in general they were good.

110:  A couple of comments……….

Comparables and Valuations

A student presented five different types of value:

• EV/EBIT,
• Price/Sales,
• liquidation value,
• Private transaction value
• and one or two others

Then he averaged the five.  I say pick one—something that is more relevant.  If they are all in the same range, it doesn’t matter.  Just picking an average doesn’t mean much.  I think the same thing with relative value—picking comparables.  A lot of people just list a bunch of comparables.  Even if some did the ROIC and EV/EBIT analysis and compared and that is good.  It is much better than doing P/E ratios where there are different tax shields and everything else.  But those eight or ten companies were not really great comparables necessarily.  I would still pick out the businesses the most likely to be similar and do comparables on two or three companies instead of an average of 8 or 10.  I think that might be more useful rather than just getting the job done.

There are other companies that don’t have good comparables, but cash is cash and what I would do on that…..You know I gave a speech at Stanford Bernstein to the young analysts there (50).   It is kind of great and sad in a way but I get these kinds of questions.  An analyst raised his hand and said, “Well I do tech stocks.  Those are valued differently than the others so how would I go about valuing them?”  Well, I said, cash is cash, and you are valuing the earnings stream–they are all green.  It depends upon your confidence level and everything else.  It is in the way you get into an institutional mindset and they are still doing it that way.  Sanford Bernstein is a great place. One of the advantages you have is thinking straight.

If you can’t find a good comparable, then try to find a comparable business with similar metrics like returns on capital and similar growth prospects.  Rob Goldstein (his partner) compared Moody’s to Coke when Buffett bought it because there were attributes to those businesses that were similar.  There were differences and similarities, but it is nice to have a benchmark of some sort.  So if you can’t find a good comparable within the industry of what you are trying to do, compare it to a comparable with similarities.  You have confidence in those cash flows, the ROIC in that business.

So that is what I would look for. That is how we have made a lot of money over the years where people only view this industry a certain way.  But, hey, things can change, but it is spinning out cash.  Maybe it will get revalued.  Look at these two metrics, they match up. This is trading at $25 to $30 and this is trading at $12.  So that doesn’t continue to last that long if they do continue to spit out the money, you have to wait two or three years, but that is a really, really powerful model to find a comparable when you don’t have one.  Or to analyze an industry a little differently than it has traditionally been analyzed.  The industry might be efficiently priced relative to each other, but they all could be cheap.  People are not used to paying for………

People just used to pay only 10 times for banks, but then people started to pay more for them because they were earning more as businesses; they went into different businesses.

If it is tough finding comparables  find something similar in market share attributes and prospects.

Retailer:

They said, the average P/E over the past five years was this or the highest P/E over the last five years was that, and I think the price will go back to that.  That doesn’t make sense sometimes because the business could have been much different with different growth prospects back five years ago.  Now the company is in 1000 malls and five years ago they were in only 400 malls.  Five years ago they were in 4 countries and now they are in 8 countries.  The retailer’s growth prospects could be different.

Just to say it will go back to its historical P/E, you can see the flaw in that logic.  Don’t fall into that trap.

Another Example of Conventional Thinking: DELL

From: The Detective and The Investor: Uncovering Investment Techniques from the Legendary Sleuths by Robert G. Hagstrom

In those critical early years of 1992 through 1994, most investors and analysts who followed computer companies were still operating on old assumptions.  Conventional wisdom at that time held that the time to buy stocks of PC manufacturers was when the price was six times earnings, and the time to sell was when it hit twelve times earnings.  That was the historical trading pattern, and few people saw any reason to question it.  The simplistic view of most on Wall Street was, This rule of thumb has worked reasonable well in the past, so why change it?

The concept of economic value added hit the mainstream financial press in 1993, with a cover story in Fortune.  Anyone reading the article carefully would come away with an important message: If a company’s cash earnings represent a high return on capital that should bode well for its future stock price.

At that point, thoughtful investors could have reasoned their way to a profitable conclusion: I should be looking for companies with strong earnings and low cost of capital.  And if they were looking at computer companies, they would have hit on Dell.

The lesson: Why would you, as an investor, sell Dell when it reached twelve (12) times earnings if its ROIC was high and going higher.   Dell’s economic model is built on maintaining low capital costs.

What is excess cash?

Understand the business before deducting cash from Enterprise Value.  Some businesses run with just a little cash.  Some business use negative working capital.  I assume the acquirer doesn’t need the cash, so you would get it back then.  A retailer has a lot of cash to weather a bad season or two.  There are times that when you deduct the cash from Enterprise value, it is the wrong thing to do.   Some retailers need to keep a certain percentage of cash in the til to accommodate customers. In summary, before deducting cash from Enterprise Value, determine the cash needed to annually run the business, for example: 1% to 2% of sales.

Cheap on EV analysis.  The stock is at $6 with $5 in cash and the stock is going to $7 in two years.  But you are laying out $6 and it is only going to $7.  The EV doubles (100%) but your return is 8% annually compounded over two years.  Also, think about how management will spend the excess cash.

Marvel Entertainment

There was a great report on Marvel, but I struggled with that one.   It is on the Magic Formula Investing Site as one of the recent picks. The approach taken was reasonable. You have a big movie, then they make money over the rights to the characters.  They do have a stable of characters, so there is some recurring nature to the business with their characters, but the question is: what are normalized earnings?  In a couple of years there will be two movies out and it will do this, but last year they had one movie out.  Should you normalize at 2 movies or 1 movie a year.  How long will it last?   The person picked 1.5 movies per year.  Unless it is super cheap, I might pass on something like that.   It is a particularly good business—licensing brand names—however, I struggle in figuring out normalized earnings. .

An Option Question: Weighting your position in Stocks vs. Options

Let us say you find something interesting, how much do you weight your position in options vs. a stock position?

JG: That is a great question.  This is how I would view it. If I had a 30% position in a stock, I don’t think I am at risk for that 30% of the portfolio because the investment is in an unleveraged company.  I view a disaster as being down 33% (or 10% of the portfolio—33% x 30%) because if I am going to be buying a 30% position I am buying it at ½ of intrinsic value.  So I am buying at $5, and I think it is at worth $10.  So I assume it goes down to $3.50 or $3.  That is how much I have at risk.  But with a leap…

What is great about investing in stocks—one way to look at them–is that they are like perpetual options. They never expire unless the company goes bankrupt.  So…the comfort you have being a value investor is it may take an extra year but I think it will get to fair value so I may have to hang out for two or three years.

Then you go buy an option that expires in two years you are taking that off the table.   We have a few bets like that.  We have some combination of stocks and some options that expire in two years and some in 2.5 years. You are adding another risk because stuff happens.  The market could crash; the housing market could crash; the consumer drops dead; another 9/11.  I know that if I draw a line from now until the next five years I know where the business will be—sort of a Warren Buffett thing; I feel very confident from here to there the business will grow and go up.  The business will grow 7% to 15%.  I feel very confident that the business will grow 15% during that time.   If things stink and there is a big drop in the middle, it will still grow 7% from today until five years from now.

With an option, it may get very lumpy, so I take that into account.  The way I compare a 20% position to risk 40% of my money so right away I risk 8% in that position.  Then I take the time element (of a wasting asset), because I could get it right but have the timing wrong.  So I take the position down to 5% from 8%.  I assume I could lose all my money in my option.  So an option position might not exceed 5% of my portfolio not 15% to 30% of a stock position.

What I mean by not leveraging, is that they can’t carry me away with my entire portfolio.  When I make money I look at it pre-tax and when I lose money I look at it post-tax. Oh, I lost 50% on that but after-tax it was only 10%.  There are little mind tricks you can play.

Student: Do you buy in the money or out of the money options?  How do you choose what strike price of an option?

JG: Generally I buy a little bit in the money.  A Call option or a Call/Leap is the same as buying a put and buying a stock; they are identical to each other.  Generally, I don’t want to pay a lot of money for the put so usually I would rather take a lower strike price where the Call strike price is struck at a lower price so the put option aspect of the Call is not worth as much. I am not investing as much money in my put the lower the price I go.

So bottom line—another way to look at it is your risk & reward.  There are two ways to look at that in answer to your question. One is the risk/reward.  Let us say I own IBM and it is $60 and I think my valuation thesis is that in two and a half years I think it has a good shot it can be worth $90.  Ok?  I can buy these $75 calls for a $1 for a 15 to 1 payoff.  Or alternatively I could say, “Look, right now I could buy the $55 calls at $9—they are $5 in the money—the stock is at $60 and it is costing me $9 or $10 to buy that but that $10 can go to $30 so I triple my money and even if I am wrong I will get back all my money back if the stock is at $65.”  So I will factor that in.  It would be unlikely to lose all my money if I am close to right, because I am thinking $90.   To lose all my money it would have to go to $55.  I factor that in, but it is not a science.

The thing that I showed you was—how do I know to buy the $55 calls at $10 instead of the $60 calls at $7.50 when the stock is at $60?  Which is better of the two Call strike prices?  What I say is, “I always I look at the call spread—a bull spread.”  What that involves is buying the $55 call and selling the $60 call.  If I bought the $55 call for $10 and sold the $60 call for $7.50 for a net cost of $2.50 ($10 – $7.50, not including commissions).  The most I can make if the stock is above $60 is $5.00 or a 100% return. If the stock is at $55 then I lose 100%.  The spread is worth $5.  If the stock is at $57.5,  I am at break even ($55 Call Strike Price plus $2.50 paid for the call spread = $57.5).

If the stock is above $60 it will be a double in 2.5 years because I believe the stock will be at $90.  Does that sound like a good bet based on my thesis?  I think the stock will be at $90.  So I will buy the 55 call because I am effectively buying the spread of $55 call/$60 call.

It is an exercise that I do in my head when I want to own an option outright..  I don’t really buy the spread. Do I want to own the 55 call or the 60 call?  So I compare the two by doing the bull spread in my head.   By laying out an extra $2.5 to buy the $55 call at $10 vs. the $60 call at $7.50, I am effectively choosing a bull spread.

The most I can make is $5 but the spread will never close until the end.  I would never pay $4.5 for example.

The $55 calls are plus $10 or lay out $7.50 for the $60 call?  Buying the $55 vs. the $60 is effectively like owning the spread.   If I buy the $55 call I am effectively paying for the $60 call and the $55/$60 call spread.  Laying out the $2.50 brings me $5.00 if I am right for a 100% return. Just go home and think about it in your head.

Student: Why would you ever buy a stock when you can get a higher return with an option?

JG: If the stock goes down 8% over the next two years because the world is a crazy place, I lose 8% in owning the stock, but 100% of my money owning the option spread.

The problem is that I am wrong a lot despite what I tell you in here so that is risky. If it is a good bet–and I would call any option or spread position a bet–I will win over time but not necessary on any one bet.    I want to be the betting house where I will win a series of bets over time if my valuations of the companies in the group of bets are correct.

Anyone read Fortune’s Formula—it is a new book out (See shaded box below).  It talks about the optimal way to structure a portfolio.  It is about horse racing and odds.  What is the optimal way to structure a portfolio if you have good odds?  If I could flip a coin and I could get $1 if it is heads and lose $0.50 if it is tails.   You want to do that a lot but if you have a pile of money you wouldn’t put 100% of your money on that particular bet.  Even though it is a great bet, you wouldn’t put all your money into it because you could hit a bad run and lose all your money.

From www.bankstocks.com Solve the following problem. You’re at the track with $1,000 in your pocket, and see that the posted odds on a certain horse winning an upcoming race are 5 to 1. You (and only you) have a secret line of communication to the horse’s trainer, and learn that the horse’s chances of winning are meaningfully higher than the posted odds—say, 1 in 3. Which is to say, you have a material information advantage over other bettors. How much of your $1,000 do you bet?

That, in a nutshell, is one of the most crucial and least discussed dilemmas in the capital allocation process. While CAPM types preach about the virtues of diversification, the Warren Buffets of the world know better. Diversification only assures mediocre returns, they point out; the real money is made when you put a lot of capital to work in those rare opportunities when you have a true edge. Like, say the 1-in-3 shot above that’s going off at 5-to-1.

William Poundstone gets at this issue in Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street. The book is a history of a formula called the “Kelly Criterion” that allows gamblers (and other capital allocators) to maximize their profits on a series of bets where they have an information edge, but without betting so much that they risk going broke. Take the horse-racing example, above. Yes, you’ll want to bet more than you normally would, to make the most of your insider knowledge. But you don’t want to bet everything: even by your own reckoning, the horse has just a 33% chance of winning. Once you’re bankrupt, you can’t get back in the game. The optimal bet size is somewhere in between.

The namesake and inventor of the Kelly formula is a man named John Kelly, a mathematician at Bell Labs in the 1950s and 1960s. Kelly developed his formula by building on the work of another Bell Labs mathematician, Claude Shannon. Poundstone says Shannon is considered by many to be the second-most-brilliant individual of the twentieth century, after Einstein. In particular, Shannon is the father of “information theory,” which serves as the broad mathematical foundation for essentially the entire electronics and digital revolutions. Everything from integrated circuits to fiber-optic cable to DNA sequencers rely at rock-bottom on Shannon’s work. His models apply to any kind information conduit, electronic or otherwise. They allow communications engineers to minimize the amount of noise—static, gossip, whatever–in a given conduit, and maximize the amount of information the conduit can carry. Which is to say, Shannon essentially developed a mathematical way to convert uncertainty into certainty.

