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Joel Greenblatt's Special Situations Investing Class Notes at Columbia

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Joel Greenblatt's Special Situations Investing Class Notes at Columbia Special Situation Investing Classes at Columbia University Business School 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 [email protected] 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. 1 Special Situation Investing Classes at Columbia University Business School 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 2 Special Situation Investing Classes at Columbia University Business School 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.
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