Chit Chat Stocks - Joel Greenblatt: The Intersection Of Quality And Value (Magic Formula For Stocks)

Episode Date: June 11, 2025

On this episode of Chit Chat Stocks, we research Joel Greenblatt and what we can learn from the investor who put up 50% annualized returns before fees for Gotham Capital. We discuss: (02:55) Who is Joel Greenblatt? (08:34) Gotham Capital's Performance (11:36) Special Situations Investing (12:34) Understanding Spin-Offs (19:30) Mergers and Arbitrage (23:35) Bankruptcies and Restructurings (32:35) Recapitalizations, Options, and Leaps (36:19) Understanding the Little Book: Quality Stocks at Cheap Prices (41:11) Screening for Value: EV to EBIT and ROIC (49:13) The Magic Formula: Combining Quality and Value (57:59) Lessons from Joel Greenblatt: Complexity and Homework ***************************************************** JOIN OUR NEWSLETTER AND FREE CHAT COMMUNITY: https://chitchatstocks.substack.com/  ********************************************************************* Chit Chat Stocks is presented by Interactive Brokers. Get professional pricing, global access, and premier technology with the best brokerage for investors today:  https://www.interactivebrokers.com/  Interactive Brokers is a member of SIPC.  ********************************************************************* FinChat.io is the complete stock research platform for fundamental investors. With its beautiful design and institutional-quality data, FinChat is incredibly powerful and easy to use. Use our LINK and get 15% off any premium plan: ⁠finchat.io/chitchat  ********************************************************************* Bluechippers Club is a tight-knit community of stock focused investors. Members share ideas, participate in weekly calls, and compete in portfolio competitions. To join, go to ⁠Blue Chippers and apply! Link: ⁠https://bluechippersclub.com/ ********************************************************************* Disclosure: Chit Chat Stocks hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Learn more about your ad choices. Visit megaphone.fm/adchoices

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On this show, hosts Ryan Henderson and Brett Schaefer analyze businesses and riff on the world of investing. As a quick reminder, Chitchat Stocks is a CCM Media Group podcast. Anything discussed on Chitchat Stocks by Ryan, Brett, or any other podcast guest is not formal advice or recommendation. Now, please enjoy this episode. Welcome into Chitchat Stocks. My name is Brett Schaefer, and I'm joined as always by

Ryan Henderson. We have a great episode today. We are talking one of our super investors, Joel Greenblatt, the, and Ryan will get into it, professor, inventor of the magic formula, writer of two books, founder of Value Investors Club, and someone who has put up some pretty dang good returns over the last few decades. I'm going to let Ryan introduce it. First, quick housekeeping items. If you want the show notes, if you want any of our written analysis, And if you want to join our chat community, subscribe to our free newsletter on Substack. The link for that will be in the show notes. And if you enjoy these episodes, if you enjoyed a past episode as well, the best way to give thanks is to give us a five-star review on Apple Podcasts and Spotify.

It takes about five seconds, and we appreciate the people that do that. So Ryan, let's dive in. Joel Greenblatt, who is he? What kind of investor is he? Yeah. Joel Greenblatt is maybe a name people that are in the investing world or have been investing for a while have heard of. They might not know why though. So Joel Greenblatt is famous for a number of reasons. One, he's a very successful author. He's written a number of very popular books. He's also one of the most well-known adjunct professors from the Columbia Business School for his value investing courses, which are public on YouTube. They're great courses. And he ran a fund of his own where he actually crushed the market for a decade straight. And

I'll talk about some of those returns in a bit and kind of the strategy that he used to earn those returns. And then he's also one of the founders of Value Investors Club, which is still popular today but back in kind of the turn of the century 2000 i think was when it was started that was extremely popular as an extremely popular forum there are some legendary investors that have been uh that started on value investors club michael burry norbert lou norbert we've covered before on chit chat stocks you can go listen to the episodes in your queue or in your feed on both of those investors. And they actually got their start because they posted on Value Investors Club and

Greenblatt liked their pitches and this was kind of later in his career, ended up giving them sort of seed money to start their own funds. We can get into that in a bit, but before we do, let's give a little bit of background. Greenblatt was born in 1957 in New York. His father ran a shoe manufacturing company, which he credits to giving him sort of an early understanding of the behind the scenes on how a business works and what it's like to run a business. He was always a strong student from what I saw. He attended the Wharton School of Business at the University of Pennsylvania, which is where he became attracted to the stock market initially. I listened to an interview with him and I always think it's funny when people ask,

how did you get into investing? You're expecting some crazy story, but he's basically like, I saw a Forbes article that showed Ben Graham's rules for investing, and he said it just clicked and took him down the rabbit hole of reading all the Buffett letters and everything he'd get his hands on at that time. Like Graham, though, Greenblatt was focused primarily on the quantitative aspects of securities. And in 1981, at the age of 24, he wrote his master's thesis paper called How the Small Investor Can Beat the Market. That paper was circulated widely. It was actually a very successful paper. And basically, I believe it kind of laid the groundwork for his later book called The Little Book That Beats the Market.