Communications engineers aren’t the only ones with an interest in separating information from noise, of course. Bettors and investors could use some help there, too. So it’s perhaps not coincidental that some of Shannon’s math can be put to use at the race track, the blackjack table, and on Wall Street. One of the first to apply Kelly’s formula was a young physics grad student, Edward Thorp, who used it in conjunction with a card counting system he developed for blackjack. (Thorp later wrote a book on card counting called Beat the Dealer that’s now considered a classic among blackjack aficionados. Later on he ran a hugely successful quant fund, Princeton-Newport Partners that eventually got tangled up in Rudolph Giuliani’s pursuit of Michael Milken in the 1980s. But that’s another story.)

How does the Kelly formula work, you ask? It’s pretty simple. The formula says that the optimal wager size is determined according to the following fraction:

Edge/Odds

The denominator, odds, is the public odds posted on the track’s tote board. The numerator, edge, is the amount you stand to profit, on average, if you could make this same bet over and over and over. Let’s go back to the horse racing hypothetical in the first paragraph, and see how it works. The posted odds are 5 to 1. So we’ll put a 5 in the denominator. But recall that you believe the true odds are 1 in 3, not 5 to 1. If you bet $1,000, then, you’ll have a 33% chance of winning $6,000 ($5,000 plus your original $1,000 wager), or $2,000, on average. On a $1,000 bet, your profit is thus $1,000. That’s your edge. For the formula’s purposes, the $1,000 becomes a 1.

So according to Kelly, the edge is 1 and the odds are 5. Plug in the numbers and you get 1/5. You should bet 20% of your bankroll.

A few comments are in order. First off, this only works in instances when you have a true, material information advantage. If you don’t, your edge is zero, so you shouldn’t bet. Second, the only time the formula will tell you to bet all you’ve got is when you’re absolutely, positively sure you’ll win. In the real world, that hardly ever happens. Thus Kelly prevents bettors avoid being wiped out completely, so that they’ll have capital to put to work when the next opportunity rolls around. This is no small advantage. Other capital allocation strategies gamblers use, most notably “martingale,” in which the player doubles down after a losing bet in order to quickly recoup losses, a can be quick trips to bankruptcy. Finally, using Kelly on a series of bets is the most efficient way to compound your winnings. Models show that, say, a more aggressive “Kelly times 2” strategy actually leads to lower long-term returns.

Kelly’s advantages shows the results of various strategies for betting on a series of hypothetical coin flips where the bettor has a 55% chance of winning.

It scarcely needs to be added, of course, that the economics profession has roughly zero use for all this. First off, the formula was developed by a mathematician, not an economist, which naturally makes economists skeptical. Second, the notion that an investor can have a true edge is anathema to the efficient-market dogma that still dominates most economics departments. Paul Samuelson is particularly scornful of Kelly (or “g,” as it’s referred to in economics circles), calling it a “fallacy.”

The Kelly criterion’s virtual absence in economics and M.B.A. curricula explains why the formula is not well known on Wall Street. It shouldn’t be. It is hard enough to find ideas where an information advantage is even possible. When those do occur, investors can use all the help they can get in figuring out how much capital to apply. Kelly may not be as ideally suited to Wall Street as it is to blackjack, but it sure seems like a good place to start.

Student: Do you use the Kelly Formula?

JG: It (investing in stocks & options) is not as clear as the Kelly Formula.  What are the odds of doing that. You are not taking bets where you lose it all; it is not as clear as the Kelly Formula.  There is not an optimum way to bet on stocks.

1. It is uncertain and
2. You don’t lose all the money you put up.

Student: What if you have an inkling of IBM moving quickly to $90.

JG: If I put on a bull spread…. The opposite of a bull spread is a put spread.   The puts at $60/$55 by definition has to be at $2.50 because they (call and put prices) have to add up.   There is still a chance that within a year the spread will still be worth something.  Sometimes in the spreads, a shorter expiration is better than a longer expiration.  If it is expiring .  You have a whole year for the stock to fall.  There is an interesting dynamic in spread.  A lot of this stuff has been learned the hard way. (Study the time decay of options).

Moody Corporation Example

Student: Could you go over Moody’s Example?

JG: This took a long time to learn but hopefully it won’t take a long time to teach.   Let us say, that when Buffett bought Coke it was growing at 12% per year and Moody’s was growing at 12% and they both are earning $1 per share.   For Coke to continue to grow at 12% it has to take 20 cents for every dollar and plow it back into its business for working capital, etc.  Coke uses the 20 cents of the dollar they earn to continue to grow at 12% so the remainder is 80 cents for other uses.  Moody’s meanwhile needs $0 to grow 12%.  So what we said was that a $1 from Coke is worth 80 cents compared to $1 for Moody’s.  Moody’s earnings are worth 25% more (80 cents to 100 cents or 20 cents/80 cents for 25%).

The dollar of Moody’s earnings was worth 20 cents more (20/80 cents = 25%) $1 vs. $0.80 for Coke.  Or 20 cents/80 cents, so Moody’s earnings is worth 25% more.   Coke will eventually grow 5% a year, so they don’t need to invest as much to grow at 5%.  So 8 years from now they only have to invest 10 cents per year to grow at 5%.  So Moody’s won’t be worth 25% more forever, it might be worth 10% more.   So on average a dollar of Moody’s earnings is worth 15% more than Coke’s earnings of $1.  Moody’s earnings would be worth 10% more not 25% over time.   I assume both grow at 5% forever but Coke puts in 10 cents per dollar while Moody’s puts in $0.

Student: What about the reinvestment rate?  The payout rate?

JG: I would say these 80 cents will be growing at a certain rate.  Yes, to grow you need more working capital.  In that particular business (MCO) you don’t need more working capital, but with Coke I assumed that you need more working capital to grow.   Now you are talking about returns on working capital of over 100% for Moody’s. Yes, you have to lay out for working capital.   We looked at history to determine reinvestment rates for Coke and Moody’s.

Look let us say interest rates were the same so apples to apples we can pay 15% more for that.   Coke moved to some price and now it has come down, but let’s ignore the crazy prices that it traded at in the late 1990’s.  But the next two or three years, the stock (Moody’s) tripled.   We are comparing the two because we thought we could get a triple in two or three years.   But don’t forget, remember the truck driving thought the huge gap.   Don’t try to fine tune it.  If you have to fine tune it, then the investment thesis is a little too close.

Forget about the crazy price Coke traded at—65 times earnings in 1998.

Go look at Duff & Phelps’ change in tangible assets as they grew.  There was no change, they spent every nickel on stock buy backs.  They didn’t need any capital to grow.   They were very similar to Moody’s. This is the best business you will ever going to see.

I gave out that one first (the Moody’s Example) so you have something to compare it to. Almost all other businesses will be inferior.   How good a business is it relative to Moody’s?

We were looking at American Express recently and so we were comparing it to Coke.  It is a lot closer to Coke than Moody’s.  It is a nice way to compare.  It is nice to have that type of metric.

Buffett’s Advice to Students

JG: I just want to play one thing………. A video of Warren Buffett speaking to business students………

Buffett Lecture:  Maugham at Salomon Brothers never once spoke about salary.  He worked 18 hours days for months and months. He showed uncanny judgment on what to bring up to me. I often use this illustration in my talks to classes.  If one of you could pick one of your classmates in order to share in their earnings for the rest of their life.  And you could pick anyone you wanted and you would get 10% of their earnings of that individual for the rest of their life, what would you think about in terms of whom you picked?   Would you think about the person with the highest IQ?  The highest grades?  Probably not.   You are thinking about a whole bunch of qualities of character.

Every one of those qualities is attainable.   You are not thinking about who can throw a football 65 yards. Ben Graham wrote down all the qualities that he admired in other people and the qualities that he found objectionable.  Those qualities are ones that you can chose.   The chains of habit are too light to be felt until they are too heavy to be broken.  The right habits that you would want to obtain of someone you would want to own 10% of their earnings.  The people I see who function well are the ones who don’t have the biggest motors but the most efficient motors.  It is those qualities of character that are most important.  What on the left hand side of this list (good qualities) I can’t achieve myself and what on the right hand side of the list I can’t get rid of myself (bad qualities). In the end decide that you will be the one you would buy 10% of.

Think how few people actually keep that in mind—think of those in the business world. I think you can all be very special.  You all have the ability and the intelligence.  You can decide to be very successful in very many ways by trying always to do the right thing.   I enjoyed teaching you.

APPLAUSE.

END

Appendix

Books by Robert Haugen:

The three books about the behavior of the stock market that he wrote were:

The Inefficient Stock Market.  What Pays Off and Why.  This focused on expected-return factor models, which, in part, attempt to exploit error-driven volatility. The positive payoff to cheapness results from the market’s overreaction to success and failure.  The positive payoff to intermediate-term momentum results from the market’s under reaction to positive and negative surprises in individual earnings reports.

The New Finance focused on the market’s major systemic mistake.  In failing to appreciate the strength of competitive forces in a market economy, it over-estimates the length of competitive forces in a market economy, it over-estimates the length of the short run.  In doing so, it overreacts to records of success and failure for individual companies, driving the prices of successful firms too high and their unsuccessful counterparts too low.

The market doesn’t under react to a unique event.

Beast on Wall Street focuses on stock volatility.  It contends that stock volatility has three components.  Rational and unbiased responses of stock market prices to real, economic events are the source of event-driven volatility.

Joel Greenblatt Columbia Class notes on special situations. Please see part I, part II, part III, part IV,  part V , Part VI, Part IIX Part IX, and Part X the disclaimer there (also massive archive of videos and text here). 

We will be posting many more articles throughout the week from Greenblatt’s class notes so make sure to check back at least daily or subscribe on Twitter, Facebook,  Google+, Linkedin,   RSS (or Feedly specifically),  or best of all sign up for our new and enhanced newsletter (make sure to select value investing and daily under the options).

Joel Greenblatt wrote one of the best books ever on investing (with one of the worst titles ever) You Can Be a Stock Market Genius (which focuses on special situations) and The Little Book That Beats the Market (on the magic formula); both are referenced extensively below. So if for some reason you have not read them make sure to check them out.

Note: Readers can print this (or any) article, convert it into PDF by scrolling to the very bottom. Enjoy!

Magic Formula of Little Book Just May Work                  November 9, 2005; Page C1

As hard as it is to envision, hedge-fund titans and other masters of the universe soon will be tucking themselves into bed with a thin tome bearing a cutesy title: “The Little Book That Beats the Market.”

Here’s why: The author is Joel Greenblatt, a former hedge-fund manager. His first investment guide, published in 1997, also sported a hokey title, “You Can Be a Stock Market Genius (Even If You’re Not Too Smart),” and sold about 38,000 hardcover and soft cover copies.

Not bad as first books go, but it also became a cult hit in the insular world of hedge funds, passed like samizdat from manager to manager. A book of war stories and case studies written clearly and laced with jokes, it had two profound insights, say hedge-fund managers who have pressed the book on me.

One was that there are secret hiding places in the stock market, like spin-offs and restructurings, where bargains tend to lurk. The other was there wasn’t any compelling reason to have a giant portfolio of dozens of stocks when a well-designed, concentrated portfolio could accomplish the same goal of achieving high returns without adding risk.

“His book on investing is by far the most valuable thing I have read,” says David Einhorn, who manages a large, successful hedge fund, Greenlight Capital.

But hedge-fund managers “were not quite the underprivileged group I was shooting for when I wrote it,” he says. So for his second book, Mr. Greenblatt says he wanted to write an even more basic and fundamental book on investing that would appeal beyond Wall Street. Think Benjamin Graham does Borscht Belt.

Mr. Greenblatt, 47 years old, says his goal was to provide advice that, while sophisticated, could be understood and followed by his five children, ages 6 to 15. They are in luck. His soon-to-be-released “Little Book” is one of the best, clearest guides to value investing out there. I have some minor quibbles, but in a world where individual-investor advice is dominated by jargon-filled short-termism on the one hand and oversimplified throw-up-your-hands indexing on the other, Mr. Greenblatt’s approach is valuable.

It is so simple and cute that an investor with a little bit of knowledge might mistakenly dismiss it. Mr. Greenblatt titles his investment approach a “magic formula.” His tongue is in his cheek, but not entirely. He writes as if he were J.M. Barrie spinning a Peter Pan-esque fairy tale, but with the fervor of a true believer:

“You have to take the time to understand the story, and most important, you have to actually believe that the story is true. In fact, the story concludes with a magic formula that can make you rich over time. I kid you not.”

What is the magic formula? Invest in good companies when they are cheap. As Mr. Greenblatt might say: See? We told you it sounded obvious. Yeah, so what’s “good”? And what’s “cheap”?

