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Ze n w a y .com
Enlightened Investor Digest
BEST IDEAS, BEST PRACTICES AND BEST JOKES FROM THE WORLD’S BEST INVESTORS
Joel Greenblatt’s Lecture at NYSSA by Brian Zen and Garret Hamai
In the freezing cold evening of December 7th,
2005, Joel Greenblatt of Gotham Capital, armed
with delightful jokes and a magic formula,
warmed the hearts and souls of about 200
security analysts in a seminar organized by New
York Society of Security Analysts (NYSSA.org).
We are pleased to bring you the financial
enlightenments captured from that event:
Crunching Data, Searching Magic Formula
♦ During his years at Wharton, Joel Greenblatt
manually entered stock data based on 9 years
worth of S&P Stock Guides and created their
own database for research.
♦ Cleaned up the data by eliminating certain
things. Now they use Compustat database.
♦ Richard Pzena figured out how to enter those
data into the mainframe computers at Wharton
Business School. At that time, the computers
were about the size of two conference rooms.
♦ Sometimes, the market throws off bargains
because it is unreasonable about the prospects
of certain companies.
Joel Greenblatt speaking at NYSSA
Buying Cheap Stocks Works Over Time
♦ In the 70's, they tested Benjamin Graham's
Net-net Formula and found that picking stocks
below liquidation value worked well.
(Liquidation value = Current Assets – All
Liabilities.)
♦ Not every cheap stock performed well
individually, but as a basket they did well.
♦ However, these types of opportunities are
practically extinct in today's market.
♦ Many other studies have shown the strategy of
buying cheap companies works over time.
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For Evaluation Only. Dec 9, 2005 Issue 051209
Buffettized: Buying “Cheap” and “Good”
♦ Starting out as a die-hard value investor,
Greenblatt became "Buffettized" in early 90's.
Why not look for the good ones amongst the
cheap companies?!
♦ Greenblatt says that he didn't realize that
trying to find cheap and good companies,
rather than just the cheap ones, was so
important until the 1990s. While Graham was
looking for starkly cheap companies, Buffett
wants only the good ones.
♦ Greenblatt’s friend, Richard Pzena, remains
committed to buying troubled companies at
dirt cheap prices, the cigar butt approach. You
see this saggy cigar butt on a dirty corner of
Wall Street. You pick it up and get one last
puff out of it. The puff not very tasty. The act
is not very elegant. But it’s free (Laugh).
The Magic Formula Was Born
♦ By combining Graham and Buffett, Joel
Greenblatt’s magic formula is a computerized
system to invest in good companies whose
stocks are cheap.
♦ Good companies = High return on capital
(ROC defined as operating profit divided by
net working capital plus net fixed assets.)
♦ Cheap stocks = High earnings yield (Earnings
yield defined as pre-tax operating earnings
divided by enterprise value.)
♦ ROC = EBIT/(Net working capital + Net fixed
assets)
♦ Earnings yield = EBIT/(Enterprise Value)
♦ If net working capital is negative, use zero.
♦ Here, EBIT is last 12-month’s earnings before
interests and taxes (EBIT).
♦ Two key issues addressed by his magic
formulas: (1) What is the return on the price
you paid? (2) What is the return on the capital
the company is investing?
Ranking the “Cheapness” and “Goodness”
♦ Greenblatt turned to his computers to rank
companies by two factors, good (high ROC)
and cheap (high earnings yield).
♦ Ranking Method: If company XYZ ranked 10
out of 3,500 companies in terms return on
capital, and it ranked 20 in terms of earnings
yield, the combined ranking of XYZ would be
10 + 20 = 30.
Page 2 Enlightened Investor Digest
Greenblatt’s “Not-Trying-Very-Hard” Model
♦ Buy the top 30 of the highest ranked
companies. Hold them for one year.
♦ Turnover the portfolio at year end to buy a
new list of 30 highest ranked stocks based on
one-year’s worth of new financial data.
♦ Sell losers right before a year is up, and sell
winners right after 12 months for tax benefits.
Why the One-Year Holding Period?
♦ It is interesting to note that more stocks
worked out over one-year rolling periods,
rather than two-year periods. Maybe the time
window that a value stock stays undiscovered
is being shortened towards one year as more
and more people start searching for values.
♦ Besides, after one year, you get a complete set
of new earnings data. It would be a good time
to run the rankings again.
