Vol 3. Santangel's Review - Gotham Asset Management PDF

March 2011
212.365.8730 | info@santangels.com | www.santangelsreview.com
Joel Greenblatt and Robert Goldstein

of Gotham Asset Management, LLC
G
otham Capital returned more years in the making, with more Gotham Asset Management and
all of its limited partners than $20 million spent on research and interviewing Joel and Rob in person.
capital in 1995, closing the development. During this time, Joel They granted us access to many
book on one of the best performing and Rob built a proprietary database details they consider proprietary
investment partnerships of its of stocks that may be the only one details that were essential to our due
generation. After compounding at of its kind in the world. The result is diligence but that we agreed to not
50 percent annually after expenses Gotham Asset Management, which publish. We sought to learn why two
over 10 years, Joel Greenblatt and opened in 2010 and already manages of the best value investors of their
Robert Goldstein planned to simply $600 million in several institutional generation have virtually abandoned
continue investing their own money long-only strategies and two long- special situation investing and instead
in the same concentrated style with short partnerships. Each strategy is decided to put a majority of their net
which theyd had so much success, based on an idea that is as simple to worths into something that on the
leaving allocators to look for the next state as it was difficult to execute: Take surface seems so different. The more
Gotham Capital. the best of what Joel and Rob learned we learned, the more we realized
about valuing companies over the that Gotham Asset Management is
Then in 2002, a little experiment last 20 years, and apply it to a much actually pure value investing
intended to satisfy their intellectual broader universe of stocks. The goal: and in many ways a return to the root
curiosity proved so encouraging to produce outstanding returns after of the discipline. We also learned
that in 2005 Joel turned it into a fees, while capturing the benefits of that if Joel and Rob are right about
bestselling book, The Little Book that diversification and superior liquidity. what they have spent eight years
Beats the Market. The book marked building, the next Gotham may be
the beginning of a longer project, five We spent several months analyzing Gotham itself.
Santangels Review produces original research on There is no more cost-

undiscovered investors. Each quarter we publish one effective way to extend
an internal staffs
profile of a money manager who has an outstanding
hedge fund capabilities
track record, but is largely unknown to the wider
than by subscribing to
community of fund allocators. Our clients include Santangels Review.
family offices, high net worth individuals, hedge Jay Namyet
Chief Investment Officer,
fund managers, funds of funds, and endowments. University of Oregon Foundation
Full quote continuted on pg 12
WE RECEIVE NO COMPENSATION FROM THE MANAGERS WE PROFILE. PLEASE SEE ADDITIONAL DISCLOSURES ON PAGE 25.
Santangels Review | 2
Grahams new approach, an apparent

paradox for one of investings great
Behind the Santangels Name thinkers, was to choose stocks according

to a formula that required very little
thinking at all: Buy groups of stocks
Luis de Santangel was the treasurer to the
that meet some simple criterion for
royal court of Spain in 1491, the year Ferdinand being undervalued regardless of the
and Isabella refused for the second time to industry and with very little attention
finance the voyage of Christopher Columbus. to the individual company. To follow
Dejected, the then-unknown sailor was on his his formula, one would buy all stocks
way to petition the King of France when a rider that met certain tests that anyone with
intercepted him with a message: Santangel had convinced the a Moodys guide and a knowledge
Spanish monarchs to change their minds. Santangels quiet of basic arithmetic could calculate
role in what became one of histor ys greatest investments is factors that related to a stocks
the inspiration for our name. earnings yield, price to liquidation
value, and dividend yield. One would
sell the stock after it appreciated by 50
percent or after two years, whichever
Medicis Pharmaceutical is a Scottsdale- Medicis would never have made it came first, and then simply repeat the
based maker of dermatology products. into the portfolio of Gotham Capital, process as new stocks met the tests.
On December 31, 2010, it was not a the partnership Joel founded in 1985. Graham and a team of assistants had
hedge fund favorite; its unremarkable But while Gotham Asset Management spent two years back-testing this
P/E of 14 was on the high side for a looks different and is different than formula for the years 1925 through
pharmaceutical company, and it faced Gotham Capital, it is not as different 1975, and discovered that despite
concerns about looming generic as it appears. In many ways, Gotham periods of underperformance, over the
competition for one of its key drugs, Asset Management represents a logical full period, the formula produced an
Solodyn. At first glance, it did not next step in a journey for Joel and Rob annualized return more than double
look like a typical position in a value that began over 30 years ago, with the the Dow Jones average. It seems too
investors portfolio, let alone a portfolio father of value investing himself. good to be true, Graham conceded.
designed by two of the greatest value But all I can tell you after 60 years of
investors in history. What also seemed BENJAMIN GRAHAMS LAST experience, it seems to stand up under
strange was that no one at Gotham WILL AND TESTAMENT any of the tests that I would make up.
Asset Management, the firm which Months before his death in 1976,
owned Medicis stock in its Institutional Benjamin Graham gave a rare interview Nearly a year after Grahams death,
Value Portfolio, had made a prediction to the Financial Analysts Journal. Forbes magazine published a more
about how the company would do in Though 82 years old and long retired, detailed explanation of his formula
the future. The stock, like every other the father of value investing seemed in an article titled Ben Grahams
one Gotham Asset Management owns, as fascinated with the stock market Last Will and Testament. The article
was chosen by a formula. as ever. But in the interview, the man seized the attention of Joel Greenblatt,
who literally wrote the bible of stock- then a 19-year-old college junior from
Medicis closed on that day at picking made a surprising admission: Long Island who had left high school
$26.79, and two months later the a year early to attend The Wharton
company reported fourth quarter I have lost most of the interest I had School. A light bulb went off, Joel
earnings. While the results only in the details of security analysis which said of reading the Forbes article. I
matched expectations, the company I devoted myself to so strenuously for cant tell you exactly what it was about
unexpectedly announced a settlement many years. I feel they are relatively it that made me very excited, but it had
with Teva, a competitor, that would unimportant, which, in a sense, has elements of the things I was interested
shield Solodyn from competition for put me opposed to developments in the in: how to look at companies, how to
a few more years. With Medicis key whole profession. I think we can do it think about the stock market, how to
product suddenly given a new lease on successfully with a few techniques and do something with a formula that could
life, its stock popped up from $25.82 simple principles. actually make money. For whatever
to $32.09 on the news a 24 percent reason, thats when I really got turned
bump in just one day. on to the stock market.

