Notes from Joel Greenblatt’s Special Situation Class

Excerpts: Notes from Joel Greenblatt’s Special Situation Class

  • Market prices fluctuate more than values–so therein lies the opportunity.
  • Why are prices of each company so variable and volatile compared to the value of companies?
  • People invest with their emotions. They process information differently.
  • 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.
  • There are lots of 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 spreadsheets 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.
  • 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.
  • 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.
  • 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.
  • 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.
  • The most interesting point is that the author points out those investors often are too emotionally involved to have the discipline to see the strategy through.
  • 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 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 money in the long run. We are all capable of doing the valuation work.
  • 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.
  • 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).
  • Current Assets (CA): First, we look at cash. We have often found companies are trading close to its cash per share. Technology stocks in 2002. 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.