Good companies earn high returns on their investments, he explains, while cheap companies sport share prices that are low (based on past earnings). His proxies for these criteria are return on capital (operating profit as a percentage of net working capital and net fixed assets) and earnings yield (pretax operating earnings compared with enterprise value, which is the market value plus the net debt). To his credit, however, Mr. Greenblatt explains all that parenthetical jargon in terms that shouldn’t insult his peers but that will ring a bell for the unschooled masses.

To make things simpler still, his free Web site, www.magicformulainvesting.com, screens companies using his criteria. He advises individual investors to buy a basket of top stocks and turn them over on a strict schedule, depending on how they perform. (For maximum tax advantage, sell losers just before a year’s up and winners just after a year.)

It sounds too easy. But in fact, his approach is difficult not because it is hard to understand, but because it requires patience and faith that you are right when the market is saying you’re wrong.

This is based on Warren Buffett’s investment principles. But they bear repeating. Even a die-hard value investor like Mr. Greenblatt says he didn’t realize that trying to find cheap, good companies, rather than just cheap ones, was so important until the 1990s. While Mr. Graham, Mr. Buffett’s mentor, was looking for starkly cheap companies, Mr. Buffett wants only the great ones.

“I didn’t get Buffettized until the early 1990s,” says Mr. Greenblatt. “I wish it happened earlier.”

Looked at retroactively, the returns of the “magic formula” beat the market handily. From 1988 through 2004, according to Mr. Greenblatt’s book, the high-return/low-price stocks of the largest 1,000 companies had returns of 22.9% annually, compared with 12.4% for the S&P 500.

The most convincing part of Mr. Greenblatt’s argument is that when 2,500 companies are ranked for price and returns (based on the formula), the top 10% outperformed the second 10%, which outperformed the third 10% and so on. “The darn thing works in order,” he says.

There are some limitations to the approach. It seems prone to tossing up stocks whose high returns and growth may be in the past. Magic-formula stocks with more than $1 billion in stock-market value include lots of fast-growing specialty retailers and niche pharmaceutical companies. Some of these will flame out.

That’s why Mr. Greenblatt argues that novice investors buy at least 20 or 30 of them. For himself, he buys a smaller number that he can know deeply. But that requires something not easily taught in a book: good instincts and judgment to distinguish true cheap gems from one-hit wonders.

Though he always was a value investor, his hedge-fund firm, Gotham Capital, wasn’t always run on his magic formula, especially in the early years, when he tended toward complex arbitrage. He started Gotham in 1985 and ran it for outside investors for 10 years, achieving compounded annual returns, before fees but after expenses, of 50%. He started with $7 million, mostly raised through junk-bond king Michael Milken. After five years, he returned half the outside capital. He finished with more than $350 million and returned all the remaining outside capital.

These days, he spends his time teaching at ColumbiaBusinessSchool and helping run a Web site for pros, the Value Investors Club. His wealth is mostly tied up in Gotham Capital, which manages $1.6 billion, including some outside money in a fund of hedge funds he started a few years back.

Joel Greenblatt Class for Special Situations Investing

Wednesday, March 23, 2005

Brian Gains of Springhouse Capital

Case Study of Investing in a “Dying” Industry

Italics: Transcript by John Chew

Joel Greenblatt Introduction:

Our guest will not sing, but he is really smart and he runs a fund called Springhouse Capital.  He started in 2002.

I hope you took a look at BBI, MOVI and Hollywood.

Brian Gains, Founder of Springhouse Capital

My title is: Making money in a “dying” industry

I will take you through how I came up with the idea, the work I did and then a couple of different case studies, which I think will be pretty interesting along the way–the facts or the things that were going on–so you can experience what I was thinking or the thought process I was trying to go through. 

As you know from your studies of the stock market, there are often hated industries where you want to go if you have more of a value bent. Some of the places I go to find investment ideas.

Idea Generation

• 52 week low lists
• High short interest
• Investors’ Business Daily negative momentum
• Spin-offs
• Distressed Debt: Highest yielding areas

Everyone makes fun of Investors’ Business Daily but you can go in there and find negative momentum industries where everyone hates the industry(s).  You can see what people hate. Start with some industries that may give you some ideas.  I am sure Joel has spoken about spin-offs.  You can see what is in the distressed area. Obviously, if debt is trading at 50 to 60 cents on the dollar, people don’t like it–that would be a good place to start.  This leads you to a place to look for ideas.

• Challenge is figuring out if the hate is logical (there are reasons why businesses are hated.)
• Companies fall in one of four categories:

–  Unsustainable business

q          Avoid

–Bad balance sheet (Cellular in 2002)

q           Analyze the capital structure

q           Often times akin to an option bet and understanding cap structure

determines the maturity of the option.

–Cyclical (Commodities in down cycle)

q     Normalized earnings

–Dying businesses (Photography, Photocopying, etc.)

q     How long will it last?

q     Is it really dead?

q     What are the people on the inside doing?

q     Where is the cash going?

The challenge is figuring out if there is a logical reason(s) a business is hated.  I like to think that things fall into four different categories:

1. Unsustainable Business:

• AVOID

An unsustainable business is like an eToys.com, Pets.com.  Something that collapses in 2001-2002 and you are looking at it. You can say it is really cheap; the stock used to be at $50 and it is at $2 now. In reality, it is not a business–no matter how much cash it has or the capital structure, eventually it wasn’t going to work. So that is one example.

Student: General Motors (GM)?

BRIAN GAINS: GM’s business is probably sustainable. Sure it has problems with its debt structure, but it makes cars that people need.

2. Bad Balance Sheet: (Cellular in 2002)

• Analyze the capital structure
• Often times akin to an option bet and understanding cap structure determines the maturity of

the option

Then I put Bad Balance Sheet, which I think Cellular companies in 2002 are a prime example.   The important thing there is analyzing the capital structure. Everyone knew that cellular phones would be around, but it is a question of they had too much debt on the balance sheet. Sprint and all these different companies, if they could pay the debt, they clearly could make money. They way to look at it is to analyze the capital structure. You literally have an option bet.  And you have to figure out, “Are the banks going to take this under?” And if you can survive past that point–if the debt is due in five years, which is long enough for the company to survive–you probably have a great option bet.

3. Cyclical Business (Commodities in a down cycle)

• Normalized Earnings

Richard Pzena is the king of normalizing earnings for cyclical businesses. These businesses have a reason to exist, but you have to look for the middle point. You have all been through that.

4. Dying businesses (Photography, Photocopying, etc.)

• How long will it last?
• Is it really dead?
• What are the people on the inside doing?
• Where is the cash going?

I will talk about the last category, the allegedly dying business.  Maybe it is dying; maybe it is not.  And some people would say non-digital photography, photocopying, fax machines. I will talk about video rental.  And the key questions are: “Is it really dead?”  How long it is going to last? Number three is key: follow the insiders to see if they have confidence in their business. That is a great key to see if this thing has some legs left in it.  Also key is where is the cash going?  Because when you are dealing with these stocks, it is less about a multiple and more about how much cash they are going to generate and what are they doing with the cash. It is really important when you are looking at the return to think about the next two years, they are going to generate $2 dollars a share in cash and if you are buying the stock at $8, well that is pretty good.  You still have to figure out how long that will last. But following the cash is key.

Analyzing the “dying” business

• Process involves going through all the negative arguments and constructing a thesis as to the merit

of each. (Thesis vs. Antithesis)

–Most time intensive activity

• Some things to accept before attempting this at home:

–Your behavior and gut instinct probably won’t support your thesis

–People will say you are nuts

–Your friends at other funds will tell you they are short the stock and you are nuts.

–At times you will come to believe they are right and you are nuts.

The way I tend to look at things is that I pick up an industry and I go through all the reasons why people hate it. List all of the things that are really, really bad about it. Then try to find a reason. OK, is it as bad as they think? Is there a reason why it is not as bad as they think?

So right now someone pointed out General Motors (GM). You can see GM down and then you look at all the auto parts guys and list all the negative thoughts on the industry.  Then construct a thesis as to why the business is not as bad as people think because of ABC.

Your behavior and gut instinct are probably not going to support what you are doing. If you are looking at video rentals, you are probably saying, “I don’t rent videos anymore.”   The one key to remember is that you are not the target audience.  You are not like most of America.  For one thing, you are younger and more urban. A lot of things you do will be more technologically advanced.   So if it is faxing or renting videos you will say, I don’t do that anymore so forget that industry.  Your friends will say you are crazy.

What’s Bad about Video Rental?

• Sell-Through

–Long-term trend?

–Pricing continuing downward?

• VOD

–45 day window

–Additional features/24 hour limit/HD and selection constrained

•  Netflix/Home delivery

–Niche product

–Instant Gratification

• Digital Distribution

–Computer watching

–Time to download relative to length of movie

–Quality/HD

• Piracy
• TIVO
• Ever expanding entertainment options.

Brian Gains: So what is bad about the rental business? Why wouldn’t you like the Video Rental Business? 

Students:  Netflix, Wal-Mart selling DVDs. VOD. 

Brian Gains: Wal-Mart sells cheap DVDs, so people don’t need to rent.

One of the things I would add is file sharing, piracy and digital distribution.  I would talk to different people and ask what is not good about the business. And then sell through. Is the selling of cheap DVDs–$6 for two DVDs—going to continue.   Is this a long- term trend? Can the price continue downward? Wal-Mart is selling DVD’s at a loss to drive traffic.  The studios love this.  What other business has the distributors of their product intentionally selling the product at a loss?

Anyone have any thoughts?

So, I guess the way to look at this is that this is a risk. So we can accept that we don’t know what is going to happen in pricing.  We know that the studios currently make a lot of money off of DVDs and you can establish that.  As to pricing it is very hard to predict.  That is going to be one of those variables where you just don’t know–is pricing going to steadily creep down?  You know these guys (studios) don’t want to cut the prices.  If the DVD are growing every year, they have no incentive to cut the prices.  It costs about $2 to make a DVD and they are selling new releases for $17 to $18.  They (the studios) have no incentive to cut prices.   Research will show you that Wal-Mart is selling new DVDs at a loss.  So Wal-Mart is doing the studios a favor.  How often do you see a distributor of your product sell at a loss?   It is infrequent.  We know the studios are pretty happy. They have no desire at this point to cut prices.  So logically, the studios don’t have an incentive to lower prices.

VOD: It is important to understand how new releases enter the theatres and they are there for two or three months, then they sit on the sidelines.  Then they go to DVD.  45 days.  New releases are important for video stores.  80% of their rentals are new releases.   The studios don’t want it to go to VOD.  They make $15 every time they sell a DVD. THIS IS CRITICAL because someone can say VOD will destroy the video rental stores. You can make a case that the studios make so much money off of selling(DVDs) that they will not collapse the window of time for the video stores to sell the DVDs before the releases go to VOD.

You can’t say that it (VOD eliminating DVDs and videos) isn’t going to happen.  It is a question of how quickly people change their habits.  2% of all music sold is digitally distributed.  So 98% of all music sold is through CDs.

I would say eventually it is going to happen, it is just how long will it take.

The other thing about VOD, you need to have digital cable so you are talking about a smaller portion of the country. You need to not have (or not care about) additional features like extra scenes.   Studios are moving toward high definition DVD, so you have another reason not to buy VOD.

Netflix home delivery.  Netflix has about 2.6 million customers. Blockbuster has 750,000 customers. It is a different business. It has Premier customers–people who want more category depth. A lot of niche films.  These aren’t the same customers.

Digital distribution takes too long to download.  In reality it takes time too much time for the average consumer.

TIVO came out, but people still want to watch movies.  People want to watch new movies. A truism no matter how distributed.  People go to movies because of the experience.

Ever expanding entertainment options.

What’s Good about Video Rental?

• Good cash flows
• Good returns on new investments
• 45 day window

–Economics of DVD

• More stable than people think

–Note that most businesses will last longer than people think

• Mom and Pop’s still hold 40% share

• What else can they do with their infrastructure?

–Retail/Video Games/Used

Brian Gains: What is good about the video rental business?

Student: The cash flows are good.

Brian Gains: The cash flows are great.   They have a great retail box.  Video stores can sell other stuff.

The returns on new video stores are absolutely amazing.  Because it doesn’t cost much (to set up a store with inventory).  It is $150,000 to open a Blockbuster.  The beauty of it, is that if it doesn’t work, then you can move it eight miles down the road and try again.  You can move the business easily.  The returns are high and you can afford to screw up a little bit. The 45-day window is critical for video stores (allowing Video Stores to sell DVDs).  This is more stable than people think.  A lot of businesses last a lot longer than people think.  For another 20 or 30 years people will still be buying videos.  People are still buying phonographic records and there is a replacement for records.

There still is a 30% to 40% share of the market in mom & pop stores.  It is kind of evil sounding but it is capitalism.  If the small business owners still have share, as a chain like Blockbuster, you can go in and you can take them out.  So Blockbuster can still gain share.

What else can they do with the infrastructure?

So that is where a lot of the research is done.   A lot of time talking to people to figure out how much of this is real.

Macro to micro

Simplest place to look to find all these factors rolled up into one easy measure of video rental performance is the same store sales of the respective stores.

–Mitigating factors that will disrupt this analysis

OK, so how do I make money off of this? Before it was all-theoretical; before you were kind of thinking about the industry.