The article inspired Joel to test

Grahams formula for a more recent
period, from April 1972 to April 1978,
a period that included both a severe
bear market and a sharp recovery. He
enlisted the help of two classmates,
Bruce Newberg and Richard Pzena,
to conduct this new study. Joel was an
intense, focused guy back in college,
remembered Richard, who now heads
Pzena Investment Management, a $15
billion investment firm in New York.
But then and now, he had one of the
most upbeat, enthusiastic, and decent
dispositions of anybody Ive known. He
just made you feel like working with
him was an honor.
The historical data the three students

needed for their research was not
yet available in computer databases,
so they sat in Whartons Lippincott
Library with a stack of Standard &
Poors stock guides. Starting with the
As, they resolved to go line by line
through the guides until they had
collected a random and unbiased
sample of companies. After several
months of work, 750 stocks seemed
himself had used.1 Just as Graham had, results as formally as he could and
like enough although the students
the students made no effort to evaluate submitted the paper to several
did not get as far into the alphabet as
individual companies, industries, or academic publications. One rejected
they had hoped. We took just the As
management teams and used only data it outright, and he heard nothing from
and Bs, which was a decent chunk
that would have been widely available the others until he got a letter from
of the universe at the time, Joel
had they been managing the portfolios Peter Bernstein, who was then editor of
remembered. Physically, the three of
in real time. the Journal of Portfolio Management.
us just couldnt do any more.
Bernstein agreed to publish the paper
The results were outstanding. Each on one condition. He said he loved
The trio then entered their
of the four model portfolios beat its the study, Joel remembered. But he
handwritten data into a DEC10, one
relevant index by over 10 percent a added, Could you please have someone
of the few computers on campus at the
year after trading costs and taxes, and who can write send it back? Joel duly
time. It took up an entire room, and
with only slightly more volatility. The made the language a little less formal,
was secured and climate-controlled,
top portfolio returned 29.2 percent and the revised paper was eventually
Richard said. You sat at a terminal
per year, but any one of them would published in the summer of 1981.
and punched data onto IBM punch
have beaten nearly every professionally
cards, and fed them into the computer
managed portfolio over the same In the papers last section, under the
for analysis. They used the computer
period. heading Why does it Work?, the
to back-test four model portfolios they
three co-authors addressed how such
had come up with, each based on slight Joel, who thought about one day simple models could produce such
variations of the same factors Graham becoming an author, wrote up their great results. It was obviously not
1. Specifically: Portfolio 1 bought stocks selling below their per share liquidation value with earnings yields that exceeded twice the prevailing triple A bond yield. Portfolio 2
was similar to Portfolio 1 except stocks had to sell below 85 percent of liquidation value. Portfolio 3 bought stocks selling below liquidation value with price-to-earnings ratios
less than 5. Portfolio 4 bought stocks selling below 85 percent of liquidation value with P/E ratios less than 5. In a slight tweak to Grahams formula, each of the four model
portfolios sold stocks after they had doubled (as opposed to appreciated by 50 percent) or two years passed, whichever came first.