Despite the interest in the stock market though, and despite writing his thesis paper on it, after graduating from Wharton, Greenblatt went to Stanford for a year because he thought he was going to become a lawyer, wanted to go study law. And within that year, he quickly realized that was not what he wanted to do. He was enamored with the stock market, very interested in it. So he moved back to the East Coast. He apparently took a job as an analyst, I think, for a couple of years at a small firm where it was just three partners and himself. He was the only analyst. And while he was there, it was that job that Greenblatt was really able to hone his focus

on special situations. and as the story goes he was talking with a friend and he mentioned to the friend like in passing you know i think i could run my own fund one day uh there's no reason i couldn't do this kind of thing and then he says the next day his friend called back and his friend worked for michael milken who's considered the junk bond king he was very popular at this time very wealthy and he would give seed capital to other investors so his friend phoned him back and was like michael said that's fine and greenblatt didn't really know what was going on but essentially michael milken said you know he'll uh give you seed capital to start a fund so greenblatt flew out to the west coast

had to negotiate a fee structure apparently it was a lot harder than he was expecting to negotiate the fee structure but he finally got the terms he liked greenblatt received a seven million dollar check from michael milken and which served as the foundation for gotham capital i'm not sure how he chose the name gotham capital but that was kind of the fund the initial long short fund that basically gave him the notoriety that he has today yeah and i think well born in new york i'm guessing that's why and honestly very good name better than bridgewater blackstone you know this one actually has some creativity to it uh oak mark oak tree river rock you just have to come up with something with nature and river stones trees mountains yeah just not volcano

you don't want anything blowing up no one any of those analogies we want smooth very calming and we're going to generate lots of return for you but ryan maybe you can take us through gotham capital and for any listeners ryan read what's the other book he he wrote that you read you can be a stock market genius which is by the way the worst name ever uh and he says that he's like this was a mistake to name it that but it was actually chock full of good information and it ended up selling pretty well so and i read the little book that beats the market which will cover that uh on the second half of the episode but let's talk gotham capital i'm looking at the numbers right here what sort of returns did greenblatt put up for his investors yeah so greenblatt launched the fund

in 1985 gotham's investor letters are not public but his returns are he published his total returns in at the end of his book for uh you could be a stock market genius and from 1985 to 1994 Gotham Capital generated one of the best 10-year track records I've ever seen. He earned 50% annually on a gross basis and a 34.4% return on a net basis. So investors got 34.4% returns annually. And we can talk about some of the particulars of it, but essentially, i believe the fee structure was at the start the first 20 percent have no fees on them per year returns each year yeah but then it's a 30 percent then apparently it's a 30 share of profits after that so that's where he because he absolutely crushed the market 50 gross annually he was able

to collect a nice fee that was the michael milken structure it may have been different once he started getting going and attracting other investors as well so that might have distorted kind of the net fee but it looks like i'm looking at his numbers here he beat that every year worst returns 29 28 well if your worst years over a 10-year period are 29 28 yeah quite good and i think did you just mention it he decided to just go out on top yeah that's probably the best part. There wasn't some huge blow up in 1994 where, because we've looked at investors before and we're like, wow, they did really good until 2008 or they did really good until whatever this year was. And then they blew up and then they started a new fund. That wasn't the case. Greenblatt

decided in 1994 that he had become in quotes, sufficiently rich and returned outside money to investors. How he generated those returns is not 100% public information, but he does discuss his overall strategy and some of his most successful investments in his book. So I'm going to go through some of those. And this is not the traditional path, I'd say, where we've looked at some investors that have generated astounding 20, 30-year track records because they owned one or two stocks in huge concentration that were just phenomenal businesses. That was not the model at all. In fact, just pure equities was not the approach for him either. He was willing to invest across the full world of securities. And it didn't matter on the industry.

It didn't matter what the company did. If he was able to figure out what he thought the returns would look like he was going to bet on it and if he felt like the odds were in his favor. So I'm going to go through some of those. But for the most part, from what I understand, he really earned his returns in special situations. And then in 1994, he unwound the fund, gave money back to investors. Size might have had part of the reasoning to return money because it's harder to invest in small cap special situations when you become too big. So that could have contributed to it, but he didn't say that anywhere. But now he just runs, Gotham Capital is still a thing, and he just runs a number of mutual

funds through it. Okay, let's talk about the four special situations from his book. I'll list them off for a little bit of a tease for the listeners. Spinoffs, risk merger and arbitrage, bankruptcy restructurings, and recapitalizations, warrants, options, leaps. wow he was a probably not day trading zero zero uh zero day expiry options but we'll get into that that's the last one ryan why don't we go through spinoffs for maybe to catch up some of the listeners i don't know what this is tell us about what they are why they worked for him and maybe

i'll try to think of some examples for the listeners yes just in general spinoffs are when a company decides to, as it sounds, spin off a portion of their business, make it its own publicly traded security, either the entirety of that business or that division, or sometimes they'll spin off like a portion of it and they'll retain a certain equity percentage as well. But from what I can guess and the fact that he makes this his first category and he mentions this constantly throughout the book, how lucrative spinoffs can be. I would guess spinoffs are likely the category where he made the majority of his returns from 1985 to 1994. He knows these

situations really well, and he was particularly good at understanding management incentives related to spinoffs. So the general theme with spinoffs that seemed to be why he was so successful is because once a company is spun off, there's usually a disconnect among shareholders. Either it's a small part of a big business. So when it's spun off, certain investors that own the big business can no longer own it, or it doesn't make sense to own the spun off company because it's not going to contribute to their returns, whatever it is. And some funds obviously have market cap thresholds, stuff like that. So it just creates the shareholder disconnect. The other reason is maybe that spinoff is unrelated to why shareholders wanted to own a company in the first place.