For Video rental performance, the same store sales (SSS) statistic is key for forming how much of this is coming to life. You form all these theses.  And then try to find out where it will show itself–in the video guise of same-store-sales.  But the one thing to remember in the video business there are many mitigating factors that will affect SSS as any business (weather, feature presentation schedules, political events, days in the quarter).  In this case why SSS may not be indicative of the business.  Ans: Blockbuster releases drive customers to stores–hit driven product/sales causes lumpy sales.   People look at comps and say that comps are down 3% without adjusting for what effects the change. Weather can affect sales.  12 weekends in a quarter–one bad weekend can have an affect.

I would also say, children’s movies–they sell they don’t rent.  Kids have a propensity to watch the same movies over and over again.  It would not be normal behavior for adults.

It is the type of movie that the store rents.  Sometimes political events may cause people to watch more TV then rent movies. 

The Blockbuster (BBI), Hollywood (HLYW), MOVI are all taking share from the mom & pop (stores), then it will make it look like the business is worse, but they are taking more share.  Their business is surviving, because they opened a Blockbuster (store) but the local video store shut down. So everyone who went to that local store will go to the Blockbuster.

————-

Now we will go through what I went through with Hollywood Video (HLYW).  Blockbuster has 6,000 stores while Hollywood has 2,000 stores but in the same kind of areas though more West coast oriented.  Consider it identical. 

The (stock) market had a great 2003 and I am sitting around in Dec 2003 and there is nothing too interesting going on.  So I am screening different stuff. So I say OK, everyone hates the video rental guys.  So I do all that first stuff we talked about. Then I go to an investor presentation.  I go to see Hollywood Video.  At that point I knew nothing other than I had some arguments as to why this industry could exist. Let’s look specifically at Hollywood Video.

What you will see in the Hollywood story is that they are opening up Game Crazies, which are like a game store boutique.  They are getting great returns.  The CEO is also saying he is going to open 150 new stores a year and getting great returns.  So you say, “Hey, maybe the business doesn’t last so long, but he (CEO of HLWD) seems to think so.   He is still opening stores. He is mildly positive.  

The CEO owns 10% of the stock and this will come into play a lot in this case. Because we went through all the arguments and we can say, I believe him and I can get pretty comfortable, but what is someone on the inside saying?  In this case, he (CEO) owns 10% of the stock and he is the one making the decisions to build the new video stores.  That is important to remember, because the guy who owns 10% is saying he still wants to build these things.  Maybe he is dumb, maybe he is not, but you have to give him more credit for knowing more about the business than you do because he is living it (the business) day to day; he is seeing the numbers; he is running all the different tests that say to him–this is still kind of working.  And it is his money and he will probably have more money at stake than you probably will.

So really, really important in this case and in a lot of businesses that are dying to see what insiders are doing. If the insiders are bailing out and you think the business is dying–it probably is.

Hollywood Video

Began looking at it late 2003 after attending an investor presentation

–High returns on Game Crazy (HLYW’s version of Gamestop or Electronics Boutique) and new Video Stores.

–Mom/Pop still represents 40% of industry

–CEO owns 10% of the stock

HLYW is at $13 to $14 bucks.  So this is the news release on Jan 6^th. 

Jan 6 HLYW News Release

HOLLYWOOD ENTERTAINMENT ANNOUNCES 2003 FOURTH QUARTER

SAME STORE SALES

PORTLAND, OREGON – January 6, 2004 – Hollywood Entertainment Corporation (Nasdaq: HLYW), owner and operator of more than 1,900 Hollywood Video superstores and approximately 600 Game Crazy video game specialty outlets, today announced that same store sales for the fourth quarter increased 12%.  Contribution to same store sales from rental product revenue was negative 2% while contribution from merchandise sales was 14%.

As a result, the Company expects net income for the quarter to be approximately $0.36 per diluted share and expects adjusted net income for the full year to be approximately $1.40 per diluted share.

On January 5, 2004, the Company prepaid the $20 million 2006 amortization of its senior bank credit facility.  During the fourth quarter, the

Company also used $16 million to repurchase shares of its common stock.

The Company expects to report its fourth quarter and full-year 2003

results of operations on Thursday, January 29, 2004.

So what strikes you? This business could be dead.  People are saying this business is gone. Don’t touch it.  So what strikes you about this news release? They have great merchandise sales (Merch. Sales up 14%). They are buying back their stock, it is kicking off cash and they are prepaying debt.  HLYW is buying back $16 million of stock.  Buying back expensive stock could be a bad thing.

They are still spending $90 million to open stores.  The CEO’s interest lies in the stock, not his salary.   He stopped in October 2003 his 10B-501 sales–a positive signal.

I go right to the negative 2% comps.  Everyone says this business is dead. And we talked about the mitigating factors of weather and all this different stuff that can take your numbers up 5% or down 5%. His comps are only down 2%. Does it look like something that is going to fall off the face of the earth?  It is not comping down much in the grand scheme of things.   There are businesses that comp down 5%, 7%, 8% and people still think that those are great businesses.

The stock is at $14 and for me I see he (CEO of HLYW) is looking to make $1.40 and it is trading at 10 times next year’s earnings.  So that is Jan 6^th, 2004

So now go to Jan 29^th, 2004 when they come out with full year results.

HOLLYWOOD ENTERTAINMENT CORPORATION REPORTS

FOURTH QUARTER AND FULL YEAR 2003 RESULTS

PORTLAND, OREGON – January 29, 2004 -

Hollywood Video:

Fourth quarter revenue and same store sales for Hollywood Video, excluding Game Crazy, were $388 million and negative 1% respectively…… Fourth quarter 2003 operating income was $53 million.

Full year 2003 revenue and same store sales for Hollywood Video were $1.5 billion and 3% respectively.  For the full year, there is no material difference between “rental comps” and Hollywood Video comps.  Full year 2003 operating income was $205 million.  During 2003, Hollywood Video opened 102 new stores, ending the year with 1,920 stores.

Game Crazy:

Full year 2003 revenue and same store sales for Game Crazy were $180 million and 15% respectively.  Full year 2003 operating loss was $20 million (after the allocation of approximately $2 million of general and administrative expenses from Hollywood Video to Game Crazy for information services support, treasury and accounting functions, and other general and administrative services).  During 2003, Game Crazy opened 319 new stores, ending the year with 595 stores.

….. Commenting on the Company’s performance, Mark Wattles, the Company’s Founder, Chairman and CEO said, “While I was disappointed by Game Crazy’s performance in the first nine months of the year and by Hollywood Video’s performance in the second half of the year, the Company still managed to grow total revenue by 13% and adjusted net income by 16%.  To put that in perspective, we generated 3% same store sales in a mature industry, while building Game Crazy, which was

essentially a retail start-up, into one of the leading game retailers in the country.”

First Quarter 2004 Guidance

Hollywood Video:

Although business has been trending weaker than expected quarter-to-date, Hollywood Video is maintaining the guidance it provided on December 1, 2003 of mid-single-digit negative same store sales for the first quarter of 2004.

Game Crazy:

Same store sales for Game Crazy are expected to range from 12% to 14% for the first quarter of 2004.

————–

Brian Gains: So negative 1% comps for the fourth qtr. but for the full year in 2003, the video business still comped up 3% despite everyone thinking the business is dead. It is still comping up 3%.  He opened 102 new stores in 2003.

To put this into context, that when you start looking at multiples of operating income. What is key in Crazy?

What strikes me there is that he lost $20 million in Game Crazy, which is a start-up.  It is a growing business, comping up a lot; he is allowed to lose money. At some point that–$20 million loss (in Game Crazy) at some point will turn positive.  He can stop opening new immature stores. He also has a lot of new stores with inventory in them.  Even if it is a disaster, he can liquidate the inventory.   So he is losing negative $20 million.  When you are looking at the poor results for Hollywood, you must remember he has one division, which he can separate. He can do all sorts of different things with where he is losing $20 million. This division has inventory value.   So you have negative $20 million, value of inventory and plus it is probably going positive.  

In a lot of these dying businesses, you need to look at another area where they are making money.  There is a reason why this could get better.

Second half of the press release.

Full Year 2004 Guidance

Hollywood Video: Assuming a neutral comparison of aggregate home video new releases during the nine months following the first quarter of 2004, and adjusting for the volatility and weakness seen over the last several months, Hollywood Video quarterly same store sales are expected to range from negative 2% to positive 2% for the last three quarters of the year.  Hollywood Video is maintaining the guidance it provided on December 1, 2003 of negative 1% to negative 2% same

store sales for the full year 2004.

In addition, Hollywood Video plans to open 150 new stores in 2004, weighted toward the second half of the year.

Game Crazy: Based on the limited information available regarding upcoming software releases and other factors affecting the game industry, same store sales for Game Crazy are expected to average mid-to-high single-digit for the nine months following the first quarter and the full year 2004.

Hollywood Entertainment Corporation:

Based on the above assumptions for Hollywood Video and Game Crazy same store sales, the planned opening of 150 new Hollywood Video stores and 150 new Game Crazy stores, and the recent volatility and weakness experienced by Hollywood Video, the Company believes 2004 net income per diluted share could be lower than 2003 adjusted net income per diluted share, but does not expect it to be less than $1.33 per diluted share. In addition to operating Hollywood Video and Game Crazy, the Company is evaluating other long-term strategic initiatives.  Should the Company choose to pursue one or more of these initiatives during 2004, it is likely that earnings

would be negatively impacted by a material amount.  Assuming that no significant new strategic initiatives are implemented in 2004, the Company expects total spending for growth, including inventory and store opening expenses associated with new Hollywood Video stores and Game Crazy stores, to be approximately $90 million.

——–

Student: The press release seems fluffy and uncertain

Brian Gains: There are a lot of things that the CEO can’t predict. 

He is still not making money in Game Crazy but he is comping up 12% to 14% (in that segment), so eventually he will make money.  And the reason he is not making money is because he is opening a lot of new stores.  When you open a new video store, no one shows up.  It takes time to change people’s patterns.  It takes time for that business to mature. He is still growing Game Crazy.  A lot of this relates to his owning more than 10% of the stock.  What strikes me is that he is still opening video stores. He still thinks the returns are good.   If you told someone who thought the business is dead that the CEO is till opening 150 new stores, they would reply that he is nuts.  He owns 10% of the stock.  He has more of an incentive than I do.

The CEO talks about developing a strategic initiative to develop a Netflix-like product.

The CEO knows the business better day in and day out than I do.  He has the best data.  Whether he is using it well is another question.

Student question: How do you assess the CEO?

Brian Gains: Look at his track record.  He has been smart about his ability to grow his business. When did he buy stocks and when did he sell his stock. Is he smart with his stock?  A CEO, like this one, who has been called “shady” can mean self-interested.  You will hear people be effected by their emotions.

He was thinking about spending $150 million to compete against Netflix. He will do what is right. 

He is going to do something that will have a return.  Maybe he thinks the return is 30% pre-tax. Maybe he thinks it is 70% or maybe 10%.  I am just saying he has these parameters set and let’s hope that he hits them.

Now it is Feb. March and I am starting to buy the stock.  The stock is at $11.50 to $11.50 and it starts to trend down.  Here are two years trailing:

What strikes you here? Really high ROIC, EBIT, good operating margin and it is really cheap.  So I have operating income and I need to set a maintenance capex level.  So what does it cost to keep one of these video stores going? If all hell breaks loose, nothing is good, he is not spending any money, he stops Game Crazy; he stops building new stores. What is it going to cost him to keep this business going? And 3.6 multiple is cheap and someone pointed out the Returns on Capital–it is worth noting that when you do ROC–there is a company-wide ROC and taking operating income and dividing by net working capital, his PPE  (Property, Plant and Equipment) and in this case his rental inventory. And then there is the incremental returns on capital (ROC) on his new stores. And the incremental ROC on his new stores may be higher because he doesn’t have SG&A–it is just incremental.  Here on the whole company he is doing a company-wide pre-tax ROC of greater than 42%.  It is still fantastic. 

Student: What is the type of the lease? Capital or operating?

Brian Gains:  This is an operating lease. They have two or three -year leases so it is not a big factor.

Student: How did you calculate Return on Invested Capital (ROIC)?

Brian Gains: So all I am doing is taking net working capital and net PPE.  In this case (rental) inventory as well.  I did not capitalize the leases because they are only for three years. I assumed they could break the lease if their business is not working.

Taking that as operating cost.  Net of all rental cost. 

Student: If the stores are having to constantly replenish inventory–is that capitalized?

Brian Gains: No.  I treat it as an expense–an operating expense.

One thing you wouldn’t have known–HLYW had an NOL asset.  It has a net operating loss (NOL) of $73 million so that is an asset.  He will realize it all pretty quickly.  That is an asset.  It is important to know whether they are paying cash taxes or not.  Operating income is running 187 million dollars so he will realize all of his NOL right away.  With these companies with a lot of cash, it is important to understand their tax situation.  Are they paying taxes in cash or not.  When you are looking at multiples, you would deduct the NOL from Enterprise Value (EV).