because the formula knew anything Wall Street, but Joel decided instead A friend introduced Joel to a new
about the companies, their products, to enroll at Stanford Law School. I investment partnership called Halcyon
or their future prospects. Nor were never wanted to be a lawyer, he later Investments, whose three founding
there any magic qualities, as the admitted. But I also didnt want to partners Alan Slifka, John Scully,
young men put it, associated with the take a 90-hour-a-week investment and Martin Bernstein were looking
stocks the formula told them to buy. banking job on Wall Street. I was to hire their first research analyst.
Rather, the formula used simple tools probably just hiding from the work Halcyons main focus was risk arbitrage
to identify companies that appeared world. investing in companies subject to
severely depressed usually due takeovers. Joels knowledge of this area
to uncertainty or pessimism about He still had the investing bug, so was limited, and he had to weigh taking
their immediate future. The formula during his first year of law school he the job against just running his Ben
worked because the uncertainty and started a small fund based on Grahams Graham fund, which he believed could
pessimism were already incorporated principles, with capital from his father earn 20 to 25 percent a year. In the end,
into the prices of the stocks it selected. and a few family friends. The following Joel decided Halcyon was the better
If negative expectations turned out to summer, he took an internship on the choice, largely because the job would
be justified, the stock would trade down options desk of Bear Stearns. Before allow him to keep learning. My friend
a little or not at all. But if the future, quantitative Ph.D.s took over later in Bruce was in the business already, and
for whatever reason, turned out to be the decade, options trading was still he was learning a lot that I didnt know,
better than expected, the stock would a backwater on Wall Street, and only and I just thought I should learn some
go up significantly. Bad performance scrappy firms like Bear Stearns did stuff too, he explained. But it was also
does not hurt you too much, and good much of it at all. But this institutional because at that time, risk arbitrage
performance gives you asymmetric neglect often led to mispricing, which, was an extremely inefficient market,
returns, Joel later said. Joel, who if spotted in time, could be traded potentially more so than Grahams
had spent more of his youth thinking using forward conversions. These depressed stocks or even the mispriced
about horse racing than he would later represented true arbitrage profit options Joel had traded at Bear. Even
care to admit, instinctively understood modest upside, but no risk. Joel spent if you werent particularly good at risk
Grahams formula as a handicapping the summer running back and forth arbitrage, at that time you could make
system a way of identifying stocks across the trading floor, from the lone 80 percent a year for just showing up,
that, on average, were good bets. computer that spat out options prices he later joked. Halcyon offered him a
to his desk phone to execute trades. $22,000 salary, about half the prevailing
DEALS WITH A LITTLE It was almost stuff a monkey could rate for MBAs. Joel accepted, and
FLAVOR do, he said, and soon realized that he joined the group in December 1981
Joel earned a B.S. in economics summa did not want to make options trading
cum laude in 1979, with concentrations a career. He also decided that he was Halcyon proved an ideal education
in accounting and finance. One year finished hiding out at Stanford and for Joel. As the only research analyst,
later, he received his MBA as part of would finally head to Wall Street. I he was given enormous responsibility.
Whartons submatriculation program. took a leave of absence and just never I had to do everything chief cook
The natural next step was toward went back. and bottle washer, he recalled. It
was a learn-by-fire situation with real
money and smart guys. I couldnt ask
for anything better. The nature of his
SUBSCRIBE TO position meant that the firm tended to
Santangels Review focus on whatever he wanted to look
at. Over time, he gravitated away from
Santangels Review is sold by subscription, most of the traditional one up and 10
down risk arbitrage deals, where if an
and receives no compensation from the
announced takeover was completed
managers profiled. A one-year subscription, you made a little money, but if it fell
which includes four profiles, is $1,600. through you lost a lot. Instead, he
looked for those situations where the
Visit www.santangelsreview.com to subscribe or join our mailing list. odds were more in his favor. He found
them in complicated takeovers. I

voting control of the target company

necessary to approve the deal. In
the second, called the back end, the
acquirer sought to buy the remaining
shares as cheaply as possible. The value
offered in the front end was always
significantly higher than that of the
back end, in order to induce target
shareholders to tender into the front
end.
The stock of a company subject to a

two-tier tender offer would naturally
fall after the front end tender period
expired to reflect the fact that it was
now only worth the forthcoming
smaller back end. By that point, the
puts on that stock should have been
priced off the back end value alone.
However, Joel saw to his surprise that
sometimes a put remained priced as
if the stock were still about to receive
a higher value than just the back end.
If he spotted the mispricing, he could
buy a $2 put that would turn into $10
the day after the front end tender
period expired. I did that three or
four times before people woke up, he
remembered.
Joel found another source of great

risk/rewards in buying calls of a
target company that the acquirer was
purchasing using its own stock. For
example, if a target company was
being taken over at $51 in one month,
its three-month $50 calls might trade
very close to $1, reflecting the near
developed a style for myself. I liked to rewards with options than you could certainty that the deal would soon close
play deals with a little flavor, he said. with stocks. at $512. If Joel saw that the acquirers
Complicated deals scared away other stock was temporarily depressed by
risk arbitrageurs just as pessimism and Some of these risk/rewards came arbitrageurs shorting it, he knew it was
uncertainty had scared away investors about because of the way deals were likely that the stock would go up after
from stocks in Grahams formula. In structured at the time. For example, the deal closed and the selling pressure
both cases, less competition led to in the early 1980s, many acquirers lifted. While others thought only about
lower stock prices, and lower prices made takeover offers in the form of buying the stock of the acquirer, he saw
led to better odds. Joels previous two-tier tenders, a strategy designed to that the better bet was on the calls of
experience at Bear Stearns also led ensure a deal would close by dividing the target. I just bought piles and piles
him to a realization that very few risk the purchase into two stages. In the of $1 call options, Joel said, noting
arbitrageurs understood at the time: first stage, called the front end, the that many quadrupled in value a few
You could set up much better risk/ acquirer sought to gain the 50 percent weeks after the merger. Ben Graham
2. i.e. the right to buy something for $50 that is about to become $51 is only worth about $1, after adjusting for the time value of money tied up while you wait.

