The Greatest Value Investors of All Time - Joel Greenblatt

Joel Greenblatt and his magic formula

Before he turned 30, Greenblatt started the Gotham Capital hedge fund in 1985 and ran it until 2006, when he returned investors' money and stepped aside. He is now a professor at the Columbia Business School and is the co-founder of the Value Investors Club website. What has captured the attention of avid value investors, however, are his books; most notably, the best-selling The Little Book That Beats the Market.

In the book, after explaining the basics of value investing, Greenblatt claims to have a "magic formula" that will beat the market. The big secret? Rank companies by their earnings yields and on their return on capital, combine the rankings, and buy the top dozen or so companies. The earnings yield of a stock is calculated by flipping the P/E ratio. Instead of dividing the price by EPS, divide the EPS by the stock's price. The result, when expressed as a percentage, is the earnings yield. This percentage can be easily compared to bond yields, assuring investors they are accepting a greater potential for rewards by investing in stocks, a riskier asset class than bonds.  The return on capital looks for how much companies have to pay to buy the assets that created their earnings.

That simple formula, Greenblatt insists, is the secret to successful and simple investing.

Investment track record: For the two decades that Greenblatt managed Gotham Capital, the fund returned an annualized rate of 40%. That return is simply staggering and is more than Buffett averaged over any two-decade period.

Important lesson: While there are several lessons I've personally taken away from Greenblatt over the years, one of my most profound epiphanies was when I realized why Greenblatt was so high on companies that had high returns on capital. It was a way to quantify a company's moat, a competitive advantage a business holds over its competition and one of the singular factors Buffett seeks out in his investments. In The Little Book, Greenblatt explains:

"To earn a high return on capital even for one year, it's likely that, at least temporarily, there's something special about that company's business. Otherwise, competition would already have driven down returns on capital to lower levels.

It could be that the company has a relatively new business concept (perhaps a candy store that sells only gum), or a new product (like a hot video game), or a better product (such as an iPod that's smaller and easier to use than a competitors' products), a good brand name, ... or a company could have a very strong competitive position...

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."