As an undergraduate at Wharton, Joel Greenblatt didn’t buy what he was being taught. His professors’ insistence that markets are efficient made no sense on a visceral level. And he couldn’t get fired up about an investing class that focused on quadratic parametric programming. True enlightenment would have to come from elsewhere.
In his junior year, he read a magazine article about Benjamin Graham and eagerly ingested his books. Graham provided him with an intellectual framework that was “so simple and clear that it got me very excited,” says Mr. Greenblatt. The overarching message: Value businesses in a disciplined way and invest in them only when they trade at a big discount. As Mr. Greenblatt explains, Warren Buffett added a vital “twist” that “made him one of the richest people in the world: Buying cheap is great—and if I can buy good businesses cheap, even better.”
For Greenblatt, much of the joy of investing lies in the cerebral challenge of devising these strategies that defy the odds and beat the market.
In 1985, Greenblatt founded Gotham Capital and began to put these ideas to work. Robert Goldstein, who remains his partner to this day, joined him in 1989. Their returns were astounding. In its first 10 years, Gotham averaged 50 percent annually after expenses but before fees — not a bad rebuttal of his professors’ claims that stocks were perfectly priced.
How does Mr. Greenblatt account for Gotham’s spectacular record? First, the fund never got bloated. After five years, he and Goldstein returned half of their investors’ capital; after 10 years, they returned the rest and solely invested their own money. With a small fund, they could roam anywhere in search of opportunity, including obscure companies with liquidity constraints. Second, they focused only on their best ideas, betting 80 percent of the fund’s assets on six to eight stocks. Mr. Greenblatt had a particular gift for analytically complex investments such as spinoffs. “It’s easier to find bargains off the beaten path or in extraordinary situations that other people aren’t looking at,” he says. “I was looking at low hurdles — things that other people would have bought, too, if they’d done the work.”
In 1997, Mr. Greenblatt published You Can Be a Stock Market Genius, a seminal guide to this style of investing. It was equally memorable for the irreverent wit and verve of his writing. For example, the book recounts the tale of “a friend I’ll call Bob (even though his real name is Rich).” And the glossary includes the term “Village Idiot,” which Greenblatt defines as “Someone who spends $24 on an investment book and thinks he can beat the market. (Just kidding.)”
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While many money managers focus exclusively on investing, Mr. Greenblatt has always been harder to pigeon-hole, because his curiosity and restless energy have led him in multiple directions. A passionate educator, he has taught investing to more than 700 postgraduates at Columbia Business School over 19 years. As a philanthropist, he has also played an instrumental role in creating dozens of charter schools across New York, helping to establish a replicable model that has boosted the academic performance of thousands of students in underprivileged neighborhoods.
Both in philanthropy and investing, Mr. Greenblatt is always searching for a “systematic way” of “doing better.” In 2003, this led him and Goldstein to launch a $35 million research project to prove the effectiveness of the principles they had used at Gotham to identify “cheap and good” companies. They hired a “computer jockey” who backtested what would have happened over 17 years if investors had bought stocks with a high earnings yield and a high return on capital. They concluded that these two metrics provided a “magic formula” for outperformance. Mr. Greenblatt revealed this finding in The Little Book that Beats the Market, which he wrote for his five children. It has since sold well over 300,000 copies.
In response to his readers, he set up a free website to help investors use this formula. But when he studied their accounts, he found that many of them couldn’t resist overriding the system: “They piled in when the strategy was outperforming. When it was underperforming, they stopped doing it.” These irrational tendencies caused them to underperform over two years when the strategy beat the market by 22 percentage points.
Mr. Greenblatt responded by developing another approach that was intended to protect investors from themselves. In 2012, he and Mr. Goldstein launched a series of mutual funds that take long positions in about 300 undervalued stocks while shorting about 300 overvalued stocks. Each company is ranked, so the biggest position on the long side is the cheapest stock; the biggest short position is the priciest stock. It’s a systematic approach that’s designed to remove emotion from the process of picking cheap stocks. By diversifying broadly, Mr. Greenblatt aims to reduce volatility, so that investors find it “less painful” to stick with the strategy over the long term.
For Mr. Greenblatt, much of the joy of investing lies in the cerebral challenge of devising these strategies that defy the odds and beat the market. “I always found it a fun process,” he says, “to solve the puzzle.” And as an added bonus, there’s also the rebellious pleasure of proving his college professors wrong once again.
Excerpted from The Great Minds of Investing, a new book featuring profiles by William Green and photographs by Michael O’Brien. Available on Amazon.com.