Another thing to note–despite everyone saying the business is dying– you went from 244 stores  to 252; operating income was up as well. Another thing I noted was that his rental gross profit–the part of the business everyone hates–well, you can say merchandise is growing 12%, that is not a great a business because he has lower gross margins–he took rental gross profit from $876 to $945 and he grew the rental gross margin.  To me this doesn’t look so awful.  I am actually seeing a business that is trending up.  And getting it for 3.6x EV/EBITDA-MCX or for a 28% pre-tax return.

 So at this point I am excited.  I am buying the stock here between $10 and $11.

How bad is it?

$1,500Video SSS1%Video Rental-2%Video Op Inc.

$205New Video Stores

102Ending1,920  Game Crazy Rev

$180Game Crazy15.0%Op Inc($20)New Stores319EOY595

How bad is it? He has Game Crazy where he is getting good returns and he has low MCX and everything above is a summary.

HLYW Conclusion

Here is my final work (below).  I said how many different ways can this turn out OK for me? 

The normal case–what the CEO is telling you he will do in 2004–$230 in EBITDA.  His capex is: he has 2,000 stores and $10,000 per store so $20 million plus he has corporate capex.  So let’s say he just goes MCX then he has interest, so I calculate Free Cash Flow (FCF) tax adjusted is–he has a NOL but we set it aside just to be safe.  Let us look at this fully taxed.  He is doing $1.90 in cash EPS.  I put a 8 multiple on that so you get to $15 per share—the business is not dying as quickly as people think.

Then you say over the next year, you will get $1.90 back in cash, that is what I talked about before–how much cash you will get back right away. You will get back $1.90 right away.  So I said, OK if this kind of works out in this fashion, if people look at it as if, OK, it were really dying; it is really bad, I could get 70%. 

If the people in the end say it is really a growth business, I may get something much better. Then I said it does $225 and I am wrong on Capex and it is $35, so maybe my return is only 36%.  But then you can go through these numbers and see how bad does it have to be to get to $10 where the stock is trading. And you have to take it down quite a bit to say, OK, it is worth what it is (now).  And in one case I am saying it could be worth 70% more.

In this last example, I am saying he is losing $20 million on Game Crazy per year.  He is actually estimated to lose $16 million for 2004, so let’s add that back. Let’s say he liquidates Game Crazy so interest expense is not as high because he has 500 stores; he sells the inventory.  So he immediately sells that down.  In that situation, he ends up with$16 per share and $2 in cash and he gets $18 per share for 82% if I bought the stock at $10 per share.  So there are a lot of ways this could work out.

Businesses isn’t as bad. Or if it is bad, and if  MCX  is what really comes into play because he realizes things are falling apart–so he stops doing it.   I am still probably going to do OK.  At this point I say, OK, I will take the bet.

In the worse case scenario at the end of the year, I have a $10 stock.  But I think, I make a lot of money on this.  There is chance I make 80%.  (0% to 10% downside for a 36% to 82% upside).

This summarizes what I was talking about.

A lot of ways to win…….

HLYW Conclusion (cont…)

• Since CEO owns stock, he will do the right thing with high return Game Crazy
• Margin of safety from backing out Game Crazy losses, NOL, value of inventory at GC stores and bare level of

Maintenance capital expenditures (MCX).

• Logical reasoning of video rental business durability.

Brian Gains: The margin of safety is the Game Crazy stores because they are losing money, but they could be making money–more upside.   That is where I came to buy HLYW between $10 and $11.

So March 29^th, 2005.   Read the whole thing and what strikes you the most?

On March 28, 2004, Hollywood Entertainment Corporation (the “Company”)entered into an agreement and plan of merger (the “Merger Agreement”) with Carso Holdings Corporation (“Holdings”) and its wholly owned subsidiary.  Holdings is a wholly owned subsidiary of Leonard Green & Partners, L.P. (“LGP”), a private equity firm that manages more than $3.6 billion of private equity capital….And each share of Company common stock will be converted into the right to receive $14.00.

Mark Wattles, Hollywood’s Founder, Chairman and CEO will continue in his current capacities following the merger.  Mr. Wattles will exchange a substantial portion of his equity holdings in Hollywood for 50% of the common equity in the surviving company.

Brian Gains: Note that the Founder and CEO is going to take 10% of the equity of the company–now he will take 50% of the company.  So maybe he was sure, but now he is doubling down, tripling down.  He won’t take any cash off the table, I am going to throw all the cards in with these new guys coming in at $14 per share.   If you know Leonard Green, they are fairly well regarded. Note that the CEO thinks the business is good, now he thinks it is great. He is willing to take everything in at $14.

So the stock rallies and everyone happy, but you see that the CEO gets to roll in for 50% of the equity.  I want in on that.  So I sold.  The stock was trading at $13.50 and I say there are merger arbs who can do better work than I can do (no more edge), so I sold.  I will move onto the next one.

Move on to the next one and use your edge…

If you have done the work on an industry (particularly one with a lot of angles), always look at the competitors.

–Applying HLYW take-out multiple (where CEO of HLYW is buying his own business) to Movie Gallery

(MOVI) implied a $20 stock price.

• MOVI arguably a better business so worth doing more work

So you have done all this work in understanding the Video business.  Don’t give up at that point. And this is where there are other people in the business.  Go look for other stuff.  People look at insider sales–well, here you have an insider buying half the company. You see insiders buying 10,000 shares.  He (HLYW CEO) is willing to buy 30 million shares.

MOVI: This same multiple given to HLYW applied to MOVI Gallery would give you at $20 stock.

MOVI

• Rural version of HLYW and BBI
• Fewer than 1/3 of stores compete with either HLYW or BBI

–Mainly single operator competition

• High ROIC on new stores
• Stable comps
• Rural nature implies less technology risk
• CEO owns 15% of stock
• Possibility of recap or stock buyback.

MOVI Gallery is in the rural areas of the country, so for all the talk about other entertainment options, MOVI Gallery has none of that.  Plus, we will see some other stuff that makes it kind of interesting.

So it is trading right around $20.  So you are not getting a steal the day the merger happens. Maybe you are getting something good.

So MOVI has less technology risk if I was worried about that, not much competition and the comps in MOVI Gallery are still comping up and are really, really stable.  The CEO of MOVI owns 15% of the stock.  This capital structure does not have debt on it. 

So HYLW had some debt on it.  This has no debt on it, so there is a possibility to lever it up because he has a lot of cash, you get a tax shield from putting the interest expense against the pretax income.   All sorts of different things you can do.

MOVI FINANCIALS

He has cash on the balance sheet.  I am not giving you any yr/yr stuff so you can’t even take a look at those. What is interesting…. So it costs him $12,000 to open these MOVI Gallery stores and three years out he makes 62%.  A mature store three years out makes 62% pre-tax returns on capital and he has been opening stores successfully. He has 2000 stores now and he is adding 200 stores a year.  And this, I am sure you know this from retailers, with 62% (returns) you build all day without screwing up. 62% returns on capital, you can’t probably find better alternatives.

Even in year 1,  it is 35% without it being mature.  Particularly, a business trading at 6 x EBIT

THROWING away money?

Now we get another piece on August 6^th, 2004

August 9, 2004

PORTLAND, OR, August 6, 2004 — Hollywood Entertainment Corporation (Nasdaq: HLYW), owner and operator of more than 1,950 Hollywood Video superstores, today announced that Leonard Green & Partners, L.P., an affiliate of Carso Holdings Corporation (“Holdings”) and its wholly owned subsidiary (the entities with which Hollywood entered into a merger agreement on March 29, 2004), has informed Hollywood that, due to industry and market conditions, Leonard Green & Partners believes that the financing condition to the consummation of the merger will not be satisfied.

Hollywood and the Special Committee of its Board of Directors are considering Hollywood’s alternatives to determine the course of action that would be in the best interests of Hollywood’s shareholders. There is no assurance that a merger with Holdings will be completed, or if completed, that it would be completed on terms that do not differ materially from those in the merger agreement.

It is kind of vague, but it –what is the most important sentence here besides you lose if you are in the stock and you are an arb.–Leonard Green is bowing out because of the financing condition.  It wasn’t because of the conditions or quality of HLYW’s business.  Leonard Green probably couldn’t get something done in the high yield market.  They are saying, we are not leaving the deal, but we don’t like it at $14. So you can guess what happens now, so the stock trades back to $10.  You know the financing didn’t get done, the numbers are probably OK and you are back to where you were.

Everybody loves a good spin

• Viacom adds 1B of debt to Blockbuster and says don’t let the door hit you on the way out.
• Ramifications of the newly independent BBI?

MOVI has traded down a little bit that day.  At the same time as this, BBI is trending lower. Coincidently BBI pays a special dividend to Viacom after being spun-off from Viacom.  Everything is bad at HLYW, Summer Redstone over at Viacom says BBI gives me a lower multiple, I am sick of it, get rid of it and at the same time pay a special dividend-$5.  They kick it off.  BBI had everything to look for in a spin-off that may be hated—big debt load, bad industry, etc.  Now BBI is completely independent. I missed this.  I didn’t get it. 

More Chances to win..

• HLYW and MOVI trade down

–Significance of MOVI capital structure?

• Is MOVI affected?

• CEO of HLYW’s thoughts?

• BBI?

HLYW and MOVI traded down.  Since MOVI has cash on the balance sheet, a trade down in MOVI Gallery is huge, because it is cash rich.  Any fall off in price is pretty significant on a multiple basis.

Is MOVI affected by what happened?  NO.

What is the CEO of HLYW thinking about everything that is going on around him.  This is the CEO who wanted to triple down. Does he care where the merger happens–he would prefer a lower price. He is more excited if Leonard Green comes back and offers $3.  A take-under.

…and then it becomes a food fight

• Leonard Green comes back on 10/14/04 and offers $10.25
• On November 11/11, BBI confirms interest to acquire at $11.50
• Movi offers to acquire HLYW at $13.25.

Leonard Green shows up again on Oct 14^th.  We will do it for $10.25, then they hang around.  Classic private equity guys who say, the CEO doesn’t care about a lower price, so let’s offer $4 less. Then a wrench gets thrown in their plans, because a newly independent blockbuster comes back says they will do it for $11.50.  Then MOVI gets interested to acquire at $13.25.  All these strategic buyers get excited. With a key event, you had a BBI spin-off and you had L. Green get greedy and then a food fight begins.   It is funny how this stuff works.  L Green woke everybody up to it is not so bad. Everything transpired from there.

The HLYW’s CEO offers to acquire half of HLYW’s stores.

What I did when the merger announcement came out when Movi was going to acquire HLYW at $13.25, I said BBI runs into anti-trust problems because they have 60% of the market.   You do some quick math on MOVI and say wow this is a home run.  You can say they can cut costs, they can do the same thing as L. Green.

I am in MOVI but not in HLYW the second time around.  Putting a 8 multiple on MOVI’s $3.50, you could get a $28 stock.  So you could get really excited with MOVI if they get it and if they don’t, then a lot of time in these mergers, BBI is forced to sell off stores if BBI were to acquire HLYW, then MOVI could acquire those stores on the cheap.

Another thing about BBI’s bid is that it is in cash and stock.  And any Board of Directors will favor cash over stock.  It is the easier to go with the cash bid.  BBI is at a disadvantage because they have too much debt.  This is what is happening with Quest and Horizon–MCI’s Board is saying we want to go with Verizon since they are offering cash.

The HLYW’s Board is tired.  They know there is very little upside.  They know it will be acquired.  The Board personally does not want to be sued.  Clean this up and get out of town.

Dynamics of merger

• Ex-Hollywood CEO comes out and wants to buy 1/2 HLYW stores
• MOVI All cash bid

–Quick math on MOVI acquisition says they could do $3.50 in EPS if they acquire HLYW

• Concessions from BBI if they don’t win
• No overlap
• BBI issues

–Antitrust

–Cash and stock bid

• Implications for the board

So we will just finish up the story.  HYW trades back to $14 and MOVI  to $26. BBI pops as well.  You could do well in any of these companies.

END

Questions and Answers

I put 10% in HLYW, since I did all my work, I knew the downside was $9 to $10 and the upside was good.

For me, 20% would be huge, but 10% is usually my position.

What is your best bet–MOVI seemed better.

If you knew MOVI was a sure deal to acquire HLYW, then MOVI would be over $30. 

In the end, people rent videos near where they live.  With BBI, will it be able to be successful against Net-flix?

END 

Joel Greenblatt Columbia Class notes on special situations. Please see part I, part II, part III, part IV,  part V , Part VI, Part IIX, Part IX, and Part X the disclaimer there (also massive archive of videos and text here). 

We will be posting many more articles throughout the week from Greenblatt’s class notes so make sure to check back at least daily or subscribe on Twitter, Facebook,  Google+, Linkedin,   RSS (or Feedly specifically),  or best of all sign up for our new and enhanced newsletter (make sure to select value investing and daily under the options).

Joel Greenblatt wrote one of the best books ever on investing (with one of the worst titles ever) You Can Be a Stock Market Genius (which focuses on special situations) and The Little Book That Beats the Market (on the magic formula); both are referenced extensively below. So if for some reason you have not read them make sure to check them out.