♦ Selling has always been difficult. The other
day, Greenblatt and his partners went on and
on talking about the stocks that made a huge
move after they sold at intrinsic value. To
remove the uncertainties and difficulties of
selling, a one-year holding period was picked.
“I call it the Not-Trying-Very-Hard Model
(Laugh). My mantra is to keep things simple,”
said Greenblatt.
♦ Besides, trading cost is cheap now.
Joel Greenblatt (left) and Christopher Kehoe
Sell Rules
♦ Sell close to intrinsic value.
♦ Sell if something even cheaper is found.
♦ “We never mastered the art of selling. We are
semi-bubbling idiots at it,” confessed Joel.
The Magic 30.8% Per Year for 17 Years
♦ Magic formula works! Using stocks of all
sizes, it produced a 17 year annual return of
30.8%. Using only the largest 1,000 stocks,
the annual return was 22.9%.
♦ When ranked by 10 deciles (250 stocks in
each, higher deciles consistently outperformed
those below them from top to bottom.
♦ The cheap portfolio tends to have less
volatility also.
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♦ The magic formula beats the market 96% of
the time.
Magic Formula Investing:
The Operating Steps
In his new bestseller: “The little Book that Beats
the Market”, Joel Greenblatt also discussed in
detail the operating steps of the magic formula
investing:
1. Go to magicformulainvesting.com (Nice
plug!)
2. Specify your criteria for minimum company
size.
3. Get a list top-ranked companies based on
high return on capital and high earnings
yield.
4. Invest 1/3 or 1/5 of your money into 5 to 7
top-ranked companies every 2 to 3 months.
(Dollar-cost-average into the “good and
cheap”.)
5. After 9 to 10 months, construct a portfolio
of 20 to 30 stocks.
6. Sell each stock after holding it for one year.
For tax purposes, sell winners a few days
after the one-year holding period. Sell losers
a few days before the one-year holding
period.
7. Reinvest the proceeds into new top-ranked
companies. Stick to this simple and
mechanical system for at lease 3 to 5 years
to give the magic formula a chance to work.
Greenblatt’s Personal Investment Process
♦ Looks for value with a catalyst, so nice things
happen sooner. Special situations are just
value investing with a catalyst. They are
simply different places to find cheap stocks.
♦ In his own hedge fund, Greenblatt uses the
basic principals in the magic formula: Look
for high ROC and high earnings yield.
♦ Tries to figure out what “normalized earnings”
will be 3-4 years into the future.
♦ Makes sure the stock is very cheap based on
normalized earnings.
♦ 5 to 8 securities can make up 80% of his
portfolio. One position could be up to 30%.
♦ Having a concentrated portfolio works well
for lazy people. Not that many stocks to track.
♦ Thinks about how much he could lose if he's
disastrously wrong.
♦ No formal process or time frame for purchase
decisions. Usually spend one month or so to
do research. In difficult situations for which
he and his partners have time, research could
take months.
♦ If there is a great opportunity which, in their
opinion, won't last, and if they feel they
 Enlightened Investor Digest
understand it, they sometimes use the
approach of "Ready, Fire, Aim!"
♦ Has financials and utilities in the portfolio.
EBITDA Minus Maintenance CapEx
♦ For his own investment practice, Greenblatt
uses a different input for earnings.
♦ He thinks that “EBITDA – Maintenance
Capital Expenditure” would be a better
measure of earnings power, but it can be
difficult to calculate.
No Edge in Foreign Markets
♦ Greenblatt prefers to invest domestically
because it's within his circle of competence
and he hasn't run out of opportunities.
♦ He does acknowledge that you could probably
find cheaper companies internationally and it
is a good idea if it is within your area of
expertise.
♦ If he was younger, he may do more with
international investing.
On Long-Short Strategies
♦ Q: “How about long the top deciles of cheap
stocks and short the bottom deciles of
expensive stocks?”
♦ A: “I am not a fan of shorting. The long-short
guys blow up every eight years. I call it the ‘I
got it! I got it! I ain’t got it!’ Strategy.”
Fair Bet Yet Unfair Investing
♦ Look for a big mess that seems too
complicated, not well understood, not well
followed, and requires too much work. People
don't want to do the work, but once you do the
research, you will be at an advantage.
♦ Look for semi-complicated situations. The key
is to identify what cuts to the core.
Numbers Are More Important than People
♦ First look at the numbers as they don't lie.
You can learn a lot about the management by
looking at what they've done though the
numbers.