So for example, I think in the 70s or the 80s, Altria spun off Kraft Foods. And I doubt most people that were buying Altria were buying it for their mac and cheese exposure. So it's just an example of, well, I bought into this company. I didn't really buy into this small division. It's not a big deal to me. I got my share. I'm going to sell it. And so you see a lot of indiscriminate selling. And he talks about that as being a leading contributor to why there's constantly undervaluations in situations like this. And Greenblatt offers a seven-point checklist for spinoffs. So I'm going to go through these. The first one is, number one, and this is news to me, spinoffs in general beat the market. I did not know that. Two, he says, picking your spots

within the spinoff universe can result in even better results than the average spinoff. I guess that makes sense. Obviously, if you can determine any sort of edge or find something that looks slightly more attractive, you should do better than just a general spinoff. Then three, I think this is the really important one. Certain characteristics point to an exceptional spinoff opportunity. A, institutions don't want the spinoff. B, insiders do want the spinoff. So if you have insiders really looking for a division to be spun out, and especially if they can get like an equity stake or some sort of like option package in the spinoff, you should look for that. And then C, a previously hidden investment opportunity is uncovered by the spinoff

transaction. So maybe it makes either side of the business look better financially, either the parent company or the spinoff. And I'm going to go through the last couple here. He says the fourth point on his checklist is you can locate and analyze new spinoff prospects by reading the business press and following up with sec filings that's just kind of he did this all the time basically a lot of people just didn't want to read the prospectus they didn't want to read the sec filings but oftentimes there were a ton of nuggets in there that weren't covered by the press five he says paying attention to parents which is the parent company the company that's doing the spinoff can pay off handsomely and then six partial spinoffs and rights offerings create

unique investment opportunities. Seven, oh yes, keep an eye on the insiders. One big lesson that I took away from this part of the book, he did not really care what industry the companies were in. If it's complex to him, it's probably just as complex to everyone else. So he would always read the filing and try to understand the situation to the best of his ability because he found that often the complexity created even wider mispricings and the fact that he was willing to do the digging is probably a huge reason why he was able to generate such great returns at Gotham Capital. Yeah, let's talk some examples of spinoffs. You mentioned Kraft Foods. Just a quick correction for the listeners. I know someone probably knew this

and was going to get mad. The spinoff was in 2007, not in the 1980s, and was all a part of the same company that is now split up into Altria Group, Philip Morris International, and Kraft Foods, and maybe some others here from what I'm trying to read quickly. So that was quite the monster business and one of the largest in the world for a time there before they spun off. And, hey, some of those have done quite well. There's the PayPal one, which was a little bit of a better investment a couple of years ago and now seems to be doing OK. We have Ferrari from Fiat Chrysler. It seemed people underestimated that one.

And then another one that I thought was interesting that was probably right up his alley is the recent GE, not breakup, but basically spinning off and you have the stock like GE Vernova. And now there's GE Healthcare and then GE Aerospace, which I think is the leftover parent company is GE Aerospace. GE for Nova, Ryan, looks like, according to just a quick Google chart here, started publicly trading in March of 2024 and is already up 254%. So there was apparently a huge undervaluation because of this spinoff and people didn't really get the situation. And that seems what Greenblatt was looking after. And I wouldn't put it past him to have invested in this one, you know, just last year. Yeah, I mean, the list goes on and on. The incentives or what he talks about here as to what causes the indiscriminate selling still exists today. It's maybe even more amplified, especially when you think about the market cap thresholds for a lot of funds. the the examples he uses in his book are primarily small caps and that was you know you talk about

the paypal spinoff of ebay the craft spinoff from altria vernova spinoff from ge those are all going to be fairly well covered you can still make money as brett just showed but particularly in the small caps there's so few people paying attention to the companies that are spun off and especially the uh management incentives and whether or not they want some sort of vested interest in the spinoff all right let's talk number two mergers and arbitrage now this one is one that a lot of people know i think we even tried that once well maybe did we do that with activision blizzard are we kind of i think we were just following the situation i don't know if we ever owned it but greenblatt unsuccessfully we owned it yeah there we go greenblatt is not

fond of merger arbitrage now tell the listeners why ryan yeah i mean the simple reason and i guess for those unfamiliar merger arbitrage just refers to the spread that exists between uh when a merger between the quoted acquisition stock price for a company that's been announced that it's going to be acquired and the current trading price when the deal is announced. So sometimes there will be a spread between the current trading price and the closing price because in the meantime, either the acquiring company has to do more due diligence or they have to wait for regulatory approval. There's a number of ways that a deal could break.

And so there's a little spread that you can make in the meantime. green black green black basically says that he was just never fond of the low potential upside high potential downside that came with this category so he really doesn't spend a whole lot of time on it you know you still can find situations where it could be very lucrative but he liked to focus more on quote merger securities which to be honest i did not really no this category of securities existed prior to him talking about it so he says although cash and stocks are the most common forms of payment to shareholders in a merger situation sometimes an acquirer may use other types of securities to pay for an acquisition these securities can include

all varieties of bonds preferred stocks warrants and rights this was a general theme with greenblatt I mean, he invested in some things that I had no idea even existed, like security types that I did not know existed. And basically, the fact that people like myself don't know they exist and it's too complex for a lot of people to analyze is what creates these massive mispricings. and varies in the same vein as spinoffs where you get this indiscriminate sell-in because people didn't buy when they bought the initial security they didn't want the spun-off security you get the same thing with merger security so greenblatt finds opportunities in this area because let's say you invested in a company's stock and then three years down the road that company gets acquired and all of a sudden you've got some bond, some merger bond in a company that you

didn't even invest in in the first place, you're probably going to sell it. I'm thinking about it in my own case. If I bought a company, they got acquired and all of a sudden I've got bonds. I don't typically own bonds. I'd probably sell it. So you get these huge mispricings and discounts to their face value. So, or I guess bond discounts overall. So that's where he was generally looking when it came to risk slash merger arb. He didn't really spend a lot of time, I don't think, on pure merger arbitrage with the equities, but the other types of securities, that's where he was really doing most of his digging. All right. Nothing to add. And I will say I have not heard of these either. Maybe they

