Joel Greenblatt & Howard Marks Discuss Value Investing

It's a real great pleasure for me to have Joel here to spend the next hour with us. I got to know Joel about 25 years ago through a mutual friend. There is an unusual cluster of successful investors at Wharton at the end of the 70s. We had finally explored what was in the water at the time. But Joel was one of them and certainly among the most successful. I got to know Joel socially but then he convinced me to come up to Columbia and teach a class for him in his value investing course once a year, which I'm glad to do. He very graciously reciprocated here today. This is supposed to be a lecture series for outstanding investors and Joel certainly is one. I have a bunch of questions here which I wrote out. I thought they'd be great and Joel said, yeah, they'd be fine. But then my son, Andrew, class of 2009, wrote me his today and his are much better. So we're going to go through Andrew's questions and Joel hasn't had the benefit of seeing them so his answers will be fresh and spontaneous. And if you don't mind, I think Andrew put them well so I'm just going to read them. You wrote the book on special situations investing, enumerating a number of ways to make money from spinoffs, recaps, reorgs, bankruptcies, mergers and the like. Given that you wrote the book and thus there were no books before you wrote yours, how did you figure out how to invest in this way? How did you figure out what was important and where you could and couldn't make money? You're right, that is a great question. Well, I actually started, my first job was with, they didn't call them hedge funds back then but it was with a risk arbitrage firm. And risk arbitrage, otherwise known as merger arbitrage, involves buying a company after a merger deal is announced and hoping that it closes. And generally the risk reward in that business is, well, if the merger closes you make a dollar and if it breaks you lose 10 or 15 dollars. And that risk reward wasn't that appealing to me and so I started looking for other ways to do it. So I looked for mergers that had interesting security, you know, coming off, you know, the way they were paying for the merger. I looked for extraordinary events happening within companies, whether it be capitalizations or spinoffs or anything where I could get out of the business and I could make a dollar and lose 10 or 15. And so I was just looking for things that were a little off the beaten path. I really started learning when I was at Wharton and at the time Wharton was really in the efficient market camp, the way they were teaching things and it didn't resonate with me. And my junior year I happened to read an article about a guy named Benjamin Graham. And as soon as I read that article I said, ah, this makes sense to me. And I started reading everything that he wrote and started looking at the world really through a different lens. And that lens was not the first job I took which was a risk arbitrage, it was really looking for figuring out what something is worth and paying a lot less, leaving a large margin of safety. And so these special situations gave me that opportunity. I opened up that book, You Can Be a Stock Market Genius, one of the worst titles ever given to a book. It was supposed to be any fool can be a stock market genius. And then my editor had the Motley Fools at the time which was very popular. So he said, oh, you can't use the word fool. And so my dad said, how about you can be a stock market genius and then in parentheses even if you're not too smart. And so I giggled a little bit and they only gave me a day to change the title so I just went with it. And that wasn't a good choice. But I opened the book with a story about my in-laws who used to live in Connecticut for part of the year. And they would spend their time antiquing, going to country auctions, going to tag sales. And they were looking for art and antiques that were undervalued. And when they found a painting at a country auction or a tag sale, the question they asked was if they saw a painting by an artist and they had seen that that artist had just gone for auction with a similar type painting, similar size, similar genre, whatever it was. And it had sold at auction recently at two or three times the price that they could buy it for, they would go buy it. That's a lot different question than asking is this painter going to be the next Picasso. That's a much harder challenge. So I opened the book saying special situation is a little like that. You don't want to be so smart to know who's going to be the next Picasso. You sort of want to look a little off the beaten path because this is a little more obscure. It's smaller market cap. It's something strange is going on and the normal people who follow this aren't going to look at it because it's too complicated. You've got to read a 400-page thing. Or the piece being spun off is not really why people bought the original stock in the first place. It's not for the little small business that's being spun off. So these were discarded things. So it's my way of making the challenge easier. Finding things that were selling well below their fair value. It wasn't so much. I finished that first chapter of UPD Stock Market Genius with a story about the plumber who comes to your house and bangs on the pipe once and says that'll be $200. He fixes your pipes and says that'll be $200. And you say to the plumber, what do you mean $200? You came here and banged on the pipe once. He says, oh no, that's only $5. It's $195 to nowhere to bang. So that's how I view special situation investing, just making the challenge easier. And so I'd rather be a little, not as smart and a little bit lazy, but go for, you know, Warren Buffett would call them one-foot hurdles. Why go around looking for ten-foot hurdles