Note: Readers can print this (or any) article, convert it into PDF by scrolling to the very bottom. Enjoy!

NOTE: If any readers have more up to date notes and are allowed to share, please send us at info (@) valuewalk.com, we would be happy to credit you or keep it anonymous, as you wish!

CASE STUDY

Munsingwear, Inc. Case Study Instructions

Prize:

Pretend you have traded in your hush puppy shoes or sandals in for a pair of wing-tips.  You are now an investment banker who is being asked to help Munsingwear, Inc. “enhance shareholder value.”  How would you advise the CEO in improving their operations and profitability?   Your fee, if your advice salvages value for shareholders and/or turns this company around, would be $300,000.

Instructions:

Use only what is in this case study for your analysis.  If you feel critical information is lacking, then state what is missing and how it prevents you from advising your client.  You will have a chance to speak to the CEO, Mr. Lowell Fisher, in class.

After reading the 10-K what would you advise?  Why?   Please give no more than a written paragraph answer.  Provide a brief pro-forma of your analysis if necessary.   What value might you put on the company after your recommendation?   Show work and assumptions.

This case test your strategic thinking ability and business sense.

Good luck in your new wing tips!

Munsingwear, Inc. Case Study

FORM 10-K

For the fiscal year ended January 6, 1996

Munsingwear, Inc.

IRS # 41-0429620

8000 W. 78^th Street, Suite-400, Minneapolis, Minnesota 55439

Telephone number: 612-943-5000

Delaware: State of Incorporation

The aggregate market value of the voting stock held by nonaffiliates of the Registrant at April 1, 1996 was $9,384,000 based on the closing price of $7.25 per share at that date.

The number of shares of common stock outstanding at April 1, 1996 was 2,037,078

1. GENERAL DEVELOPMENT OF BUSINESS

The Company was incorporated under the laws of Delaware in 1923 as the successor to a business founded in 1886.  The Company’s principal executive offices are located at 8000 W. 78^th Street, Suite-400, Minneapolis, Minnesota 55439, and its telephone number: 612-943-5000.  As used in this document, the term “Company” refers to Munsingwear, Inc. and its subsidiaries unless otherwise noted or indicated by the context.  At Jan. 6, 1996, the Company had one subsidiary, Munsingwear UK Limited, which was idled in 1994.

After suffering a severely weakened financial condition, primarily due to losses of $89, 243,000 during the years 1989 through 1990, the Company, on July 3, 1991, filed a voluntary petition for bankruptcy under Chapter 11 of the US Bankruptcy Code, together with a proposed Plan of Reorganization.  The Company emerged from bankruptcy on Oct. 29, 1991.

Prior to the reductions in operation implemented during 1989 through 1991, the Company designed, manufactured and distributed a broad range of men’s and children’s apparel through several operating divisions and subsidiaries.  Today the Company’s operations consist of what was formerly the Men’s Apparel Division and sell primarily men’s knit sport shirts under the following major brands or labels: Munsingwear ®, Grand Slam ®, Grand Slam Tour ™, Penguin Sport ™ and Slammer ®.  In addition, the Company licenses its trade names and trademarks for use in a variety of products.

In the recent two fiscal years, the Company’s sales by channel of distribution have undergone significant change.  In 1995, sales to premium/special markets and golf Pro shop customers rose 52% collectively over 1994.  This is the result of management’s attempt to reduce the Company’s reliance on sales to traditional retail apparel channels of distribution where heavy promotional pricing, discounting and advertising activities are required.

In late 1995, the Company retained the services of an investment banking firm to explore a range of opportunities to maximize shareholder value.

2. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS

The Company operates in one industry segment, apparel manufacturing.  As of Jan. 6, 1996, the Company’s foreign operations were not material.

3. NARRATIVE DESCRIPTION OF BUSINESS

Principal Products:

The Company sells primarily men’s knit sport shirts under four major brands or labels: Munsingwear ®, Grand Slam ®, Grand Slam Tour ™, and Penguin Sport ™.  Grand Slam ® and Penguin Sport ™ products are sold primarily to department stores, specialty stores and Sears.  Munsingwear ® products are sold primarily to premium/special markets customers and to national chain stores, such as Montgomery Ward.  Grand Slam Tour ™ is sold primarily through golf pro shops.

Sources and Availability of Raw Materials and Products:

Approximately 60% of the Company’s products are manufactured domestically.  The other 40% is sourced primarily from manufacturers in the Far East through a relationship with Associated Merchandising Corporation (AMC).  The Company also sources some product through the 807 program in the Caribbean Basin.  The principal raw materials used in the domestic production process are cotton, synthetic and cotton/synthetic blended goods obtained principally from United States sources.  The Company purchases most of its piece goods from approximately ten sources.  There are currently no major problems in availability of raw materials and alternative sources are available.  The Company’s Fairmount, NC manufacturing facility includes a material warehouse, cutting, sewing and embroidery operations, and finished goods distribution center.  The company also utilizes contract swing manufacturers in close proximity to its North Carolina facility to meet demand during peak production periods.  All products, both domestically and offshore produced, are distributed to customers from the North Carolina facility.

Trademarks and Trade Names:

In 1991, management initiated the strategy to actively pursue licensing as a vital part of the Company’s growth plan.  During the period 1991 through 1993, the Company entered into eleven license agreements, and in 1994, renegotiated its licenses with Fruit of the Loom which, among other things, extended the original agreement for twenty-five years.  In 1995, the Company entered into four additional license agreements.  Management intends to continue development of its licensing programs and believes that its advertising, styling and brand name identification established over many years are important to the competitive position of the company.  The Company has the following license agreements:

• A license with Fruit of the Loom, Inc. to market underwear and active wear.
• A license with a New York entity to market sleepwear.
• Five licenses with Montgomery Ward to market men’s pants, outerwear, accessories, dress wear and shirts.
• A license with a Canadian corporation to market knit shirts.
• A license with a North Carolina entity to market men’s and boys’ hosiery.
• A license with a Peoples Republic of China entity to market a variety of clothing and accessories.
• A license with a South Carolina entity to market sweaters.
• A license with a Missouri entity to market outerwear.
• A license with a New York entity to market woven shirts.
• A license with a South African entity for apparel.

Management’s emphasis on licensing activities in recent years has led to a dramatic increase in the Company’s royalty income, from $1,162,000 in 1991 to $4,609,000 in 1995.

Seasonal Aspects of the Business:

Sales of the Company’s products can vary significantly by season, with peak shipments normally occurring in the first and second quarters of the fiscal year.

Working Capital Practices:

The Company maintains a secured bank line of credit to meet its working capital needs.  Peak borrowings under this agreement normally occur in the first six months of the year during the heavier shipping period and during the fourth quarter when inventories are increased to meet the additional first and second quarter sales volume.  Seasonal increases in inventory are normal for the apparel manufacturing industry.  The bank line of credit is also used for letters of credit that are required for generally all of the Company’s purchases from offshore sources.  The Company allows returns of merchandise as a result of shipping errors, damaged merchandise and for other reasons.  Returns have been less than 4% of sales in each of the past two years.

Customers:

The Company sells to approximately 4,500 customers.  Sales to Sam’s Club (a division of Wal-Mart Stores, Inc.) in 1994 and 1993 were 16% and 21%, respectively, of net sales.  In 1995, no single customers represented more than 10% of total Company sales.

Backlog of Orders:

The Company’s backlog of unfilled orders at January 6, 1996 was approximately $15,600,000 as compared to $18,800,000 a year ago.  The decrease was due primarily to management’s emphasis on reducing reliance on traditional retail apparel customers.  The unfilled order backlog does not necessarily relate directly to future sales.

Competition:

The apparel industry in the United States is highly competitive and characterized by a relatively small number of broad line companies and a large number of specialty manufacturers.  In addition, there are unbranded and private label competitors as well as numerous, small specialty manufacturers competing with the Company.  The principal methods of competition in the apparel industry are pricing, styling, quality (both in material and production), inventory replenishment programs and customer service.  The Company seeks to maintain its competitive position in the markets in which it operates through the use of all these methods.

Research and Development:

The Company is involved in limited experimental research activities related to the development of new fabrics and production methods.  Research and development expenses, other than for product design, are not significant.

Environmental Considerations:

The Company’s manufacturing operations are subject to various federal, state and local laws restricting the discharge of materials into the environment.  The Company is not involved in any pending or threatened proceedings which would require curtailment of its operations because of such regulations.  In 1995, the company’s capital expenditures for environmental control facilities were not significant, and no significant capital expenditures related to environmental issues are projected in 1996.

Item 1: Employees:

As of January 6, 1996, there were 343 employees, none of whom were represented by a union.

4. FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES

Sales to unaffiliated foreign customers located outside the United States and its territories for the past three years were not significant.

Item 2. Properties

At January 6, 1996, the Company occupied the following properties:

Management considers facilities adequate for current operations.  At Jan. 6, 1996, no facilities were occupied

Under capitalized leases.

Item 3.  Legal Proceedings

None of a significant nature.

Item 4.  Submission of Matters to a Vote of Security Holders

None.

Executive Officers of the Registrant

The following information is furnished with respect to the Company’s executive officers as of the date hereof, pursuant to Item 401 (b) of Regulation S-K.  Each of the officers has been appointed to serve in his respective office until his successor has been elected.

ABOUT THE COMPANY

The Company was founded in 1886 as a manufacturer of men’s underwear.  Throughout the early 1900’s, the Company was an innovator of new textile and apparel manufacturing processes and, during the 1940’s and 1950’s, expanded its product lines, acquired a women’s intimate apparel company and, in 1955, introduced the Gran Slam (R) collection of golf apparel bearing the well-known Penguin ® emblem.  During the 1960’s and 1970’s, manufacturing facilities were added, textile research and development departments were established and the Company entered into numerous licensing agreements for the use of its trade names and trademarks.

Today the Company derives its revenues primarily from the sale of men’s sportswear apparel and the licensing of men’s underwear, active wear and other related apparel.  The Company’s products are sold primarily through premium/special markets, department stores, golf pro shops, national chain stores, specialty stores, sporting goods stores and wholesale clubs.  The Company designs, manufactures, imports, markets and licenses branded men’s lifestyle apparel under the Grand Slam ®, Grand Slam Tour®, Munsingwear ®, and Penguin Sport ™ labels.  The Company is headquartered in Minneapolis, MN and has 343 employees in company-wide operations.

LETTER TO STOCKHOLDERS

Revenues for 1995 were $56.1 million, a 34% increase over last year.  Dramatic sales growth in our premium/special markets and golf pro shop businesses more than offset a small decline in business with our traditional customers, such as department and specialty stores, national chain stores and wholesale clubs.   Premium/special markets volume increased seven-fold while golf Pro shop volume increased 52%.  In 1995 these two businesses represented 40% of our total sales volume and are expected to exceed 50% of total Company sales in 1996.  As recent transition the Company has undergone over the past two years, significantly reducing our exposure to the difficult retail apparel marketplace.

Royalty income was up slightly to $4.6 million.  As a reminder, 1994 royalty income had increased 25% as a result of additional license agreements and a twenty-five year extension to the Fruit of the Loom license, which will also lead to lower cash receipts from existing licensing agreements starting in 1996.  The Munsingwear trade names and trademarks have always signified quality to the licensing market and we will continue to actively pursue additional license agreements.

While we achieved significant revenue growth in 1995, we were not successful in becoming profitable.  The loss of $2.3 million, $1.13 per share, was primarily the result of deep markdowns on excess end-of-season merchandise related to the retail department store channel of distribution, losses related to an unsuccessful entry into “Friday-wear”, increased advertising expenses in support of the retail department store business and restructuring costs related to completed staff reductions and reduced office space requirements.  In addition, costs associated with our PGA Tour endorsement program increased, yet we feel this program is necessary to give Munsingwear brands consumer exposure.  We were successful in reducing selling, general and administrative expenses as a percent of sales – from 32% in 1994 to 27% in 1995.  Interest expense was up significantly due to inventory build-up required to service the explosive sales growth in the premium/special markets business.  Throughout the year we also experienced higher than planned levels of inventory for the retail department store business, which did not meet sales forecasts.  Ultimately, we sold this inventory at deep discounts.

Looking ahead to 1996, we plan to continue to grow the premium/special markets business which has achieved exceptional results the past two years.  Munsingwear’s strong consumer brand recognition, the Penguin logo, quality product and the agility to merchandise across a broad product line give us a competitive advantage.  We are confident that increased revenues and a return to profitability will be achieved due to the following:

• Continued strong sales growth in premium/special markets and golf pro shop businesses.
• Cost reduction programs.
• Continued focus on core capability – men’s, short sleeve, knit, and moderately priced golf shirts.

(Picture of LOWELL M. FISHER)

• Innovative designs and fabrics throughout all product lines.
• Continued upgrading of management information systems.
• Strengthening of our Board of Directors by the addition of three new members, Thomas D. Gleason, who was named non-executive Chairman of the Board in January of this year, and Kevin S. Moore and William J. Morgan, who represent the Company’s two largest single stockholders.

In late 1995 we retained the services of an investment banking firm to help us explore a range of opportunities to maximize shareholder value, and we expect this activity to accelerate in 1996.  Please refer to the Management’s discussion and analysis section in this annual report for additional financial analysis and a statement regarding forward-looking information.