don't really exist anymore not sure but any listener that has dabbled in them before let us know maybe we could do some more digging on that although i guess greenblatt isn't really pitching that this is such an exciting category he likes these other three better let's move to another to number three apparently i can't say this word bankruptcies and restructurings we have maybe one of the best, and it could have been because of some political stuff, but Fannie Mae and Freddie Mac. This could end up being one of Ackman's, Bill Ackman's best returns. And I think that was basically a restructuring with the government. That was a little bit of a complicated situation, but I'm sure Greenblatt would put that in this category. How does he look at bankruptcies,

restructuring, and where's the opportunity for investors? Yeah. And before I get into this, I will just say some of these strategies are not easy to replicate for the average person that just has a day job and invests on the side. Yeah, it requires a ton of digging, a ton of reading of filings and legal speak and bankruptcies and restructurings in particular. So Greenblatt explains that there are a number of reasons a company goes bankrupt beyond just being a bad business. one, sometimes it's mismanagement. Sometimes there's too much leverage. Sometimes they made an acquisition, they paid too much, they levered up to do it. There really are a number of reasons that a company can go into chapter 11 bankruptcy protection. And a company that goes into chapter 11 bankruptcy production can still be a good business. And so here are his tips for analyzing

in bankruptcies. He says, bankruptcies can create unique investment opportunities, but be choosy. As a general rule, don't buy the common stock of a bankrupt company. I see this a lot, and especially now when a company is on the verge of bankruptcy, I see people say, once it goes into bankruptcy, you can still make money and then buy the common stock. And that's usually not what you want to do because that's going to get wiped to zero for the most part but what he looks for is the bonds bank debt and trade claims which another example i don't know trade claims was a tradable security i don't even know explicitly what that refers to but me neither yeah so it's bonds bank debt and trade claims of bankrupt companies can make attractive

investments but first he says quit your day job that's basically him saying it's going to require a ton of research he then says searching among the newly issued stocks of companies emerging from bankruptcy can be worthwhile. Just like spinoffs and mergers, bargains are often created by anxious sellers who never wanted the stuff in the first place. If you were a debt holder or a credit holder, or say you gave the bank debt, for example, to a company, and they end up giving newly issued stock to you as the form of recapitalizing through bankruptcy protections, that's not really what you're looking for you're going to see a lot of indiscriminate selling so it's another example i mean that is a common common theme that he sees is or he looks for is

just where is indiscriminate selling happening and then the last one is unless the price is irresistible invest in companies with attractive businesses so try to find out why the company went bankrupt if it's because they're so unprofitable and they were just hemorrhaging cash that they had to go bankrupt, that's probably not the type of company you're looking for. If it's a profitable company that had mismanagement or too much leverage, but their core operations are still generating cash each year, that can be really good when you get the newly issued stock of the company that's emerging from bankruptcy. To add on to that, this is not really something I guess investors could replicate,

but I believe that was likely the mindset of JP Morgan taking on First Republic Bank. They had that liquidity crunch. They really made a few mistakes, but they had a great brand. Hopefully, it's not totally ruined because of that banking crisis of 2023, Silicon Valley Bank, First Republic, if people don't remember. Then JP Morgan took them probably at an extremely cheap price. They were able to absorb that on the balance sheet. And hey, it was a good franchise.

it had been for a long time and maybe they got it on an absolute steal yeah and then his selling tips are trade the bad ones invest in the good ones that is you can still make money on a bad company that goes bankrupt right you can trade the debt securities uh the bank debt the trade claims and squeak out in economic return you can hold the good companies that were forced to go bankrupt and they get this newly issued stock, those are the ones that you can actually hold for a long time. So I think he really stresses the importance of distinguishing between the two. But yes, in general, he has and you can too make money through bankruptcies,

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The link will be in the description. The way I'm looking at this is it feels like these bankruptcy plays or restructurings are almost like deep value investing. You want to get some absolutely dirt cheap stuff. You might not make it your entire portfolio, but a collection of them, maybe there's not that many going on at one time, but over time, if you keep repeating this process and trying to be idiotic about it, that can be much better. Whereas the spinoffs, that's almost like quality. Oh, I have this undervalued quality stock that's coming to market. Ferrari, the best example, the stock we both should own today, but somehow I guess didn't see that mistake, you know, learn learn in a for next time but uh with restructurings yeah i guess that's just kind

of how i was looking at it doesn't feel like and maybe you can agree or disagree i don't have an incentive to do bankruptcy it doesn't feel like it's something i'd want to do i just i'd rather do invest in something that i can buy and not check every day and go to the beach yeah greenblatt in general is not for the most part probably not the kind of investor i would copy but there are lessons to be learned here spinoffs i would feel incentivized to look at more because the other part is all of a sudden there's this newly issued security that doesn't have nearly the hype of a company that goes public or goes public via spack or traditional ipo route whatever it is. They're not going on a roadshow and trying to get investment banks to get their

clients to buy it. This is just like in a lot of the cases, management doesn't really want it to be all that public. They might have a stake in the spinoff company. They know it's going to be worth a lot more in the future. Or maybe they have options that they want to have a low strike on so that they can buy it, I don't know, three months, four months, whatever it is a year in, and then they get all the upside. So they're actually like, it makes sense as a great hunting ground for potential new investments, especially, I mean, you just called it out. It's still happening today. The GE spinoffs, I think there's been a number of, I think 3M has kind of been splitting itself up as well. Yeah. I haven't followed that one closely. Honestly, yeah. The

GE one, that's one that I think is a perfect lesson. Like the company was just two decades of mismanagement. Jack Welch, I know a lot of people like him, but I'm not the biggest fan after reading that book, kind of exposing his short-term thinking in the 90s. And people just hated the stock. Then they decided to split up. And if you looked at the individual businesses, and maybe, I think Vernova is the energy one, but Vernova and Aerospace seem like solid businesses. Maybe you didn't want the healthcare part. I'm not sure how good of a business that is. And you could look at the sum of the parts there and say, well, you know, we're actually going to get the ability to trade these separately and shareholders have actually crushed it. That's one that I think we could have seen if we looked at it closely.