to jump over if you could find some one-foot ones? So I don't have to be all that smart to do it if I'm looking in the right direction. You know, Joel, I wrote a memo in January of 14 called Getting Lucky. And I told the story of a guy who was working on becoming a better poker player. He was working on learning the odds of getting the cards you need, the odds that the hand you had would beat other hands, the tells that tell you whether the other side is a flop or not. And his uncle said to him, you're wasting your time trying to become a better poker player. Why don't you just find an easier game? And it sounds to me like what you did is look for what you thought was an easy game. Yeah, it's, you know, the last story I told in the book that illustrates the same point is I tell a story that I lost a bet. And the loser had to take the winner to the best restaurant in New York. At the time it was Le Test. There was a chef there, Andre Saltner, which at the time was considered probably the world's greatest chef. And so first I called up and they wouldn't give me a reservation. You know, I thought, I said I'll take any time, any day. And they said, sorry. I didn't understand that. And it turns out, you know, there's some 30 day period where they'll only book for 30 days and they will book. So I kept calling back, finally got in. We get to the restaurant. And I wasn't really paying attention to who came over to take my order. But I pull out my menu and point to one of the appetizers. And I said innocently, I pointed to one and I said, is this one any good? So Andre Saltner turns to me and says, no, it stinks. So, you know, best chef in the world. I'm asking him, you know, this thing you just cooked, is any good? And so the point was, I think the point he was making was everything on the menu is good. I mean, it's the best restaurant in the world. And so I tried to shop in the best places where almost everything is good. And I just have to discern between a bunch of different foods. So, Joel, you mentioned buying things for a lot less than they're worth. And that that provides the margin of safety. Would you say that those are the core elements in value investing? And do you want to enhance that definition? Or is that enough? And one other question. You mentioned that you didn't think it would be a great idea for your in-laws to try to find the next Picasso. Would you analogize that to growth investing? Sometimes. I mean, my definition of value investing is figure out what it's worth, pay a lot less. It has nothing to do with low price book or low price sales. And so that's how a lot of people like Russell or Morningstar would classify value investors. And so they probably wouldn't classify me as a value investor. I'm a growth investor. They kind of don't know what to do with us. And as Buffett has said, growth and value are tied at the hip. I mean, part of what makes value is investing in a business that can grow over time. So they're not too different. The way they're classified by, let's say, Morningstar or Russell, maybe there's much lower growth in value and much higher growth in growth. And they make it that way. But I'm looking for good businesses that are cheap. And Ben Graham said, figure out what it's worth, pay a lot less, leave a large margin of safety. Between those two. Big space between those two. Warren Buffett, his best student, made one little twist that made him one of the richest people in the world. Buffett simply said, if I can buy a good business cheap, even better. Part of good is a business that can grow over time. And so I slowly gravitated, not fast enough, certainly in my first decade of investing, gravitated more towards the way that Warren Buffett invests. He's looking for good and cheap businesses. And growth is part of sometimes being cheap. But at the beginning, Buffett wasn't so entranced with good businesses. He was famous for starting off with the cigar butt approach, where he wasn't looking for quality, he was just looking for cheapness. But then he, too, made a transition. Yeah, I mean, my master's thesis at Wharton, or it turned into that, with my friend Rich Grazina and Bruce Neuberg, was a paper we wrote that eventually got published in the Journal of Portfolio Management about buying cigar butts. They were called net nets, buying stocks selling below their liquidation value. And showed that just buying, if you bought it cheap enough, you could make nice money. And that's sort of the way Warren Buffett started. But when you think about why we moved towards quality, let's say you find a stock that's worth $10 and it's selling at $6. It's pretty cheap. But if you're not controlling the business, and it's not in a good business, your margin of safety may erode over time, meaning that $10 could turn to $8 if you're not really controlling those assets. And what you're really looking for are businesses, or what looks better to me anyway, are businesses where that $10 might be growing to $11 or $12, increasing your margin of safety. So I might take a lower margin of safety if I thought that was growing, but there's more. Buying things cheap works. I have nothing against it. It's just that you have to get out of it. So Buffett, who runs $100 billion or some number like that, it's not easy to go spend $5 billion and then go sell it to some other guy who's going to pay you more than the $5 billion. It's too big. And he said, as recently as around the year 2000, he said, well, if you give me $1 million, I can make 50% a year on that. There's plenty of opportunities. Your opportunity set shrinks as the businesses become larger. You can invest in anything. If you don't have a lot of money, you can invest in thousands and thousands of businesses. Buffett is now looking at the top 300 businesses in size, because the smaller ones