Reuters / Mike Segar
- Legendary investor Joel Greenblatt runs the Gotham Index Plus fund, which has beaten 99% of its peers over the past three years.
- The fund's methodology is largely based on Warren Buffett's classic value-investing tenets, with a special twist added.
- Greenblatt calls his "crude" offshoot of Buffett's techniques a "magic formula." He broke down his strategy in detail during an exclusive interview with Business Insider.
- Greenblatt also explained why the Gotham Index Plus fund is primed to continue outperforming, even amid recent market turbulence.
Warren Buffett's investment prowess is often imitated but rarely replicated.
After all, if everyone was able to easily and successfully employ the mega-billionaire's techniques, there would be a lot more super-wealthy investors.
At the same time, if that was the case, there wouldn't be as many inefficiencies for Buffett to exploit. Because it's ultimately the faction that doesn't subscribe to his school of thought that creates opportunity.
He's an old-fashioned value investor seeking bargains in the market. Chasing momentum - as so many have done throughout the record bull market - doesn't interest him.
But there's another wholly unique set of investors out there. Rather than using Buffett's methods to a tee, they use his principles as the foundation for more specialized techniques.
Joel Greenblatt - the legendary investor who oversees $5 billion as the managing principal and co-chief investment officer at Gotham Funds - is one such disciple.
He employs what he describes as a "magic formula," which is built on Buffett's main value-investing principles. As an extension of that, Greenblatt is focused on attractively priced stocks that also have viable underlying businesses. His so-called formula equates to value plus quality.
"Buffett is looking for companies that generate high returns on tangible capital," Greenblatt told Business Insider in a recent interview. "If you combine that with buying a cheap version of a company that's providing a high return on tangible capital, that's a crude version of Buffett's approach - cheap and good businesses."
He continued: "At Gotham, we're doing that on steroids. While the principles are the same, we are actually valuing businesses. We look at every financial statement."
We are actually valuing businesses. We look at every financial statement.
To further quantify Greenblatt's commitment to the cause, consider that Gotham employs 38 people, 20 of whom are focused on research. That's a formidable backbone of manpower dedicated to building upon Buffett's core methods.
And going off past results, Greenblatt's enhanced approach to the Buffett method seems to be working. The Gotham Index Plus, which is the firm's flagship fund, has generated a 16% return over the last three years, putting it in the 99th percentile relative to peers, according to Bloomberg data. On a trailing one-year basis, the fund is up 15%, putting it in the 97th percentile.
A deeper dive on Greenblatt's methodology
There are three additional wrinkles to Greenblatt's methodology that have helped make his investing strategy a market-dominating force.
The first is the way he constructs his portfolio, which has both long and short portions. For every dollar that's invested in the Gotham fund, Greenblatt does the following:
- Uses that $1 to buy the stocks underlying the S&P 500, at the index's set weighting
- Puts an additional 90 cents in his favorite S&P 500 stocks - the cheapest ones, in terms of trading at a discount to fair value
- Sells short 90 cents worth of stocks that are the most expensive, based on those same terms
With a portfolio set up like this, when Gotham's longs beat their shorts, the firm is able to add that additional return to what the index has generated. Clearly they've succeeded in doing so over the past few years.
"On average, we want to buy cheap companies that are doing well, and short expensive companies," explained Greenblatt.
The second prong of Greenblatt's core methodology is the way he looks at investing overall. Greenblatt is largely focused on the amount of cash generated, rather than simple price level, which immediately differentiates him from more traditional value investors.
"When you're buying a business, you're looking at cash flows, not whether a business is trading at low valuations relative to history," he told Business Insider. "We're just valuing the business, and buying at a discount."
Third, Greenblatt doesn't just pick one single stock to serve as his bellwether for an investment theme. If he sees something he likes, he buys stakes in numerous other companies that share similar attributes. He then simultaneously shorts handfuls of stocks that don't strike his fancy.
We own a bucket of Apples, and we're short a bucket of Teslas.
As he's doing this, Greenblatt is keen to weed out stocks whose prices aren't supportive of their current cash flows. That means betting against companies like Tesla, which are based on their predicted cash flow several years down the line.
But that doesn't mean he's opposed to all high-flying tech names. In the end, all that matters is cash flow. Some cash-rich companies - like Apple - are still enticing when viewed through those terms, even if they might look expensive to the novice observer.
Greenblatt sums it up succinctly: "We own a bucket of Apples, and we're short a bucket of Teslas."
What the future holds
The elephant in the room when discussing the future for any investment firm - or strategy - is that the landscape as we know it seems to be warping into something unrecognizable.
One of the bull market's most tried and true trades has stopped working, volatility is spiking, and the whole playing field feels flipped upside down.
But Gotham appears uniquely positioned to withstand these topsy-turvy conditions. Greenblatt notes that the worst type of environment for his strategy is a "hopeful" market that keeps pushing prices higher for speculative stocks not supported by cash flows.
Considering many Wall Street experts characterized the stock market's performance throughout much of 2018 as a euphoria-based "melt up" of sorts, it's a small wonder that Greenblatt's fund is still in the 99th percentile over a long period.
Now that the entire tone of the market appears to be shifting more defensive, with investors rotating out of expensive winners and into cheaper laggards, it should play right into Gotham's hands.
"We believe we'll be much more insulated, because we're long-short investors," said Greenblatt. "Our longs will tend to hold up better because we didn't pay up for them. On the short side, we're short companies with super-high expectations. When they come down a little bit, those companies get crushed. That combination should really be helpful for our strategy."