Although 1995 was a difficult year for retailing, the Company achieved extremely promising revenue growth in our two most profitable businesses—premium/special markets and golf pro shops.  These results reaffirmed our decision to continue the Company’s transition – expanding markets, enhancing product quality, increasing consumer value and investing in infrastructure.  As a result, we are now in a much stronger strategic position and I look forward to working with Tom Gleason and the Board in continuing our efforts to ensure the long-term success and profitability of the Company.

In closing, I would like to thank our customers, suppliers and lender, who have continued to support us throughout the Company’s transition. Finally, I would like to take this opportunity to thank all Munsingwear employees for their hard work and effort which led to spectacular 1995 sales growth and reinforces our optimism for 1996.

Sincerely,

/s/ Lowell M. Fisher

Lowell M. Fisher, President and CEO.

CONSOLIDATED STATEMENTS OF OPERATIONS

(AMOUNTS IN THOUSANDS, EXCEPT PERSHARE DATA)

The accompanying notes are an integral part of these financial statements

CONSOLIDATED BALANCE SHEETS (AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA)

END

Interview with Value Investor Joel Greenblatt

By Bill Mann (TMF Otter)  December 21, 2005

The Little Book that Beats the Market. Audacious title? Maybe, but Joel Greenblatt has the chops and the record to back it up. His investment returns are amongst the most incredible in investing, with returns exceeding 40% per year over the last 2 decades.

Bill Mann: One of the things that you talked about in the beginning of this book is that you felt like your first book, You Can Be a Stock Market Genius, was a little more advanced than you had intended it to be. So you wrote The Little Book that Beats the Market with your kids in mind.  Describe for us some process that you went though in creating the book?

Joel Greenblatt: Oh sure.  Well, the way it really happened was is that there are a few simple things I have been teaching for ten years over at Columbia.  My students are always accusing me of making things sound too simple, so we sort of boiled down to what we have done for the last twenty years at Gotham Capital to a couple of important concepts.

What those concepts were were buying good companies at bargain prices.  The way we define “good companies” was companies that earn a high return on capital.  What that might mean is that if for instance a company opens stores and each store costs $400,000 and you can earn $200,000 on a store, that is a 50% return on capital.  If another company opens stores that also cost $400,000 but they only earn $10,000 a year, that is a 2.5% return on capital.  Simply, we said, “gee, the company that earns 50% a year on the capital invested is a lot better than the one that earns 2.5%.”  That is generally the course we have taken to define what a good company is, something that earns a high return on capital. Then we said, “Let’s try to buy those good companies cheaply.”  The way we defined “cheap” was companies that earn a lot relative to the price we are paying.  So we call that earnings yield, which is the inverse of P/E.  So that just means that if you can buy a lot of earnings for a cheap price, that makes the company cheap.

So if we can buy a good company that is also cheap, in combination that strikes me as being a good thing.  That is what we tend to look for when we are looking for investments at Gotham Capital.  Those concepts are not too hard for kids to understand.  If you explain to them that way, that I am just trying to buy good companies at bargain prices, they tend to understand that.

It’s very important that you understand what you are doing, not just following what I call the Magic Formula. If you are just following a Magic Formula, that formula doesn’t always work. But if you understand what you are doing, you will say, “you know what?  It just makes sense to buy good companies at bargain prices and eventually this will work.”  We did a study showing that large-cap companies can double the market’s return just following this formula. With small caps, you could actually almost triple the market’s return.

Bill Mann: I wanted to make this point.  When you say “we”, you are talking about Gotham Capital.

Joel Greenblatt: My partners at Gotham Capital, yes.

Bill Mann: And just to be clear, this is part of the process that you have used to manage money at Gotham Capital for more than 20 years.

Joel Greenblatt: Yes.  The Magic Formula from the book is not something that we fished around for by back tested extensively, using 40 different formulas until something looked like it worked.  This is the absolute first thing that we tried, and the inputs approximate how we invest professionally. So when we talked about components for a back test we thought “Let’s keep it simple.  Let’s look at what companies do.  If we rank them based on earnings yield and return on capital and picked the companies with the best combined ranking of those two factors, how would a portfolio of stocks like that do?”  That is what we back tested and that was the first thing we tested and that is what I wrote up in the book because it is so simple and obvious.

There is a slight difference in what we do at Gotham Capital.  For my kids, I did not think they were capable of projecting earnings out into the future.  At Gotham Capital what we do is, instead of using least year’s earnings, which is what we used for the Magic Formula and what got those great results of double and triple the market’s returns, we used what we think normal earnings will be several years out, three or four years from now.

We can’t make those projections for most companies, but for the companies that we can make those projections for, or we feel confident about our projections, then we plug those into the Magic Formula rather than last year’s earnings.  So there are two really different strategies that we use.  One, for the Magic Formula when we are looking at last year’s earnings, we buy a portfolio stock, either 20 or 30 companies because on average, they do incredibly well, were the results I just mentioned.  For Gotham Capital, we do a much more concentrated portfolio, perhaps five or eight companies, generally are 80% of or portfolio, and those are companies that instead of plugging in last year’s earnings, we plug in our projections for normal earnings several years out for the company, but we are actually plugging it in to the Magic Formula.

So we are more concentrated and we do a lot more work on each company that we own because of that.   For most investors who don’t do this for a living, they are better off looking at last year’s earnings and buying a portfolio of 20 or 30 companies that on average will do tremendously well.

Bill Mann: It is such an important concept and one of the facts that I thought was great about the book is that you are not talking about what will be.  You are not talking about laser beams and dental technology and all of these things that people get excited about that may not have earnings at present.  The basis for the Magic Formula rests upon what is, what earnings the company already has generated.

Joel Greenblatt: That is really I think what people can do.  There is no argument about it.  You know what happened last year and that is all you need to know.

I wouldn’t suggest people, without doing any work, pick individual stocks, but if you are willing to own a 20 or 30 stock portfolio based on these simple concepts, on average you are going to do tremendously well.

Bill Mann: What about the argument of if this works very well with the 20 and 30, why wouldn’t you pick the top three and concentrate?  I mean, if you could determine what they were.

Joel Greenblatt: Even though what I said in the book was the formula actually works in order.  In other words, we take the combined ranking of cheap and good companies and we combine those ranks into a Magic Formula ranking.

I said in the book that if you divide all 3,500 companies we modeled into deciles where you take the top 10% as ranked by the Magic Formula then the next 10% then the next 10%, the Magic Formula works in order. The top decile beats the second decile, and so on.  That’s over a large amount of stocks so there really is not much statistical difference between picking any of the top let’s say, 25 stocks versus one, so the top three don’t necessarily do better than number 22 to 24.

Bill Mann: And you would in fact increase risk by being concentrated because you are trusting a formula.

Joel Greenblatt: Right, on average it works so to just pick a few names, if you have something on average that works, you might as well shoot for that average.  You may do better with the three stocks, but you may do a lot worse.  If you have almost a sure thing, why throw it away?

Bill Mann: One of the things that you did in the study was to bifurcate what would you do if you concentrated on the largest companies and then you went down as low as $50 million.  What about going smaller than that?

Joel Greenblatt: It should work amazingly well there, but  I didn’t want to write a book that people couldn’t execute and I also wanted to show how robust the Magic Formula was.  It worked amazingly well with small caps. Using a small cap model of 30 stock portfolios that we tested over the 17 years, it earned over 30% a year.

It is just that I want to make sure people realize that the formula was very robust and that you could actually execute, you could actually buy enough stock and if you are buying a book that hopefully a lot of people will read, we even showed how it worked for the top thousand companies.

It didn’t work quite as well as with the small caps because there are many more small caps to choose from than large caps, but it worked incredibly well.  It more than doubled the market’s return. Tough to beat that.

Bill Mann: So if a company that trades 50 shares a day and shows up on that list, that makes it functionally irrelevant for most investors because you can’t execute a trade.

Joel Greenblatt: Well, we didn’t just have a minimum market cap, we also had a minimum trading requirement so that you actually had to be able to trade these stocks to be put into our model.  Sure, the small investor has many advantages over the large investor and if you aren’t running so much money that you are prevented from buying smaller cap stocks, then you have a big advantage.   You can choose from a lot more companies.

Bill Mann: Because you’re dealing with a mechanical strategy, one of the books that people will inevitably make a parallel to is Jim O’Shaughnnessy’s What Works on Wall Street.  How is this different from what O’Shaughnessy did?

Joel Greenblatt: Well number one, he tested dozens of formulas over a long period of time and then picked the ones that worked the best.  What we did is we picked a formula based on what we actually do, and we tested it.  This was it.  This formula ranks stocks in order from best deciles to worse and so it wasn’t just picking the top outliers.  It was really actually picking what we think goes into making money in the stock market, which is buying good companies when they are cheap, so it was really done somewhat differently.

I actually thought Jim O’Shaughnessy’s book was excellent.

Bill Mann: I absolutely agree. The early history of The Motley Fool was built partially around Jim O’Shaughnessy’s work, so I certainly am not casting aspersions. As you mentioned, there is a mutual fund company now that runs some of his formulas and does very, very well.  [Editor's Note: That mutual fund company is Hennessy Advisors (Nasdaq: HNNA), which we have highlighted as a Tiny Gem.]

Joel Greenblatt: Well, it is very interesting what happened.  I actually wrote up the history of formula-based investing system where a fund did start using one of O’Shaughnessy’s formulas and did very badly for the first three years.  The fund didn’t do well and the fund manager ended up selling the company and then the person who bought it continued with the same formula and ended up doing very well right afterwards. So since inception that fund has done incredibly well yet the original investors and the original fund manager are gone because it didn’t do well in the beginning.

I think that is what so great about the Magic Formula.  It doesn’t always work. If it always worked, everyone would do it.  There are one, two or three-year periods of the Magic Formula that we are talking about where it doesn’t beat the market, but over long periods of time, it always beats the market and that is very, very powerful.

I used the example, the concept of 2+2=4.  Everyone knows that that is the case and no matter what anyone tells you, 2+2 always equals four.  It doesn’t matter how smart they are, how long they tell you, you are going to stick to your guns.  So you will also stick to your guns if you understand what you are doing here, which is if you truly believe what you are doing is buying good companies at bargain prices, you will keep doing it because it makes sense, even though the market doesn’t agree with you for long periods of time.

Bill Mann: We saw in the late 1990s where a lot of companies that were just making a lot of money were very, very cheap because it seemed like the investor class as a whole was distracted by things that ended in dot com.

Joel Greenblatt: Well, that is the best example.  In the year 2000, we owned a lot of good companies at cheap prices that the market didn’t really care about and we weren’t doing very well with them.  On top of that, we thought the Internet bubble was going to burst any day because stocks were at ridiculous prices and wouldn’t that drag down our investments along with the crash in the Internet stocks that we eventually thought might take place, but we decided “hey, listen, we own good companies at bargain prices.  We are just going to just keep doing what we know makes sense.”

What ended up happening is the market did get crushed.  The S&P got crushed.  The NASDAQ got crushed in 2000, yet our portfolio was up more than 100%, so if that doesn’t tell you to stick with what you think makes sense, I don’t know what will.  So the market could do badly but as long as you are doing smart things, over time you will do quite well.

Bill Mann: I think that was one of the things about the Magic Formula that immediately attracted me.  It wasn’t something where you said “Well, if you buy it on the first Thursday of the month, it works out better.”  These are two very defensible investing components.  They are at the core of what good value investing is.

Joel Greenblatt: Well, I would say that I have learned a lot.  One of the reasons I wrote this book is because I am really a self-taught investor even though I got a BS and an MBA from Wharton, As far as investing, all they taught me was that you can’t beat the market.

Investing I learned from reading and I was reading books by Benjamin Graham.  I was reading the writings of Warren Buffett.  Those are the things that really taught me.  The readings of David Dreman and so Graham and Dreman taught buying cheap is a good thing to do and it works over time.  Buffett added the component of buying good companies when they are cheap.

I wouldn’t presume to say oh, this is a formula that is similar to Warren Buffett, but what I would say is that the concepts are the same.  Buffett says “I am going to stick to good companies and buy them when I can buy them at a good price.”  This is systematically what the Magic Formula does for you except you get to choose from a lot larger universe of stocks than Buffett does now that he is running $80 billion.

Bill Mann: It’s interesting that you mention what you didn’t learn about investing at Wharton. A lot of individual investors will look immediately to what schools a person has gone to or as they say, “this person obviously has to know about investing.  He has a Harvard MBA.” But reality is so much different, except, it seems, at one place – Columbia. You teach at Columbia Business School, so you may really be able to speak to this. Columbia is really unique in that it has a long history of actually teaching investing to students.

Joel Greenblatt: Well I always start each class to my students and say, “I aim to teach the class that I wish I had when I went to business school.” I want to give young people the benefit of the experience that I have been through. From a practical standpoint in investing this is hugely beneficial.  Every investor makes tons of mistakes.  It doesn’t matter whether they are Warren Buffett or how long they have been doing it or everything else, people make mistakes over time.  That is not the problem.  The problem is sticking to continually trying to do things that make sense over long periods of time.