won't move the needle. So there's a lot you can do in special situations. One thing a lot of my students ask me, and it happens every year now, probably for the last five or six years, and the question they ask me at some point in the semester is that, you know, when you were younger, because you're really old, they leave that part out, but you're really old, and when you were younger, things were easier. That goes unsaid. No, I just said it. But anyway, things were easier. There was less competition. There were less hedge funds. There were less computers. There were less smart guys going into this business. I mean, when I got into it, I was telling analogy, the market hadn't gone up in 13 years by the time I got to Wall Street, so it wasn't a place that really was attracting lots of people. So they said, it used to be easier for you, but, you know, it must be harder for you. You know, hey, you stupidly wrote a book about this, and there's a lot of people doing this now, not just because of that, obviously. You know, it's harder for us. You know, you've got to use this stuff. And so my response is this. People who are very good, especially in special situations, I have two responses. One is people who are good at special situation investing, really looking off the beaten path for liquidations or recapitalizations or spin-offs or any of those things. Many of them are liquidity constrained. You know, Warren Buffett started making a lot of money doing those things, but he grew too big. And so I ask, I tell them that, listen, you know, what happens to people who get very good at analyzing businesses in this area? What happens to them is they make a lot of money, and they get too big to stay in this area, and there's always a new group of people who can come in and look at some of those smaller situations because the guys who are really good at it get too big to really take advantage of some of the smaller or more obscure situations. And so there's always room for new people to come in that area. And then on a larger scale, you know, because people still teach efficient markets, and they'll say, hey, you know, active investing doesn't work, and even Warren Buffett's saying, go buy some ETFs or, you know, indexes and everything. And what I'll say is that for most people, that's true because they don't know how to value businesses. But I will give you a counter, and this is what I tell my students. Most of my students are around 27-ish or something like that. So I said, I tell them all, let's go back to when you were roughly 10 years old where you might start noticing some of this thing, and let's go look at the most followed market in the world, and that would be the United States. And let's go look at the most followed stocks in the most followed world, in the most followed market in the world, and that would be the S&P 500 stocks through a larger scale. And let's take a look at what happens if you were 10 years old. Take a look at the S&P 500 from 1996 to 2000, it doubled. From 2000 to 2002, it halved. From 2002 to 2007, it doubled. From 2007 to 2009, it halved. From 2009 till today, it's basically tripled. That's my way of saying people are still crazy. And that's really unfair. That's a really unfair thing to say because this S&P 500 is an average of 500 stocks. There's huge dispersion going on within that average between stocks that are in favor, that people love emotionally, and stocks that people hate. So it's really much worse than what I just described. There's huge dichotomy between things people like and things people don't, things that are in favor, out of favor. All this noise is going on within that average. That average is smoothing things. So if you believe what Ben Graham said, that is, here's fair value, and here's what the market prices are. It's like a wave around fair value. If you have a disciplined way to value companies and buy more than your fair share when they're down here and sell some, maybe, you're shorting and you're very disciplined. I mean, I make two guarantees to my students first day of class. First guarantee is this. If they do good valuation work, I guarantee them the market will agree with them. I just don't tell them when. Could be a couple weeks. Could be two or three years. But I tell them the market will agree with them. And the corollary to that is this, and it's very powerful. I tell them in 90% of the cases for an individual stock, two or three years is enough time for the market to recognize the value they see if they've done good work. When you put together a group of companies, that actually, on average, is actually happening quite a bit faster. Both those are very powerful. It just says good work will be rewarded. So I don't think the reason people don't think the market is cost, the market is efficient, or even close to efficient, or not emotional, very emotional, or that it can't be done. There's all kinds of institutional and agency reasons and tons of other reasons why they don't do it. But because prices are efficient, if you just pick up the paper or observe what's going on or listen to what I told my students since when they were 10 years old, it's pretty clear that people are still crazy. Joel, what are the things you wish you could go back and tell yourself when you were just graduating from Wharton? Maybe you just told us all, but are there any more? And when you were starting out on your career? Well, the first thing I would say is don't go to law school. I went to one-year law school and dropped out, so don't do that. I would say I was lucky. There was something about investing and the challenge and figuring out the puzzle of how does this work? You get to look at all these different businesses. You get to figure out does this make sense or that make sense? It was fun for me. Everything that