And I think listeners could as well as opposed to bankruptcy as well. That's tough and very high risk. All right, let's close out your section here. Fourth one, unless you have anything to add, recapitalizations, options, warrants, and leaps. yeah this is the last topic it it's not that long of a chapter in the book and it frankly it seems as sort of a like day trade tesla and nvidia options right that's what he's saying don't think that's quite what he's going for here the for the most part it seems this is kind of a way to capitalize on his analysis from the other three

sections like if you know if he's analyzed a lucrative spinoff or he's analyzed something a company some of these derivatives are a way for him to make money faster so not going to spend a whole lot of time here but also the recapitalizations we don't really see that anymore this was really popular in the 80s and 90s as a way to ward off hostile takeovers and it could create some opportunities for investors but i believe like the introduction of the poison pill and some of the other uh methods for warding off takeovers have kind of gotten rid of the need for recapitalizations so not really a whole lot of takeaways there as for the derivatives here's what he says there is a way to create your own version of a stub stock and a stub stock is like

the uh i believe the equity that's left after the recapitalization he says simply by choosing among the hundreds of available leaps you can create an investment situation that has many of the risk reward characteristics of an investment in the leveraged equity of a recapitalized company that's just to say you're kind of creating your own leverage by having this time uh time constraint time is your leverage yeah same with warrants yeah uh we've seen plenty of people in it i think it happened because uh the spack boom there was so many warrants attached to those and a lot of those have been trading out there i've seen some people give some interesting pitches on those although they always sound so promising and i don't know it's kind of like buying put options on a very

terrible company something i did once before um just as a little quick story beyond meat i was pretty confident that the company was going to zero but it took five years longer than i thought i made zero money betting against it yeah he groups warrants options leaps sort of into the same category and just basically says it's a way to amplify your return quicker If there's sort of a catalyst on it and he puts in quotes, use these when a company is undergoing extraordinary corporate change, because then that kind of creates the catalyst that you might need. I'm not going to spend too much time there. The big takeaway I would say listeners should have from this, unless you want to become a special situations investor, which I recommend reading the book in that case. when if you have a stock that you own that spins off a company pay attention don't just stop there don't sell it if there is a big or a spinoff in an industry that you think you can analyze and

understand pay attention and then look in corners of the market that maybe other people aren't and don't be too intimidated by complexity if it's complex to you it's complex to everyone else try to get to as much of an understanding as you can if you have to wave the flag and say all right fine. It's too complex for me. That's fine. But at least give it a go. That would be my advice. Let's talk about your side because this is much more digestible and understandable and implementable, if that's a word, for the individual investor. The little book that beats the market. Take us through what it's about. Okay. So the whole point of the little book, which I actually got from my local library,

use those and get it for free. Well, yeah. Paid for by tax dollars, I guess. But the whole point of it is finding high quality stocks, trading at a cheap price. That's it. That's the two factors he's going through. And for someone that maybe is a very, very beginner to investing, I'm not sure you'd be listening to our show, but if you are, I would recommend buying this book because it connects what a stock is versus a business and how they are the same and using private businesses analogies. It's very, very good. If you're starting out, if someone asked what book should I read first? I would not recommend The Intelligent Investor. I would definitely recommend this one to beginners because it's way more digestible. And that's all he's doing. Similar

to Buffett, Graham, or David Gardner, he wants to find an intersection on an X and Y axis between cheapness and durability that creates strong returns. You'd have Graham at the very extreme end on cheapness, and you'd have David Gardner on the extreme end that doesn't care as much about valuation, but just wants to buy the best companies and hold forever. In order to quantify this dynamic, Greenblatt and his team ran a study to see how a formulaic approach to the intersection of quality at a cheap price did versus the broad stock market. As he highlights in the book, these returns were simply the first run in a backtest, so they didn't optimize to find the perfect returns, and they were not repeated with varying criteria. There was no 20-20 hindsight

that they could just optimize here. They just ran the test. And as you will see, the process was fairly simple. So we have to go through each criteria and why he's using it. First, he uses the enterprise value to EBIT multiple for cheap, excuse me, cheapness. And this is trailing, I believe. So EV to EBIT enterprise value divided by EBIT. This just takes the stock's current enterprise value, which adds in the cash and net debt, kind of balances out all the assets and liabilities that are available to return to shareholders or that you have to pay off and then divide it by the trailing earnings before including your interest and tax payments for the year. The idea around it is simple, but maybe today is as good as ever to

relearn why cheapness is good, especially with the market at all-time highs and a lot of stocks that don't have any revenue trading at market caps of $5 and $10 billion. If you buy a stock at a cheaper earnings multiple, you are getting a higher earnings yield, cash flow, good cash conversion, hopefully, coming onto the balance sheet of that company that can be returned to you, the shareholder. An EV to EBIT of five is much better than 50 if the company is the exact same. And just using this and going extremely cheap, you can also use other metrics like book value, you know, trading below the net nets, all that stuff. This would be the Ben Graham, Walter Schloss, pure deep value approach of the formula. And all Greenblatt did was take a list

