TIP339: Common Sense Investing w/ Joel Greenblatt

Episode Summary

Executive Summary: Joel Greenblatt explains how his investing evolved from highly concentrated special situations to a more diversified, rules-based approach, while keeping the same core principles: buy good businesses cheaply, understand risk as permanent loss, and stay within one’s circle of competence. He also discusses teaching, position sizing, macro skepticism, and his book Common Sense’s policy ideas on education and retirement savings.

Main Topics: From law school dropout to professional investor (Priority: 5/5): Greenblatt describes being drawn to Ben Graham’s value investing ideas at Wharton, rejecting efficient-market theory, and choosing investing over law after discovering a practical formula for buying businesses at a discount. Concentrated investing and special situations (Priority: 5/5): He explains Gotham’s early years as a concentrated, event-driven portfolio focused on spin-offs, restructurings, recapitalizations, and other special situations, with large position sizes and big drawdowns as part of the process. Transition to diversified, factor-based investing (Priority: 5/5): Greenblatt says later research showed that a diversified portfolio of cheap and good companies produced smoother and slightly better returns than a highly concentrated book, leading Gotham to reopen to outside capital. The Magic Formula and valuation discipline (Priority: 4/5): He revisits the backtests behind The Little Book That Beats the Market, emphasizing the combination of earnings yield and return on capital as a powerful, simple proxy for buying good businesses cheap. Position sizing and risk management (Priority: 5/5): Greenblatt argues that the size of a position should be driven by downside risk and conviction, not by arbitrary portfolio percentages, and that the best positions are often those with the least expected loss. Macro skepticism and circle of competence (Priority: 4/5): He largely dismisses macro forecasting as too uncertain, preferring company-level valuation and a 6% long-term risk-free hurdle, while defining circle of competence as knowing where his own strengths actually lie. Common Sense: policy through an investor lens (Priority: 4/5): Greenblatt outlines his book’s proposals on education, alternative certification, retirement savings, and income mobility, arguing that capital allocation principles can help solve social problems.

Key Arguments: Ben Graham’s insight that stocks are ownership stakes in businesses, not just ticker symbols, remains the foundation of good investing. A concentrated portfolio can produce exceptional returns, but it requires real tolerance for volatility and the willingness to endure large temporary losses. Diversification can improve risk-adjusted returns when the strategy has enough breadth and enough holdings to smooth idiosyncratic outcomes. The simplest value signal—cheap plus good—works well enough to be powerful, even if it is not the most sophisticated optimization. Position size should reflect expected downside, not just upside; the best large positions are often those with limited permanent loss potential. Macro predictions are unreliable because markets and economies are complex adaptive systems; stock selection matters more than forecasting rates or the Fed. A 6% long-term risk-free benchmark is a useful personal hurdle for evaluating equity investments, regardless of the current rate environment. Teaching forced Greenblatt to simplify his thinking, improve clarity, and better articulate his own process. The U.S. remains one of the best places to invest because of rule of law, property rights, and a deep opportunity set. Educational inequality and low retirement savings are structural problems that can be attacked with market-style incentives, standards, and forced early compounding.

Data Points: Gotham early fund performance: 50%+ annual returns - Greenblatt says his concentrated fund produced more than 50% annual returns for the first decade before outside capital was returned. First 15 months of Gotham: +140% - He recalls the fund being up about 140% in its first 15 months before later drawdowns. Early setback after raising outside money: -17% - He says the first six months after bringing in family and friends’ capital were down 17%. Typical concentrated portfolio size: 6 to 8 ideas - He says 6–8 holdings often represented more than 80% of the portfolio. Value formula backtest period: 1988 to 2004 - He references the screening period used in The Little Book That Beats the Market. Highest-ranked portfolio return: 30% ROI - He cites the highest-ranked stocks in the formula portfolio producing about a 30% return. Magic Formula underperformance window: Last 3–4 years - He says the strategy likely struggled recently, similar to earlier value underperformance periods. Gotham loss years in late 1990s: -5% in 1998 and -5% in 1999 - He contrasts these losses with the market’s strong gains during the dot-com bubble. S&P 500 in 1998: +28.6% - Used as the benchmark when Gotham was down 5% in 1998. S&P 500 in 1999: +21% - Used as the benchmark when Gotham was again down 5% in 1999. Gotham in 2000: +114% - He says Gotham rebounded sharply when the market fell and value stocks finally paid off. Unloved money-losing firms in 2019: 313 companies - He notes the number of companies that lost money in 2019 and later had market value above $1 billion. Average return of those firms: Over 100% - He uses this as evidence of speculative froth in money-losing stocks. Median return of those firms: 70-something% - He cites the median return for the same cohort as another sign of excess. College earnings premium: 70% more than high school graduates - Greenblatt cites this to argue for better educational pathways. High school vs dropout earnings premium: 30% more than college dropouts - Used in his discussion of educational and labor-market inequality. College graduation odds for poorer minorities in major cities: 1 out of 11 - He says this illustrates how badly the current system serves disadvantaged students. Top marginal Social Security cutoff: About $143,000-$147,000 - He references the earnings level above which Social Security taxes no longer produce additional benefit. Australian superannuation example: Forced saving from paychecks - He uses Australia’s retirement system as a model for early, automatic savings. Compounding example: Ages 19-26 vs 26-66 - He argues that seven years of early savings can beat forty years of later saving if returns compound long enough. Alternative allocation advice: 60%-70% equities as a base range - He suggests most people should choose an equity allocation they can stick with, adjusting modestly up or down. Index return reference: About 10% per year over 50 years - He notes the S&P 500’s historical long-run return while discussing passive investing.

Pivotal Quotes: "These are actually ownership shares of businesses that you value and buy at a discount." — Joel Greenblatt: Explaining the Ben Graham epiphany that launched his investing career. "Fat wallet is the enemy of investment returns." — Joel Greenblatt: Describing why larger asset bases can reduce returns and why diversification or scale can change the game. "It ain't what you don't know that hurts you, it's what you think you know." — Joel Greenblatt: Used to caution against macro predictions and overconfidence in complex systems.

Implications: Listeners should take away that durable investing success comes from simplicity, discipline, and sizing risk correctly—not from forecasting macro conditions. Greenblatt also argues that capital markets can help solve social problems if incentives and early compounding are designed well.