was going on in the world was relevant. Things I read in the paper, things about different businesses, learning, I just enjoyed the challenge of investing from the start. And I would say I got lucky. I don't know if I, I think I pursued it because I was pursuing something I really enjoyed. I've had about 800 students since I started teaching in Columbia. And I would say since I started, remember I said the market hadn't gone up in 13 years, most people didn't go onto Wall Street thinking they were going to make a bundle at that time because no one really had too much. The market hadn't gone up in 13 years. And now, I got lucky. I got out at a time where the markets got straight up tense. Take anything I say with a grain of salt. I did start investing at a very good time in my life and in the market. But what I've noticed is that there is a lot of money to be made on Wall Street especially if you're good at this. You get paid a lot more than you deserve for being very good at this kind of thing. But I notice the most successful students are the ones who truly love what they're doing. So, what I would say to you, I don't know, don't go into this to make money. There are, you know, you're all incredibly bright and wouldn't be here otherwise. And there's many great things you can do in the world. And do it, go into it. By all means, I've had a ball because you think that this is fun and that you enjoy doing this for a living. And I make my students promise that, look, I don't think there's a lot of social value in being good at picking stocks. I mean, people argue you're making markets and you're allocating capital well, but I just assume it would do pretty well without us. And actually, we're not that good at allocating capital and the market's going crazy all the time. But, on average, we are over time. So there is that benefit. But I think it would do fine without you. So I tell them it's not the highest social value. So I make them promise that if they are successful at it, and, you know, if I'm teaching them to do something I don't think has that much social value, I'm one step removed from doing something that I think is that valuable. So I make them promise to do something good. Meaning, in other words, to find something that's important to them, that's meaningful to them, to do with their success. And then, if you enjoy this career, there's nothing wrong with it. As long as you do it for love, right? Not much. You'll all be successful doing whatever you want to do. Do this one that you really enjoy. That's great, Joel. If you look back over your career, can you talk about a home run that sticks out? How did you find it? How did you build conviction? Oh. Well, I can think of one that was actually the inspiration for the Value Investor Club. We were just running our own capital. We ran outside capital for 10 years and then we returned all our outside capital. I didn't take outside capital again until 2009 to run directly. So this was during a period where we weren't running outside capital. And one of my and so we were just looking for good ideas for ourselves and one of the we had figured out one of the best investments I had ever seen. And it was the reason it was so great was it was it was a company selling at half its cash value with a great business attached. Okay? And usually when I size positions it doesn't have so much to do. My largest positions are not the ones I think I'm going to make the most money from. My largest positions are the ones I don't think I'm going to lose money in so that I can buy a lot of that without taking much risk. And if there's some optionality meaning it can go up. And this had everything. This I was buying at half its cash value with a good business attached. It was a complicated capital structure that people couldn't figure out because it was relatively new and people hadn't seen it. But if you did that's what you were buying. You were buying something at half its cash value with a good business. So obviously we bought a lot of that and we thought oh we're so smart we're one of the only people out there who's found this. And then my partner found on a Yahoo message board of all places someone who had figured this out in all its complicated glory and funny story the gentleman who figured this out actually was working at a supermarket at the time. He was just a really smart guy and a light bulb went off and he sort of said wow there's intelligent life out there. Wouldn't it be wouldn't it be great if we could put together a group of people who could talk and people at the time this was 1999 we were looking for millions of eyeballs on the internet and you know whatever they were talking about and I thought the internet was great to like have little meetings with people who are all over the country at different times or all over the world and you could sort of have a little club. I was fascinated with the idea of an investment club. So we actually he was one of the first members of the value investors club and he got the idea of could we attract smart people to share ideas. That was the deal. It was free to join but you had to share your good ideas and this gave us the idea that it wasn't just the normal hunting places that you could find really smart people it was good work. So that was a really good one. Half that's cash value and with a good business attached and it was really because it was a complicated capital structure. the I wouldn't call it my worst investment but I'd say my most disastrous investment. Anyway I've had a bunch of my partner Rob Goldstein who joined me in 1989 always joked that if we worked for someone else over the last 15 years they would fire us about 8 times. So you have to be willing to I guess make mistakes and you can't really avoid it. And so our worst one was probably we actually bought