of every stock in his investable universe. We don't need to go into the details of all that and just rank it in order of EBIT to EBIT. So the cheapest one in EBIT to EBIT, it's a ranking of one. Most expensive gets a ranking of say a thousand if that's the last on the list. and how does it look if we target ebit in public markets today uh using our friends at finchette i'll say throughout this whole list i used the screener at finchette it was very intuitive and easy to use as i was building these lists and i use the screener all the time to help me discover new ideas and as we'll talk about at the end here potentially another new idea to investigate one that overlaps on both these lists that i'm about to go through ryan something

to add did you use the natural language screening did you type in your screener criteria i did not because i already knew what screen uh one is and i actually didn't know that was a feature but i will be testing that out shortly uh lots of good ai tools on there but all i did for this first screener to just do cheapness is stocks with a market cap above one billion dollars that have EV to EBIT below 5. I have a list of companies maybe people have heard of. There's one called Huge with three U's, CalMain Group, Botronics, Lending Club, Graham Holdings, Weatherford International. These are the hot stocks of the day that everyone's reading about on CNBC and The Motley Fool. I just made the list to, I don't know, to see what popped up. And even though you

put a market cap above a million dollars in a time when there's a lot of stuff trading at 30 times earnings 40 times earnings 50 times earnings there's still plenty of stuff out there with an ebit below five i think i've heard of one of these companies and that honestly gets me excited because it just goes to show that there are so many companies out there that no one's heard of that there's plenty of opportunity for oh yeah guaranteed there is that what you're Yeah. Lennar's probably the only one. Yeah. Maybe London Club. And this is another lesson from the list is you have to build a list and then investigate. When they ran the study, it was more quantitative, but I think CalMain is the biggest egg producer.

So there's those soaring egg prices, and I think they're probably over-earning when that's what's getting priced into the stock. But who knows? You want to investigate every time to make sure you're not buying a value trap or investing in something that earned a billion dollars last year but normalized is going to be just like 200 million dollars something like that yeah i would say looking at this list i'd probably want to add some sort of criteria to make sure that it's not a temporary the denominator in this formula the ebit in this case is not temporarily inflated you know because sometimes there could be sort of a tax situation or uh like in the cal main example they're over earning that one year suddenly it makes the valuation look a lot cheaper

than it is on a forward basis so and i believe you can actually use i think you can filter for ev to forward ebit uh on on uh on finchette as well now there's a debate on whether that's helpful or not because the analysts that that number gets compiled to be made. Turns out sometimes they're not always correct. But that's a that's a debate for another time. And the second one here is going to be buying quality, the second factor. And again, I can use all these on Finchette, use our link in the show notes, they've been a fantastic sponsor for us. And you can get 15% off any pay plan, help really analyze your existing companies. And as we're going to learn through today, finding potentially new stocks to research. So this is a quote from the little book that beats

the market. In short, companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above average profits. We've heard this talked about time and time again. It's a lesson we've learned repeatedly, and it's an important metric for every single investor to understand. That is return on invested capital, ROIC. This is another legendary investor talking about using data and price action to determine whether a stock has a competitive advantage. And typically, people go in and say, well, I think, you know, Apple has a great brand and that's a competitive advantage. You know, Greenblatt and even David Gardner, who we recently studied, they say that

what his stock has done and what their financials are telling you would say that the company is of high quality. Because if they have a high return on invested capital and have had one for a long time, that is an indicator that they are advantaged versus all of their competitors. Now, you don't need to aimlessly, what he's saying is you don't need to aimlessly start looking for a competitive advantage. Use a return on capital filter to identify potential stocks that have one and then hopefully buy them at a reasonable price. I think listeners can kind of get where we're going to connect here.

And the two are connected. If you have one, you're going to have a terribly high ROIC. And if you don't, you're probably not going to return good returns for, sorry, you're probably not going to have a good ROIC versus your competitors or versus cost of capital, all that good stuff. in Greenblatt's book, I assume he used EBIT as his earnings. But if we want to learn for anyone that doesn't know, return on invested capital is just taking an earnings number and dividing that by all the capital or just money, capital is just a fancy word for money, that has been

invested into the company. So it's your return on all the money that has been spent on, say, your manufacturing base, your store count, your headquarters, everything. Now, it doesn't include employee salaries and with intangibles and stuff like that, that can get messy in how you calculate it. I'd recommend reading Michael, is it Malboson? Malboson? He's got a lot of good papers on doing that. That's more detailed stuff that we're not going to do on this podcast. But again, it's just your return earnings over your invested capital. And on FinChat, yet again, we can easily filter for return on invested capital. Using his criteria, here are the results. Well, you're not going to be able to see unless you read the newsletter. We just filtered from highest return

on invested capital to lowest for market caps of over $1 billion. And I think I excluded biotech, but maybe that was for a different screener. Either way, there's one overlap here. Actually, a few. Cal Maine Foods was on there. We have NVIDIA on this list. Pinterest, Winmark, a sneaky compounder that has dominated the markets. Appfolio, a company I don't really know. Whirlpool, Applovin, Doximity. Ryan, anything you notice from this list or anything to add about return on invested capital before we kind of close out the episode and combine the two together? All right, folks. If you are a regular listener to Chit Chat Stocks, then you know that we use FinChat.io daily. FinChat is the complete financial data platform for stock-focused investors. They have robust financial data on more than 100,000 stocks globally, including company-specific segment and KPI data. So you want to see Amazon's revenue from advertising? FinChat's got it. How about Netflix's subscribers by region?