stocks were good, but using options to account had grown to over $1 million. to accommodate Joels request for a
play complicated deals was proving to Having always been entrepreneurial, 30 percent incentive fee (only to be
be much better. and convinced that the style of investing received after meeting a 20 percent
he was developing could run even more return hurdle) instead of the customary
Halcyon had asked Joel to close his money, Joel looked into starting his 20 percent. Joel flew to Los Angeles
Ben Graham fund soon after he joined own partnership. The main hurdle he to negotiate face-to-face with the
the firm. But he was allowed to keep faced was raising outside capital. One famously intimidating financier:
a personal account where he traded day he mentioned his fundraising goal
what he considered the best ideas in on a phone call with his old Wharton Milken didnt want to give me 30
Halcyons portfolio, many of which friend Bruce Newberg, who was then percent. I actually kept him in a meeting,
he had found himself. He owned working at Drexel, Burnham in Los negotiating my little deal, while Ron
only a few positions in this account. Angeles. Bruce called him back the Perelman was waiting for an hour to do
He did not diversify because he felt following day with a message: Mike the Revlon deal. But [Milken] wouldnt
he understood the downside of each said sure. give in. I figured he was doing 20 deals
position extremely well. In fact, he a day, but this was my life! Im a lousy
thought more positions would only Mike was Michael Milken, who negotiator, but when I have a bottom
add risk by forcing him to own things dominated the high-yield bond industry line its very easy.
he didnt understand as well. If you during the 1980s. Milken offered to
cant cover a lot of companies, then invest $14 million immediately. It was Milken finally left the meeting to speak
once you diversify, you just dont know an enormous sum at the time to give with Perelman, and when his brother
enough about most of your positions, to an unproven 27-year old, but Joel Lowell entered the room to finish the
he thought at the time. Youre diluting turned it down. He wanted enough negotiation, Joel managed to get his
your good ideas. The results bore this capital to get started, but feared that 30 percent. Mike almost hit the roof
out. He plowed his Halcyon bonuses too much money might compromise after he found out, Joel said. After
into the personal account for the next his returns, so he preferred to start resigning from Halcyon, Joel opened
three years and earned annual returns with only $7 million. Milken was happy his partnership on April 1, 1985. He
of over 100 percent. By 1984, the to accommodate this, but less happy hired a secretary, an office manager,
and one analyst his former fraternity
brother at Wharton, Daniel Nir and
sublet a 600-square-foot office. The
name he chose for his new firm, in a
nod to his love of the 1960s Batman
television series, was Gotham Capital.
UNFAIR BETS
Gotham Capital was less a hedge fund
as the term is understood today than a
continuation of Joels personal account.
It maintained the same approach to risk
management and had an undiversified
portfolio, with only five to eight positions
typically making up the vast majority of
its investments. My biggest positions
were the lowest risk positions relative
to what I could get paid, Joel said.
The partnership also initially focused
on the same kinds of complicated
deals Joel had played at Halcyon,
often using options to enhance the
risk/rewards. But with more money to
manage, Gotham Capital also extended
its search for ideas to companies
undergoing other kinds of corporate

change, like spin-offs, restructurings, for his cable stations. Id rather have My analysis was fairly simple. Turner
and reorganizations. These special good old programming than bad new may be overpaying for MGM, which
situations, as the area is now widely programming, Turner joked to a I doubt because hes a genius. But
known, lacked competition from other reporter at the time. Once he owned hes only paying half in cash. So if he
investors, just as complicated deals the library, Turner could distribute doesnt pay more than double what
and options did. No matter where he the films again and again at almost no MGM is worth, my preferreds are
searched for ideas, Joel was always cost, with no need to pay escalating backed by whatever TBS was worth
searching for the same thing: I was costs for original programming. before he bought MGM, because I
looking for unfair bets. Weve got Spencer Tracy and Jimmy come ahead of him. It was very clear
Cagney working for us from the that TBS was worth more than the
In April 1986, Joel read in the grave! Turner announced to Fortune preferreds. I also have Kirk Kerkorian
newspaper that TBS, controlled by in 1986. Although Joel did not often on my side, and a gun to Turners head
Ted Turner, was buying MGM/UA visit management teams, he went to that hes got to pay that high interest
Entertainment Co., which at the hear Turner give a presentation about rate in cash eventually or Kirk is going
time was 50 percent owned by Kirk the deal. What I remember most is to get control of TBS, and Ted doesnt
Kerkorian. The $1.6 billion purchase that he gave out free copies of Gone want that.
price was considered wildly expensive with the Wind and The Wizard of Oz,
for a company that was losing money, Joel said. But listening to him, I just With almost no downside, a current
and TBS stock plummeted after the thought: Im witnessing a true genius. yield above 20 percent, and substantial
announcement. Turner got the worst It made total sense to me. upside if Turner could find a way to
screwing in the history of American pay the dividends in cash, Gotham
business, one Hollywood executive Even if Turner was a genius, Gotham Capital made the TBS preferreds a
told Fortune at the time. Both the Capital considered the common 30 percent position in the fund. It
media and investors viewed the stock of a debt-laden TBS too risky to was a very easy decision to buy these
enormous debt Turner had incurred purchase. But as Joel looked further, things at at 55 to 60 cents on the dollar
to finance the acquisition as a disaster he discovered that hidden within the with a huge coupon, Joel said. It took
in the making, an attitude that seemed deals complicated structure was his only about six months for the market
justified when Turner had to sell kind of unfair bet. TBS had paid to catch on, and the preferreds traded
back MGMs studio and real estate to for MGM with equal portions of up to near par, for a total annualized
Kerkorian after only a few months. cash and an unusual preferred stock, return of over 150 percent. As Joel had
Skeptics were also wary of Turners which paid a coupon of 14 percent. predicted, Turner moved heaven and
wild reputation he was expelled MGM/UA shareholders dumped earth to prevent Kerkorian from taking
from Brown University, had appeared the TBS preferreds almost as soon over TBS, eventually accepting a cash
drunk at a press conference after they were issued, sending them injection from TCI and Time Warner.
winning the Americas Cup sailing race, down to a price of 60 cents on the The preferreds were eventually
and had been suspended for a year by dollar. But the preferreds contained redeemed at par in 1989, the MGM
Major League Baseball. Everyone a provision, negotiated by Kerkorian, library became the basis for three
was scared of Ted Turner, Joel that obligated their dividends to be highly profitable Turner cable channels
remembered. He wasnt considered a paid in new common shares of TBS. Turner Classic Movies, Turner
genius. He was considered a nut. Also negotiated by Kerkorian: If TBS Network Television, and the Cartoon
common stock fell below $15 a share, Network and Ted Turner became
Joel knew all this going in, but decided then Turner would be forced to pay known as a genius.
to study the deal more closely. He the dividend with additional shares of
soon learned that for all the glamour preferred stock. These two provisions Making unfair bets in special situation
associated with MGMs movie studio, meant that if Turner could not find a investing proved extremely profitable
Turner was really after MGMs library way to make the dividend payments, for Gotham Capital and its investors.
of over 3,000 films, including many the preferred holders, Kerkorian chief The partnership returned 70.4 percent3
Hollywood classics. Turner viewed among them, would gain control of in 1985 and 53.6 percent the following
the library the way he viewed the TBS from Turner. This was just the year, during which Joel allowed Milken
Atlanta Braves as programming downside protection Joel needed: to invest an additional $50 million. In
1987, Gotham Capital was up 29.4
3. All performance figures in this paragraph are after all expenses, but before general partners incentive allocation.