through a spin off a company that actually owned Comdex which used to be a computer trade show and it was the biggest one and we were actually able to create it before the spin off for about $3 a share and it was going to sell some new shares at $6 and that had been announced but yet we could create it by buying a parent and shorting another piece and creating what was left for about $3. So all good so far but we actually fell in love with the business. What I loved about the business was that they ran this trade show in Las Vegas and you could rent all the trade space you wanted in Las Vegas at the time and it was available at about $2 a square foot and they could re-rent it at $62 a square foot. So whenever the trade show grew we would spend another $2 and get a $62 contribution and so we fell in love with the operating dynamics of this business and the stock actually went from $3 they sold some more stock at $6 and the stock actually went to $12 and we had a really large position at $3 and the reason for that is that we thought we could get out right away at $6. We did not get out right away at $6 because we fell in love with the business it went to $12 so it sounds good so far but then unfortunately after about September 9th 2001 the company bought another trade show and borrowed a lot of money and then after September 11th no one wanted to travel at all and both trade shows really went downhill and everyone knows about financial leverage meaning you borrow a lot of money you pay your money you take your chances you put up a dollar you borrow nine that's a risky investment so this is how I learned about operating leverage which is when you lay out another $2 and collect $62 when the sales go down right when you lose $62 in revenue 60 of your profits just evaporated and it drops immediately to the bottom line that's called operating leverage so that was my lesson in operating leverage the stock I think I got out at a little over one or so so you know things happen it's a lesson in concentration it's a lesson in operating leverage I learned a lot of things and I can still safely say I'm always learning I'm always making a new mistake I'm trying not to make the same ones but the same ones usually have a little different face on them really making the same one but you know it's presented in a little different way and you didn't notice it and you don't make that mistake again so I guess advice would be don't be shy about making mistakes I think that's very important what Joel just said and I want everybody in the audience to take cognizance of it I wrote a memo in April called dare to be great and basically it said if you want to be exceptional as an investor you have to dare to be great everybody here is willing to be great but to be great you have to be different because if you think the same as everybody else you'll make the same actions if you take the same actions you'll have the same performance you certainly can't be exceptional if you follow the common course so to be exceptional you have to be different you also have to dare to be wrong and nobody bats a thousand and I had lunch today with a guy who works for Berkshire Hathaway and we were talking about what makes warrants successful and I said one of the things that makes them successful is not the people who that luxury and the question is for those of us who work in the world where we can be fired if not by our employers and by our clients will we still take the chance and back our ideas that there are no sure things will you back the things that have a chance of being wrong and I think you have to take that chance finally Joel one last question given that you had one of the best practices of all time why did you decide to give back outside capital when you were sure so that's kind of an easy one so I started my own firm in 1985 10 years later at the end of 1994 during those 10 years we had average 50% a year returns before our fees and then we gave back 50% of our so there's only a few ways to make 50% a year one is to stay small so after 5 years in business we returned half our outside capital after 10 years we returned all our outside capital the second way to do that is to be concentrated so traditionally 6 to 8 ideas were 80 plus percent of our portfolio during that time so we stayed very concentrated the third way was you get a little lucky right because you're very concentrated so you gotta get a little lucky to do that but what comes with that style of investing 6 or 8 names even if you're not a right so I would wake up and I wake up and I would wake up and I wake up and feeling bad when I would go through those periods for an understandable reason. I'm a pretty competitive person. I'd like to do well. And that was uncomfortable losing money for other people. So when we got to a big enough size that if I returned the money, we could still keep our staff and continue doing what I was doing, I thought I should do that because I figured I could either change my personality or change my circumstances. And I thought it would be much easier to change my circumstances. So I did that. Now we run long, short portfolios with hundreds of stocks on the side. And because our bad days are 20, 30 basis points of underperformance, I find that a lot more comfortable to run other people's money, so we started taking other people's money. Well, I think you've heard a really incredible example of how a great investment mind thinks. Very logical. Very insightful. Looking deeper into things than most people do. That's really the answer. You can't see the same things other people see and expect to do better. But also insight into human beings, the people who make markets, the reasons for error, and coupled with it, a real human being. So I think we're very fortunate to have Joel here today. Thank you.