♦ Meeting the management in person and
determining their abilities is not easy. “I used
to meet a CEO and say to myself: ‘This guy is
smart.’ Next day I meet another CEO and say
to myself: ‘This guy is smart, too.’ (Laugh) In
the end, I feel meeting CEO is not very
important because I am not good at reading
people,” said Greenblatt.
♦ What is more important is: (1) What the
management has done with the cash? (2) What
are the incentives? (3) Is the salary too high?
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Page 3
(4) Is there heavy insider selling? (5) What is
their trackrecord?
♦ Compare “what they do” with “what they say”.
♦ Bad signs: high salaries and insider sellings.
Joel Greenblatt (left) and Brian Zen
The Macro Picture Is a Distraction
♦ In 1999 and 2000, there were plenty of non-
internet values out there. If you were worried
that the burst of the internet bubble would
have dragged those values further down, you
would have made a big mistake. “Fortunately,
we ignore the macro picture,” said Greenblatt.
♦ In 2002 and 2003, there were plenty
opportunities in small caps. If you were
concerned that the bear market could go on
further, you would make another mistake.
♦ “Now the value is in big caps. But if you look
at the macro picture, the consumers could
drop dead, the housing bubble could drag
everybody down… We ignore those. We
have no macro view,” said Greenblatt.
♦ Everything is cyclical. Values can always be
found somewhere.
Ignore Volatility and Stock Prices
♦ Taking your clue from the stock prices is
crazy. If you could value companies, you
should ignore the noises from volatility and
stock prices.
♦ Things such as volatility have nothing to do
with buying a good, cheap company for the
long run. Greenblatt said, “It is kind of ironic
that, the older I get, the longer time horizon I
look at.” (Laugh)
♦ The Efficient Market Theory is a crazy way to
look at the market. “Pick and choose. You can
beat the market. It is worth the work.”
The Vogue of Return on Capital
♦ There seems to be a movement towards high
return on capital.
♦ The low P/B stocks haven’t work very well in
the past 10 years.
♦ Don’t know if or when this trend will reverse.
Page 4 Enlightened Investor Digest
One More Trick
♦ Greenblatt disclosed: “We have one more
trick. When we have gains, we look at before-
tax numbers. When we have losses, we look at
after-tax numbers. (Blank stare…pause.) That
was trying to be funny. (Laugh)”
On Thursday, January 26, 2006, New York
Society of Security Analysts http://nyssa.org will
host another great value investing seminar by
David Winter, former partner of Michael F. Price
at Mutual Series of Funds.
Details: http://tinyurl.com/9y7vt
How Joel Greenblatt Reads 10-K’s
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The Advantages of Small Investors
♦ Investment managers' performances are
judged on the basis of how well their portfolio
performs vis-à-vis the stock market index.
Small investors can afford to ignore the index.
♦ The time horizon for judging performance is
relatively short (between a few months to
maximum—a year). Investment managers
therefore tend to skip those opportunities
where the pay-off is likely to come only after
a long time.
♦ Big players could not buy small companies.
♦ Greenblatt's secret to success in the stock
market lies in identifying situations (mainly
involving corporate changes) which are not of
interest to the big players, but which offer a
high upside potential.
How to uncover the secret hiding places of
stock market profits? Joel Greenblatt provided
the following list:
Spin-offs
♦ Spin-offs are Greenblatt's favourite. When a
company hives off a part of its business into a
separate company, it may do so for several
reasons. Greenblatt quotes a study that found
that a very large number of such spin-offs
outperformed their industry peers by a
whopping 10% per year in the first three years
after the spin-off. The parents of the spin-offs
also outperformed their industry peers by 6%
during the same three-year period.
♦ Institutional investors are often uninterested in
spin-offs, as the companies tend to be small in
size. The shares of the spin-off are generally
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not sold, but distributed among the parent
company's shareholders. The shareholders
typically sell them off without regard to price
or fundamental value as their primary interest
is in the parent company. The initial price
after the spin-off, therefore, tends to be
depressed - a great bargain.
♦ Greenblatt strongly emphasises that in every
corporate change it is important to determine
where the interests of the insiders (directors of
the company) lie. If they have a large stake in
the spin-off, it means that there is a high level
of commitment to making the spin-off a
success. The credentials of the parent
company are also very important in evaluating
spin-offs.
Why Spin-off Opportunities Are Exciting
1) The spin-off of an S&P 500 company usually
causes a large sell off of the spun-off company
by S&P 500 index funds as the spin-off is
usually not added to the index.