I think that is the most important thing to teach people.  What does make sense?  You are valuing companies and you are trying to buy them at a discount.  Of course you will make mistakes valuing companies.  This is a guarantee I give to all of my students.  I say if you do a good job valuing companies, the market will agree with you.  It could take two or three years.  It usually takes only at most two or three years, but eventually the market will agree with you, as long as your evaluation work is correct.

I think statistically that is what we are trying to do with the Magic Formula, which is we are buying a group of companies that are in good businesses on average, that are cheap on average and that group of companies will go back to fairly priced within not too long a time, especially if you follow the strategy over a period of years, and you are almost guaranteed to make money over the long term, if you are patient.

Bill Mann: Why do you suppose that most business schools teach that those discounts don’t exist?

Joel Greenblatt: You know, I think business schools 40 years ago took a wrong turn into efficient market land and through it a lot of statistics and issues about volatility and things of that nature.   When you go back and you look at investing as buying a piece of a company and buying it when you think it is at a cheap price, then how much the stock bounced around over the last six months really ends up being sort of a silly thing to look at rather than thinking about it as owning a piece of company.

When you actually look at what you are doing, which is buying a piece of a company, not a security, not a share of stock, but you are actually buying a piece of a company, all the statistics and all the theory and everything else that business schools teach end up making no sense whatsoever.

Bill Mann: This has become a very nice advertisement for Columbia Business School, right?  (Laughs.)

One of the stories that I really enjoyed from the book was on your first day of class.  The other thing that you did was you had someone just name a company and you had the business section of the paper in your hand and discussed the prices, how they varied within a one-year period.

Joel Greenblatt: Right.  What I do is at the beginning of a semester, I call out to my students, “Just name a company.”  They will pick GM or GE or Foot Locker or something — Abercrombie and Fitch, for instance.  So if you pick something like Abercrombie and Fitch, I will open up the newspaper and I will look at the 52-week high and low.  So the 52-week high let’s say is 74.  The 52-week low is 43.  The company is pretty much unchanged during the course of the year, if the stock has fluctuated between 43 and 74.  If you go over the last two years, it is even a wider range.  The stock has been between 23 and 74 even though this company hasn’t changed very much in the last couple of years. How is that possible?   Has the value of this company changed so much during that time?  How do you explain that?  Does this make any sense?  My students spend a lot of time coming up with explanations as to why this makes sense and actually there are whole fields of academic study to explain why this makes sense.

So I ask the question I ask my students, Why do you think the stock can be $23 one day and $74 several months later?  Does this make any sense?   My conclusion is I don’t know why it happens and I tell them I don’t care why it happens.

Bill Mann: I thank my lucky stars that it does happen.

Joel Greenblatt: Right, it does happen.  All I have to know is that even though the price is bouncing around a lot, it is unlikely that the value of the company is bouncing around nearly as much. So what the Magic Formula is trying to do is pick out those companies that are unreasonably low priced at the times when they are low priced.  We are doing that automatically systematically by picking companies that have certain characteristics.  They are cheap and they are still good businesses.

Bill Mann: Yeah, and again I think that that is really the core element of sound investing is looking at those two, is looking at those two things.  Graham said it and Buffett said it and now you are saying it.

Joel Greenblatt: Well, I like to follow in good footsteps.

Bill Mann: The book is called The Little Book That Beats the Market and it is available now, is that correct?

Joel Greenblatt: It is.

Bill Mann: OK, well fantastic.  We wish you the best of luck and thank you so much for spending time with us here at The Motley Fool.

Joel Greenblatt: Bill, thanks so much for everything.

Bill Mann: Take care, Joel.

Bill Mann owns shares of Hennessy Advisors.

Hottest links for Tuesday August 13th, 2013 (see Monday’s edition of hottest links here). Top stories for today include; Joel Greenblatt tells his class to imagine they are wearing hush puppy shoes or sandals; A Canadian gets really drunk swims into American waters and gets arrested; A Look at performance of Dan Loeb’s Third Point Reinsurance Ltd (NYSE:TPRE) from two different angles; The ‘top’ PR firm on Wall Street can use a little PR right not; Bill Ackman says goodbye to the deals at J.C. Penney Company, Inc. (NYSE:JCP); Tips for sticking to your investment strategy, even during the bad times;  Chinese ghost towns go mainstream (sorta) and much more.

Hottest Links: Stories

Why You Need an Investment Philosophy

It is crucial to stick to your investment strategy, especially when it goes wrong, write it down and do anything you can not to shift. Some great advice here. [Christine Benz, Morningstar]

Ackman quits Penney board; not selling shares

Bill Ackman is not having a great month, both with Herbalife Ltd. (NYSE:HLF) and J.C. Penney Company, Inc. (NYSE:JCP). Today, reports have come out that Bill Ackman will be quitting the board of the company where he has an 18 percent stake. [Marty Steinberg and Paul Toscano,CNBC]

Does a Good Poker Player Make a Good Investor?

Do poker players make better investors or traders? A Look at some of the data, and the connection between investing and Texas Holdem skills. [Adam Warner, Schaeffers Research]

Sard Verbinnen, Wall Street’s Go-To Crisis PR Firm

On July 15, former Goldman Sachs Group, Inc. (NYSE:GS) banker Fabrice Tourre—better known as “Fabulous Fab”—walked into U.S. District Court accused of defrauding investors in a subprime mortgage deal during the financial crisis. Now BusinessWeek has taken a shot at the PR firm which represented SAC Capital; and also represents Greenlight, Saba and others. We cannot comment much since all conversations are “off the record”, but it looks like SARB can use their own PR agency. See some funny anecdotes here. [Nick Summers, Business Week]

Third Point Reinsurance Ltd. (TPRE)

Third Point Reinsurance Ltd (NYSE:TPRE) filed their S-1 recently.  Hedge funds do this to seek ‘permanent capital’, like David Einhorn’s Greenlight Capital Re, Ltd. (NASDAQ:GLRE). Brooklyn investor has great analysis of the company. [KK, Brooklyn Investor] Additionally, Meb Faber has a different approach. He notes that investing alongside Third Point through 13F filings does a decent job, but doesn’t capture all of Loeb’s alpha. [Mebane Faber]

Why Clients Don’t Give You Credit for Your Hard Work

For some reason which I’m not sure of but am happy to note, we get a lot of readers in the wealth management industry, so figure they might appreciate this one. [Dan Richards, Advisor Perspectives]

Joel Greenblatt: Munsingwear Case Study, Q&A w/ Bill Mann

Pretend you have traded in your hush puppy shoes or sandals in for a pair of wing-tips says Joel Greenblatt in a class on special situations.  We have more notes,  so if you have not checked them out and you like great class notes from Joel Greenblatt check them out. [Value Walk]

China RE Bubble Largest in History 60 Minutes

China’s bubble goes mainstream. After years of Jim Chanos and others have talked of Chinese ghost towns and credit bubbles, 60 minutes has finally picked up on it. Check out the latest on the situation from the world’s second largest economy.  [Value Walk]

MIKO NV: Coffee and plastics – a tasty combination?

A few weeks ago when I read the news that the Benckiser heirs were acquiring Coffee company DE Master Blenders 1753 NV (AMS:DE) for 7.5 bn EUR (2.6 times sales, 27 times book, 23 times EV/EBITDA), I decided to look at them next. Check out this piece an in depth look at valuation, from the always great Value Opportunity. [Value Opportunity]

Not the Onion

Beer-chugging Canadian sorry for swimming to America

After being released from jail on Tuesday, 47-year-old John Morillo apologized for drinking eight beers and then swimming across the Detroit River, purely to prove to his buddies he could. [Cottage Life]

Joel Greenblatt Columbia Class notes on special situations. Please see part I, part II, part III, part IV,  part V , Part VI, Part VII, Part VIII, and Part IX the disclaimer there (also massive archive of videos and text here). 

See Part XI here.

We will be posting many more articles throughout the week from Greenblatt’s class notes so make sure to check back at least daily or subscribe on Twitter, Facebook,  Google+, Linkedin,   RSS (or Feedly specifically),  or best of all sign up for our new and enhanced newsletter (make sure to select value investing and daily under the options).

Joel Greenblatt wrote one of the best books ever on investing (with one of the worst titles ever) You Can Be a Stock Market Genius (which focuses on special situations) and The Little Book That Beats the Market (on the magic formula); both are referenced extensively below. So if for some reason you have not read them make sure to check them out.

Note: Readers can print this (or any) article, convert it into PDF by scrolling to the very bottom. Enjoy!

NOTE: If any readers have more up to date notes and are allowed to share, please send us at info (@) valuewalk.com, we would be happy to credit you or keep it anonymous, as you wish!

Another Semester

Joel Greenblatt Class # 1                                               

Jan 18, 2005

This weekend outsiders must email Joel Greenblatt about auditing class.

Summary: What Joel does for a living: buying something for less.  Opportunity in value investing.   Why don’t smart people do better?   Why value investing works.  Problems with valuation techniques.

What is the social utility of passive investing?  None that Joel can see.  It is similar to being good at picking horses at the track.  Joel is good at handicapping to make money.

What does he do for a living?   Buy 4 packs of gum for 25 cents and sell one back each for 25 cents.  He sells 3 packs a day.  15 weeks x 36 for 6 years or ((4 x $0.25) – $0.25) x 5 x 36 x 6 = $810.00.  He pays $1.25 x 216 = $270.

All he does:  He finds out what businesses are worth & buy them for less.  This is the power of knowing the value of a business.

Look at stocks: EBay from $64 to $118.   GM from $29 to $55.   AAPL from $20 to $70.  Krispy Kreme $50 to $5.

Name any company: Why such a (wide) range if the market is efficient?  Intrinsic values change slowly, but prices change rapidly and widely.  Note the discrepancy.

Observe that prices move around a lot and values move slower.  Who knows and who cares?  This presents me with an opportunity if I can value businesses correctly.   The price at $35 or $55–both can’t be right.

Beating the market is not easy.

• Value companies
• Wait for the right price

1. People can’t control their emotions.
2. People don’t do the valuation work.        

Thus prices move around more than value.

• Mr. Market is crazy

Have a margin of safety

But there is no translation into action for many investors including smart MBAs.

Gotham Capital has compounded capital at 40% per year.   He just does the obvious.

Why has he outperformed if:  1.) he can’t value better?    2.) He is no smarter than others?

Because of the way he looks at the world and his ability to wait for good risk/reward opportunities.

Simplify things.  If your valuation is good–that is the key.  If he can’t value, then he walks away. If he can’t figure it out, he walks away. Swing at fat pitches.  If it is hard, then pass.

Greenblatt will invest in technology like when those companies had tons of cash and he could buy the business for free.

A good book: Stocks for the Long Run by Jeremy Siegel

Why don’t smart people from Columbia Business School and Wharton do better?  They get confused – They put value investing in the context of efficient markets.

In one year you have a 2/3 chance of losing 8% or gaining 28% if you hold for less than 1 year.

In 1996 Richard Pzena under performed the market and lost clients, yet he was doing what he always was doing.

3 to 5 years is his minimum time horizon.  This is the most inefficient part of the market.

In 1999 value was dead.  For 4.5 years, there was underperformance.   Oakmark fired their manager and brought in a new guy who kept doing the same thing and now is doing great.

Value investing doesn’t always work, because if it did, then it wouldn’t work. (This contradiction makes investing very difficult because of the persistence, patience and discipline required).

Look at special situation investing – uncovered areas, a different way of looking at the world.  Keep the context.

How he sees the world.  Now he owns three stocks – concentrated.  He is not leveraged. He believes that the market will eventually get it right.  The market can often present extreme values.

Special situations – Time frame involved, not sophisticated.  Bigger pick. Buy a company for 4.5 x EBIT, the business will do OK.

Also, the way we conduct our portfolio.   How we view risk is different than the norm.

This course is about what I know.  Basics of finance and accounting.  This is the course I wish I had while in business school.  Find things worth a dollar and pay 50 cents for it—Ben Graham’s philosophy.

The press is depressed because something bad happened, people are worried about it.  What will it earn two or three years from now?  Most focus on the short term problems versus the long term return.

When the smoke clears, what will it be worth?

Ben Graham: Buy for 50 cents a crummy business, but now the $1 is worth 75 cents. The danger with buying “cigar butts” is that time is the enemy of the bad business.

Value your businesses and assume it will pay you.  Estimate of growth, but don’t know way.

Concentrated portfolio.   Gotham returned all outside capital and stayed small.  Money Managers focus on next quarter.

There are different ways to value business.  Triangulate or cross-check your work.

• DCF Analysis.
• Relative Acquisition Value.
• Break-up value (real estate).

Acquire value – discount brokerage has 100,000 clients but worth more to another brokerage firm that has 500,000 clients.   Consolidation of clients means that a strategic buyer can pay more.

Flaws with Each Valuation Method

1. Intrinsic valuation – Discounted Cash Flow (DCF) has flaws, small changes in inputs lead to huge swings in valuation.  Use when the business is very stable and you should be very conservative (in your assumptions of growth and discount rate).