Yep, they've got that too. And they just added Morningstar research reports for all subscribers. So if you are subscribed, you can now get all the latest Morningstar high quality research reports on more than 1500 stocks globally. If you're interested, head on over to FinChat.io slash chitchat. All new users automatically get two weeks of FinChat Pro for free. But if you want to extend to any paid plans, our link will get you 15% off. that is finchat.io slash chitchat the link will be in the show notes oh i mean roic like you said

for companies that are very uh talent heavy as talent being one of their biggest costs like software companies tech companies something yeah software probably video games yeah like i I was going to say Google, but now CapEx has been a huge thing for them. ROIC is not exactly going to encapsulate that perfectly. So there's some flaw in that metric today. The reason that the numerator can change, Brett said, using some sort of an earnings figure is because for different businesses, you might want to use a different earnings to get to sort of their true take-home owner's cash flow. So sometimes it might be the free cash flow. Sometimes it might be the operating income.

Sometimes it might be NOPAT. Sometimes it might be net income. So kind of figure out whatever is the best earnings figure for the business you're studying, divide it by their invested capital, and you'll get your ROIC figure. Right. And sometimes EV to EBIT is not the best metric either. Banks, insurance, financials, you might want to use PE instead, but there's just for the study, I think they excluded that and it just makes it simpler for data and storytelling. So Ryan, what is the magic formula It is quite simple. All you do is combine the two factors together. And I guess I should mention he

did the same thing. He took his whole investable universe and ranked companies one through whatever on return on invested capital. So what you do to create the magic formula is you add the results together. So the highest returns on invested capital you add is one, and then you add whatever that EBIT is and the 30 stocks with the lowest sum. So this is the combined cheapest, you know, like EV to EBIT and ROIC together, that will be your portfolio. And you redo the results and rebalance on a regular basis. I believe he did this monthly according to his lecture, but you could maybe do it on different intervals. It doesn't really matter. And how did the strategy do? With zero other rules. Now, this is the only rule. They didn't

even probably check what companies they were buying until they did. Actually, they didn't buy this was all hypothetical. It absolutely crushed the market from 1988 to 2004. It was up, not up, had an average return of 33%. The market average, which I think may have been their investable universe, 15%. And then the S&P 500, 14%. So more than double the market average. And if we look at the S&P 500, just to put it into terms that maybe help show why this is so impressive. An annual return of 14% for 17 years turns $10,000 into approximately $93,000. Using the magic formulas results and getting a 33% return, that same $10,000 investment would be worth $1.3 million in 17 years. So quite the difference and shows why out steady, you don't

need and it's impossible but the people that are looking for oh i want the 110x return in a year blah blah blah blah the crypto non says whatever you don't need that to create outsized wealth you just need to and it's easier said than done uh slightly beat the market for an extended period and have that durability and it looks like the magic formula does work today there's been some studies that show that maybe it hasn't worked in the last 15 years for as well as it has in the past thing that could be the intangibles aspect that kind of makes everything wonky also buybacks can take the invested capital down but i think and he said it himself in his lectures greenblatt is showing that buying the best businesses at the cheapest price possible and having that

intersection of quality and value is going to work however you define it all right talk about how you used the magic formula today with fin chat and i see you've got a company that made both lists that i had never heard of prior to this talk about that as well yeah and who know this could be i have not looked at anything beside the screener it's more of the it's going to pop up maybe i'll investigate it later could totally be a fraud given the name here but who knows i believe in i just mentioned you know you weed out the bad the value traps and stuff and the unsustainable roic you do your own research after finding these screeners and for example we had one stock that made both the list above it's called huge with three use incorporated the ticker is h

u g never heard of it but i believe they're in mobile gaming that's what the fin chat summary says, that's the extent of my knowledge. And today, the stock trades at an EV to EBIT of 1.5. Now, I would want to ask, why is it so damn cheap? And the stock has had a very high return on invested capital, 137% over the last 12 months, and it's been consistently quite high. And I would also want to ask, why? And is this sustainable? Another way we can look at it and use the screener from FinChat.io is combining both ROIC and EV to EBIT into a single screener and then trying to improve on, because Greenblatt didn't use this in the book, he said he would probably try to do a 10-year average of ROIC or use some sort of long-term average ROIC to screen for

durability. And we can also move into smaller stocks. So Ryan, there are 42 stocks out there with a market cap below $1 billion, with a 10-year average ROIC above 15%, and an EV to EBIT below 10. That sounds like a good hunting ground to me. Now, there might not be any stocks you want to buy in this list, but you can repeat it and maybe a couple of different pop-up depending on what the price action has been. But that's 42 stocks you can research. If you only find one good investment out of that it's worthwhile yeah that sounds like a phenomenal hunting ground uh with the huge company i say that because it's literally h-u-u-u-g-e so that's how they spell their name i think yeah it's something with like casino mobile games stuff like that i don't know okay

yeah as i say the roic probably isn't the biggest deal because i'm guessing tech uh tech talents probably one of their biggest expenses so might not be encapsulated there but you can just filter for, like Brett said on FinChat, 10-year average ROIC, five-year average ROIC. That's usually the figure I use because some of the companies that went public in 2016 might not get encapsulated in the 10-year average ROIC figure. So I like to do the five-year. And then you can also add, And if ROIC isn't the perfect figure, you could do some sort of EPS growth parameter. Say you wanted EPS – Free cash flow per share.