percent a year that was salvaged than $200 million in assets before the around the time Joel starting working
when Joel, unnerved by an uncertain decision, Joel could see that Gotham at Halcyon, Rob became more serious
takeover environment and the markets Capitals size was starting to hurt its about the market. I remember looking
high level, decided to liquidate almost returns and that his style of investing at the newspaper, seeing that the annual
his entire portfolio just days before could handle only a certain amount of range on any given stock was say $4 to
Black Monday. (He later called the assets. It was very hard to get what I $16, and saying, Theres got to be some
move the only good market call I ever call crazy good returns with tons of opportunity in here somewhere, he
made.) Gotham Capitals assets and money, Joel said. Fewer assets would said. It didnt take a genius to figure
reputation continued growing, even help Gotham Capital continue to get out you could possibly make a lot
though Michael Milkens looming the returns Joel wanted to earn on more money doing this than delivering
indictment for numerous securities law his own money. A new addition, who newspapers.
violations forced him to withdraw all joined in 1989, would help him as well.
of his capital from Gotham at the end As an undergraduate at Tufts
of 1987. On the strength of his track ROBERT GOLDSTEIN University, Rob majored in economics
record, Joel easily replaced every dollar In late 1988, an acquaintance of while trading S&P futures from his
that Milken withdrew with capital from Joels sent him an unsolicited resume dorm room. While Robs professors
new investors. Gotham Capital was up belonging to Robert Goldstein. Rob were lecturing about efficient markets
64.4 percent in 1988 and another 31.9 grew up in Westchester, New York, and the importance of diversification,
percent in 1989. After another great the son of a Sears, Roebuck & Co. his personal trading results were
year in 1990, up 31.6 percent, Joel executive. When he was 11 he bought teaching him exactly the opposite.
could have raised as much new money his first stock, a few shares of IBM. After reviewing his recent trades
as he wanted. Instead he did the Throughout his teenage years he halfway through his senior year, he
opposite, returning one half of outside washed cars and delivered newspapers found that while only two stood out as
capital. Although the fund had less to earn money, and in high school, right unusually good risk/rewards, he was
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still betting just as heavily on more

marginal trades. It just hit me: Wait
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After that, I would just sit on my
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good trades a year.
interviewer I met that Zadeh would Joel offered Rob a job on a part-time
After graduation, Rob sought a Wall get in trouble one day.4 basis, with a salary of $20,000, and
Street job where he could learn a
Rob joined Gotham Capital in January
lot, and just as Joel had done several Soon after the contest, Rob received a
1989. One of his first assignments was
years earlier, he pursued risk arbitrage. phone call from Gotham Capital, which
to spend hours searching through the
But a series of interviews all ended in he had never heard of, asking him to
newswire to identify companies that
rejection. They wanted to hire people come in for an interview. At first I
were the subjects of takeovers. Rob
with investment banking backgrounds, thought it was some guy trying to sell
found IPM Technology, an airline
which I didnt have, he said. Seeking a me securities of some kind, Rob said.
services company based at the Los
leg up, in the fall of 1988, Rob entered I really wasnt looking to hire anyone,
Angeles International Airport. The
the U.S. Trading and Investment Joel remembered. I just thought Rob
companys CEO, Seymour Kahn,
Championship, a famous trading had an interesting resume, and that he
had announced an offer to take the
competition run by Norman Zadeh. was entrepreneurial enough to win a
company private for $4.50 per share.
Rob opened an account with $5,000, trading competition. When the two
Rob studied the deal as well as he
and with a few concentrated trades in met in person, Joel was not impressed
could, even traveling across the country
S&P futures, he grew it by 88 percent at first. Rob wasnt able to express
to meet Kahn in person. It was a very
in only four months. He submitted his himself particularly well, he couldnt
small company, so I was probably the
results, but grew suspicious when he spit much out, Joel said. At one point,
only guy who ever flew out to meet
realized that no one ever confirmed Rob brought up a futures trading
him, Rob said. He concluded that
them or would have prevented him strategy, which Joel quickly dismissed.
the deal would go through, possibly at
from entering multiple accounts Suddenly Rob revealed a new side,
a higher price if management needed
in the contest. There were guys arguing his point with a raised voice.
to raise its initial bid. With the stock
who were winning this thing every I told Rob, Youre absolutely right!
priced a little below the $4.50 deal
time, he remembered. I realized Joel remembered. There was just
price, Rob convinced Gotham Capital
that they must have been cheating, something about him that was right
to take a position.
and that Zadeh, who was profiting on. The chemistry was there.
from the competition, was obviously A few weeks later, another bid for IPM
encouraging it. Even against crooked To Rob, Joel stood out among other
emerged, led by a private investor
competition, Robs own legitimate Wall Streeters he had encountered:
named Stephen Cooperman. With
results were good enough for fourth When youre a kid interviewing,
the company now in play, the stock
place in the futures trading division people tend to treat you dismissively.
traded up, and Rob scrambled to see
and a mention in Barrons. His name Joel was just incredibly nice. I
if the Cooperman bid was legitimate.
printed on the pages of one of Wall remember the stark contrast. And I
Although Rob was only 24 years old
Streets most widely read publications had spoken to two guys who had said
and had little experience, he quickly
became his new cover letter, although great things about him. One said Joel
determined it was not. They had no
he was careful to distance himself was the smartest guy he knew on Wall
financing, he said of the Cooperman
from Zadeh. I made sure to tell every Street.
group. All you had to do was get these
4. Rob was prescient: Zadeh later suspended the contest amid an SEC investigation. He moved on to a second career as a professional poker player, and a third one as the founder
of pornography magazine Perfect 10.