2) The "parent" company of the spin-off has no
incentive to advertise or talk up the spin-off.
They have not engaged investment banks to
sell the equity and therefore there is no market
buzz or generally any advertising what so ever.
3) The spun-off company is generally some kind
of drag on the parent company's valuation;
that is the spun-off company isn't very
exciting and may not even be such a good
company.
4) Great documentation on the to-be-spun-off
company is filed with the SEC in a form-10.
Merged Securities
♦ While Greenblatt warns against merger risk
arbitrages, i.e., buying stock of a company
that is subject to an announced merger or take-
over, he is very much in favour of merged
securities.
♦ Risk arbitrages are subject to too many
uncertainties (the merger may not even go
through), so the chances of burning one's
fingers are high.
♦ However, in mergers, the acquirer sometimes
pays for the acquisition in terms of securities
other than stock—bonds, preferred stock,
warrants or rights. Institutions typically shun
these securities, and individuals who receive
them often dispose them in the market
immediately. The price is thus driven down,
making them attractive investments.
Bankruptcies
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Enlightened Investor Digest Only.
For Evaluation Page 5

♦ Another unconventional opportunity that

Greenblatt suggests is not the stock, but bonds,
bank debt and trade claims of companies that
are emerging from bankruptcies.
♦ Bargains are created as there are a large
number of anxious sellers and the businesses
tend to be unpopular. However, one needs to
be very careful in choosing the 'right' bankrupt
companies to invest in.
Major Restructuring by Companies
♦ One can either invest after restructuring has
already been announced or when a company is
ripe for restructuring.
♦ Funnily enough, many equity analysts tend to
drop coverage of companies that are
undergoing major corporate changes.
♦ Of course, like Buffet, Greenblatt too shuns
complex restructuring where one cannot
understand what is really going on.
Recapitalization
♦ Greenblatt sees recapitalization (buyback)
transaction as an investment opportunity. The
prime reason that makes buyback companies
interesting is that buyback of shares increases
the leverage in the balance sheet of the
company, thus increases the tax saving which
can then be passed on to the shareholder.
♦ According to Greenblatt "there is almost no
other area of stock market where research and
careful analysis can be rewarded as quickly
and generously".
The Disclaimer
Even Greenblatt acknowledges that a lot of
reading, learning and research is involved in
finding these hiding opportunities. After all, we
all know that there is no free lunch! Z the business?
Specific Ideas from Joel Greenblatt:
(See our paid deluxe version of EID)
“Do you have the patience to wait till the mud
settles and the water gets clear? Can you sit still
till the right action presents itself?”
− Lao Tzi
"I like to shoot fish in a barrel, but only after the
water is gone."
− Warren Buffett
“Wait for a good pitch to hit.”
− Ted Williams
How Benjamin Graham Evaluate Past Earnings Records: To obtain this premium
content, please support our research work by subscribing to EID at: http://zenway.com/eid
ZENWAY STOCK WATCH LIST
♦ Disney (DIS) at $24, Global expansion
partnering with local government to get the
best land
♦ Gannett Inc. (GCI) at $59.8, low valuation,
but earnings still under pressure.
♦ Marsh & McLennan (MMC) $28, may retain
its leadership in insurance brokerage industry.
♦ W Holding Co. Inc. (WHI) at $8.3 and
Oriental Financial Group Inc. (OFG) at $13,
two Puerto Rico banks near book value with
insider buys.
♦ Sharper Image (SHRP) at $9.5, below book
value, insider buy, and the stuff is cool.
♦ American Locker (ALGI) at $4.2, below
liquidation value with positive cash flow.
♦ QLT Inc (QLTI) at $6.2, below book value,
near tangible book value, with positive cash
flow.
♦ Boston Scientific (BSX) at $25, growth could
come back with a nice bid on GDT.
♦ Sears Holdings (SHLD), hidden assets in real
estate and subsidiaries with the next Warren
Buffett extracting cash and liquidating those
assets in pieces.
Balance Sheet Analysis according to Graham
♦ How capital is invested and how the capital
structure is divided between senior bond
issues and common stock?
♦ What are the strengths and weaknesses of the
working-capital position?
♦ Can reported income be verified by the equity
changes over the years?
♦ What are the various sources of income?
♦ What are the return on equity and return on
capital, the test of true success or prosperity of
♦ What can be detected via a study of long term
relationships between earning power, asset
values and the historical development of
financial structure? Z
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