Yeah, or free cash flow per share growth over five years, like making sure that there's some true growth over that time is quite helpful. So here's another one on valuation. Now, sometimes, and all else equal, you'd rather invest in a profitable company. Sometimes there's companies out there that are not profitable at the moment or barely generating a profit. You know, Amazon historically, as an example, would not pop up in the screener. I like to filter for EV to gross profit sometimes to pick up some of those companies that might be trading at a cheap price relative to their, quote unquote, unit economics, their gross

profit, and maybe investigate those even if their bottom line profit's not that high. And that's how I found – well, I knew about the company before, but I think that's how I found Remitly showed up on a screener. And I said, oh, wow, this is still kind of cheap, but it's not – it's cheap on an EV to gross profit level, but the PE, price-to-free cash flow, EV to EBIT, didn't look great. Yeah, I honestly love using screeners. There's a lot of garbage, and there's a lot of companies that maybe show up because of some sort of irregular accounting thing. but it's such a valuable hunting ground if you can get the right parameters like those you know if you're looking for a low enough ev to gross profit and you can filter through that list and say wow this company yeah it doesn't show up when you screen for earnings growth because they

haven't turned the corner but if you think that they can get that operating leverage yeah this can be a phenomenal place to find potential multi-baggers yeah this is why Finchette is a good screener. You could also use, I'm just spitballing here, they have all these and it's very easy to use. You could do EV to gross profit and then gross profit growth and revenue growth, say three-year average above 15%.

That can also weed things down. There's a lot of things to play around with and find investing ideas that's well worth the money. Okay, are you going to talk about lessons as we close out? Yeah, do you want to give this quote from the little book? Sure, and it'll be in the newsletter as well. It kind of encapsulates everything within the book what investors should do. So he literally asked, what should we be doing? Ideally, better than

blindly plugging in last year's earnings to the formula, we should be plugging in estimates for earnings in a normal year. Of course, last year's earnings could be representative of a normal year, but last year may not have been a typical one for a myriad of reasons. Earnings could have been higher than normal due to extraordinarily favorable conditions that may not be repeated in most years. Alternatively, there may have been a temporary problem with the company's operations and earnings may have been lower than a normal year. All he's saying is you got to project the future and the past does not matter as much.

Even though it can help you filter what stocks are potentially cheap, it will be what the company earns in the future that determines the path of the stock price. Okay, running up on time, about an hour in here, Ryan, what are the lessons you took away from studying Joel Greenblatt?

don't be intimidated by complexity it's probably one i have you know if you get in you're doing your research and you've given it your best shot and it's still too complex to understand that's one thing but don't just see the name see the industry here warrant option uh bond spinoff whatever and think that's outside my circle of competence i don't care because there's opportunities in there so i recommend at least giving a little more doing a little more digging than just omitting it right away the other thing to note is there are i'm probably not going to implement this for myself that's not really the type of stocks i'm looking for but there are more mispricings in those complicated ugly less traded parts of the market not as much as there were when

he was running gotham capital it's worth noting that he's actually mentioned that in his book and he's mentioned that a couple of times that in some of these markets it has gotten far more competitive than it used to be so bankruptcy uh and restructuring funds had really you gotta kind of think a little differently today yeah it's been kind of some of the edge there and just think if renaissance technologies can beat you on this i don't know if anyone knows that has read that book kind of thing could they crush me on this maybe it's not the area to play yeah the the last one i'll do is uh the last lesson i'll say is do your own homework he gives this quote that i really like he says there are really only two reasons to do your own work the first is pretty

simple. You have no choice. If you are truly looking at other situations that others are ignoring, there will rarely be much media or Wall Street coverage. He says the other reason to do your own homework is closely related. As much as possible, you don't want to be well-paid merely for taking big risks. Anyone can manage that. You want to be well-paid because you did your homework. If you are one of the few people to analyze a particular investment opportunity, it follows that you are in the best position to assess the appropriate payoff. So I really like that quote and it just goes – I kind of catch myself doing this sometimes and it actually goes back to our interview we had last week with Ryan O'Connor and

Tuan where Tuan says this thing. He says Value Investors Club and this is funny because Greenblatt founded Value Investors Club. He says, it's honestly made me a worse investor because you're looking at someone else's finished product and you don't gain as much value and you can't truly assess what the appropriate payoff is by looking and trying to digest someone else's work. It's so much, you can really internalize the idea when you do your own work. And I just, I like that quote and you saw that with Greenblatt in a huge way. Couldn't have said it better myself. The one thing I'll add is

it reiterated that and Ryan, this is Ryan's strategy as well, though we don't invest in the exact same companies, a strategy of being patient and waiting for the fat pitch of quality at a cheap price will work. Buffett does it. Greenblatt does it. Munger did it. So many of the best investors did it. And I just think if you're going to not invest in index funds, it's just the way for the individual to go. All right. Anything else? no i recommend reading his books he's the both of them are pretty good especially if you're interested in special situations uh yeah little book if you know what i don't know after this episode i i don't know if i'd recommend reading it i skimmed a lot of it after a while i think

i kind of summed up the but if you're a beginner you're a beginner i'd recommend reading the little book i will say you can be a stock market genius i believe is what like that was sort of what encouraged michael burry to look into this uh get into the world of special situation investing funny given sort of how their relationship ended up but he inspired uh greenblatt inspired michael burry with that book michael burry took to value investors club and showed how good of a security analyst he could be and then uh if you've ever watched the big short you kind of know how that transpired but uh he probably doesn't that's probably not his favorite movie probably not although they gave him hair in that one so that was nice uh yeah they did the green black coaching

tree it's not bad i always like to think of the great investors as like the sporting coaching trees where yeah and green blood has that gram probably one of the top dogs probably is the best coaching tree. But we're running long. Listeners don't care about this. Let's hit the disclosure and we'll get out of here. We are not financial advisors. And then we say on the show is not formal advice or recommendation. Ryan, I or any podcast guest may hold securities discussed in this podcast, may have held them in the past and may buy, sell or hold them in the future. Thank you everyone for listening. We will do more of these on a regular basis until we really just run out of investors to do when the format gets tired. We're going to cover plenty more stocks

on the podcast so keep following us thank you for listening and we'll see you next time