the same kinds of macro and futures

trading strategies that he had used in
college, including an investment in
Nikkei put warrants in early 1990 that
almost perfectly timed the end of the
Japanese bull market.
FREE CASH FLOW IS KING

Rob eventually adopted Joels brand
of unfair bet investing, and Gotham
Capital and Metropolis ended up
owning many of the same positions.
I started with a much more macro
focus, Rob recalled. I transitioned
because, in a sense, each stock is its
own market so there are thousands
of markets that are potentially
inefficient. Although Gotham Capital
looked for ideas in areas and securities
that other investors avoided, success
or failure still depended on its ability
to value companies correctly and
buy them cheaply. In other words,
Gotham Capital depended on its skill
as a value investor. Having that value
background helped me tremendously,
even though I was doing something
not directly related to long-term
value investing, Joel said. But as
stock prices rose during the 1980s
guys on the phone to know that nobody an early lesson in the importance of bull market, Gotham Capital had to
was going to lend them a nickel to buy legwork. What I learned is that you abandon Grahams old measures of
this company. Concerned about the have these markets that are sometimes value, like low price to liquidation
slow progress of Kahns bid, Rob called incredibly inefficient. You can find value. In their place, Gotham Capital
the CEO. Kahn assured him the deal great opportunities if youre willing to started valuing companies according
was on track to close, but then said in bust your butt, make the phone calls, to their ability to generate free cash
passing something about the next time and get the facts. flow in a normal year cash that was
you visit my company. The innocuous freely distributable after all the capital
phrase immediately raised a red flag After only a few months, Robs instincts needs of a company were met. For
for Rob, who thought the only reason and work ethic persuaded Joel to set Joel and Rob, a companys stated net
Kahn would have a meeting with an him up with a small partnership of income, as mandated under Generally
investor the next time would be if his own while he continued working Accepted Accounting Principles
the company remained public. Already at Gotham Capital. Sticking with (GAAP), was just the starting point
nervous about the Cooperman bid, Joels superhero theme, Rob called in the calculation of free cash flow.
Rob was now equally nervous about his new fund Metropolis Partners. Accurately measuring free cash flow
the Kahn bid. With IPM stock still up, Metropolis and Gotham Capital were was a labor-intensive process, which
Gotham Capital sold out at a profit. independently owned and managed, required certain judgment calls, and
By September of 1989, both deals but Gotham Capital was entitled to through the years Joel developed his
had been cancelled and the stock first crack at trading any idea Rob own distinctive method of calculating
traded down.5 For Rob, IPM was discovered. Early on, Rob focused on it. We picked apart the balance sheets,
5. Robs bad feeling about Cooperman proved prescient as well Cooperman went on to become a lead plaintiff-for-hire for the notorious law firm Milberg Weiss. In
1997, facing an indictment for art-related insurance fraud, Cooperman turned against his former employer and testified in the criminal case that led to the imprisonment
of Milberg Weiss founders.

income statements, and cash flow shareholders, which discussed the quality.
statements to come up with what we travails of his companys textile
thought were the right numbers, said division. No matter how much the In April 1993, Western Union filed
Joel, who considered the measurement division invested in new capital for bankruptcy protection, unable
of normalized free cash flow a puzzle equipment, Buffett lamented, it never to service a mountain of debt. The
to be pieced together for every earned a satisfactory return on that companys 19 percent secured
company he looked at. Rob, who had investment. Competitors simply made notes soon traded down to around
little experience picking apart financial the same investments, and because the 55 cents on the dollar. Rob decided
statements when he started at Gotham, industry had little pricing power, all to look at the notes, focusing first
quickly picked up that the key was of the benefits ended up accruing to on any potential downside risk. The
cash flow. The value of an investment, consumers rather than producers. Put value of the collateral securing the
by definition, is the amount of cash another way, textiles was a business that notes, consisting of the Western
something produces down the road. could not translate earnings into free Union trademark as well as several
What I am paying for that today cash flow. Joel and Rob knew how to other assets, was unclear, but the most
determines my rate of return, he said. measure free cash flow, but influenced conservative appraisals put it at half of
by Buffett, they started to think more the face value of the secured notes. Rob
As they continued developing as carefully about where it comes from then discovered after tracking down
investors, Joel and Rob began to and which businesses produce more of a representative of the Pension Benefit
feel the influence of Grahams most it. When they applied this knowledge Guarantee Corp., which was a claimant
famous student, Warren Buffett. to special situations, they had a big in the bankruptcy case that Western
Joel remembered reading one of advantage over competitors who were Union had hidden cash on its balance
Buffetts letters to Berkshire Hathaway ignoring free cash flow and business sheet that most other investors did not

know about. Rob calculated that the

collateral, conservatively valued, plus
the hidden cash, more or less equaled
the price of the secured bonds. This

There is no more cost-effective gave him a free bet on any additional
value from the rest of the company.
way to extend an internal staffs You really had very little risk, he
hedge-fund capabilities than by said. It was very easy to be optimistic
when you didnt have to worry about
subscribing to Santangel Review. The the downside.
writer/reporters are not journalists With the downside covered, Rob then
masquerading as investment analysts turned to the upside. He called around
to investment bankers representing
but rather investment professionals various constituencies in the
bankruptcy case, trying to get a feel for
turned investigative reporters. the value of Western Unions operating
business. Bankruptcy bankers were
They understand the business; how used to dealing with bad businesses
that had failed to generate enough cash
to conduct thorough and thoughtful to pay their debts, and the valuations
they assigned strongly influenced
due diligence. And, they discover market prices. The bankers Rob spoke
superb managers plying their trade with invariably lumped Western Union
in the same category, assigning it a
under the radar screen who likely typical bankrupt company valuation. I
have never raised capital by any other remember guys just said it was worth
six times EBITDA, as they valued most
means other than word of mouth. businesses back then. Thats just how
credit guys used to think, he said. But
the more Rob studied the companys
The lengthy quarterly reports are well business, the more he realized how
written, organized, and researched, inaccurate that assessment was.
comprehensive and insightful. Western Union was by far the worlds
largest money transfer service,
operating in an industry experiencing
A CIO would be proud of his/her own rapid growth as increasing numbers of
analysts for producing a report of this immigrants sent money home. Western
Union was really the only game in
caliber. I can, even though it is not in town, Rob said. This dominance
my self-interest, highly recommend
translated into essentially unlimited
pricing power. They were charging
this publication. Just dont tell too something like $30 to send $300 home
to Mexico. It was crazy, Rob added.
many of your friends! Not only could Western Union grow
earnings almost at will by raising prices,
Jay Namyet but it could also expand with little
Chief Investment Officer, University additional investment. It simply signed
of Oregon Foundation up new money transfer locations
for example at a supermarket, check
cashing company, or service station
and plugged them into its existing

and good growth, Rob said.
SPREADS YOU CAN DRIVE

A TRUCK THROUGH
At the end of 1994, Gotham Capital
decided for the second time to return
capital to outside partners this time
all of it, and this time for good. Joel
felt he had made enough money for
himself. More than that, he enjoyed
the act of investing more than the
business, and stress, of managing
other peoples money, and wanted to
devote more time to his growing family
and philanthropic interests. Equally
important, Gotham Capital had
once again run up against the major
network and infrastructure. To be than the secured notes. Believing drawback of special situation investing.
able to grow without putting up much that the increase in Western Unions We had grown to a size again where it
money was rare for any company, but value would cover those bonds as was hard to expect to keep getting those
it was almost unheard of for one in well, Gotham Capital and Metropolis returns, Joel said. Gotham Capitals
bankruptcy. It just struck me: This bought them. But they didnt stop 10-year record as a partnership is
company doesnt have any capital there. Western Union also had a one of the best in modern money
spending! Rob said. It was insane, small issue of preferred stock that was management: 50 percent annualized
he believed, for bankruptcy bankers trading close to six cents on the dollar, returns after expenses,6 without a
to value Western Union like a typical reflecting the markets opinion that it single down year despite its highly
bankrupt company. A typical bankrupt would not receive much, if anything, concentrated portfolio and almost no
company couldnt increase free cash in a bankruptcy plan. Betting that shorting. In its worst year, 1991, it was
flow by simply raising prices. And a the market was wrong, Joel and Rob up 28.5 percent.
typical bankrupt company couldnt scooped them up.
grow without a massive investment in Joel retained Gotham Capital as
new capital, which would reduce free In 1994, Western Union was sold to a personal investment vehicle for
cash flow. The bankers and the market First Data Corp. for $1.19 billion, himself and his then-partner Dan Nir
were completely missing Western significantly higher than the valuation (who left in 1997 to start his own firm)
Unions true value, Rob said. the bankers had originally assigned to as well as for his employees, family,
it. This windfall, along with the cash and friends. Rob continued running
Gotham Capital and Metropolis generated by the company during the Metropolis for another three years,
initially purchased Western Unions bankruptcy, was enough to pay the posting outstanding returns for a small
secured notes. As the bankruptcy secured note-holders a remarkable group of partners that included many
worked its way through the courts 176 cents on the dollar, reflecting their other hedge fund managers. At the
that year, Joel and Rob watched the right to both principal and several years end of 1997, he also returned all of
companys value grow as its earnings of unpaid back interest. It was also his outside capital. Over its nine-year
continued to increase. The business enough to pay the unsecured bonds life, Metropolis earned net annualized
just kept getting better as time went in full. But the biggest winner from returns of well over 30 percent after
on, and cash just kept piling up. The the sale was the security the market fees and expenses, and just like Gotham
CEO didnt even have to do anything, had nearly given up for dead. On the Capital, never had a losing year. Rob
Rob said. The secured notes traded up, day the sale was announced, Joel and then contributed his personal capital
leading Joel and Rob to look further Rob unloaded the preferreds that to Gotham Capital, and together with
down the capital structure. Western had cost them six cents on the dollar their new analyst John Petry, Joel and
Union had an issue of unsecured for a whopping 80 cents. The whole Rob continued investing in the same
bonds trading at a larger discount Western Union experience just showed style as before. We wanted to keep
you the benefit of good free cash flow on doing what we had been doing, just
6. Before incentive allocations.

Joel Greenblatt on The Big Short

We asked Joel about the way his investment in Michael Burrys fund, Scion Capital, was portrayed
in Michael Lewis recent book, The Big Short. An excerpt of his answers is below.
HOW DID YOU FIND MIKE BURRY? only by the size of the side-pocket, but also that he didnt
I found him through his own website where he was wait to discuss the situation at our planned meeting. We
writing up value stock ideas. It was really a know it had backed him into business and we were his largest
when you see it type of thing given the quality of his investor so we thought he would want to consult with us
thinking and ability to present an investment thesis that before making such a big decision.
was clear and simple.
WHAT HAPPENED AT THAT MONDAY MORNING
WHY DID YOU DECIDE TO SEED HIM? MEETING?
We were not seeding investors at that time. We only Mike told us that 40 percent of his proposed CDS side-
started our fund of funds two years later. We offered to pocket consisted of 18 different corporate credit default
seed Mike because he said he was already planning to start swaps on large companies...
up, and we thought he was exceptionally talented. We
liked him so much that he became our largest allocation WASNT THE SIDE-POCKET ONLY MORTGAGE CDSS?
after we started our fund of funds and we helped him raise Thats what Michael Lewis wrote in the book, but
much of his money from outside investors. actually 40 percent of his proposed CDS sidepocket was
in corporate CDSs.
WHY DID YOU REDEEM A PORTION OF THE
MONEY YOU HAD IN SCION CAPITAL IN LATE WHAT HAPPENED AT THE MEETING?
2006? We knew that these corporate CDSs had a very liquid
We had a large investment in Scion, and as a result two-way market and could be sold in a matter of hours.
of substantial redemption requests from our own They werent appropriate to side-pocket. At the meeting,
investors, we told Mike that we would have to make a however, Mike insisted that there was no market for
partial redemption from his fund. any of the corporate credit default swaps and that they
needed to be side-pocketed along with his mortgage
WHEN DID HE TELL YOU HE WOULDNT BE ABLE CDSs. We disagreed strongly with his position on the
TO MEET REDEMPTIONS? corporate CDSs and couldnt understand how he could
It wasnt until a phone conversation several weeks claim that there was no market for things that were
afterwards that Mike told us that he would have trouble clearly very liquid.
meeting our redemption request as well as the requests
from his other investors. On that call, we set up a THE BIG SHORT MADE IT SEEM LIKE YOU DIDNT
meeting at Mikes office in California for a date 10 days UNDERSTAND OR LIKE THE MORTGAGE CDS
later to discuss how to help him deal with the situation. TRADE WAS THAT THE CASE?
We liked the mortgage CDSs. We had talked to a
IN THE BIG SHORT, MICHAEL LEWIS WRITES number of other smart guys who had them. That wasnt a
THAT YOU HOPPED ON A PLANE TO BULLY problem. We had to meet our withdrawals and it was not
MIKE BURRY IMMEDIATELY AFTER FINDING OUT appropriate for him to side-pocket liquid securities to
HE WAS PLANNING A LARGE SIDE-POCKET. WAS prevent withdrawals.
THAT TRUE?
No, definitely not. On the Friday night before our SO WHAT ENDED UP HAPPENING?
scheduled Monday morning meeting, Mike sent out an Mike sold some of his corporate CDSs a few weeks
email to his investors that he planned to side-pocket later to meet the redemptions and did not side-pocket
over 50 percent of his portfolio. John [Petry] and I the remaining corporate CDS portfolio. But he did side-
already had our plane tickets for our planned visit two pocket the mortgage CDS portfolio. Because we liked
days later. those positions, we were willing to cash out redeeming
investors and effectively increase the size of the mortgage
WHAT WAS YOUR REACTION TO THE SIZE OF THE CDS positions held by our continuing investors, which
PROPOSED SIDE-POCKET? worked out quite well for them.
We were surprised very surprised, actually. Not

with our own money, Rob said. companies the same way he does as an An example of this kind of spread was
investor. Unlike traditional business Imagistics, in 2002. A spinoff from
After leaving the other peoples school professors, he steers his students Pitney Bowes after the tech bubble
money business, Joel finally fulfilled away from the discounted cash flow burst, Imagistics was a slow-growing
his desire to become an author by (DCF) valuation model. Although he company that leased and serviced fax
writing You Can Be a Stock Market knows it is, in theory, correct to value machines for large corporations and
Genius, published in 1997. The book a company as the discounted sum of governments. Pitney Bowes was happy
explained, at a level of detail Joel hoped all the future cash it would generate, to get rid of Imagistics; the spinoff
would appeal to the lay reader, how Joel has never used DCFs in his own would improve the parents earnings
Gotham Capital found and evaluated investing. He believes that in the real growth and margins. When Imagistics
many of its investments. The books world it is far too difficult to predict the became independent, the market more
casual tone belied its sophistication, future that far out, and he knows that or less ignored it. Everyone knew that
and it became a cult classic among even a slightly inaccurate prediction with the rapid growth of the Internet
hedge fund managers who recognized or assumption can dramatically alter and email, fax machines were a thing
Joel as one of the best value and special a companys value. Its a great skill of the past. But Joel and Rob balanced
situation investors on Wall Street. to have, but I dont have those great this against the fact that Imagistics was
David Einhorn of Greenlight Capital prediction skills, he said. He prefers a service business, not a manufacturer,
told The Wall Street Journal it was making a more modest prediction, and enjoyed a large and installed base
by far the most valuable thing I have about a companys free cash flow two of customers. Seventy-five percent
read. Joel also became an adjunct or three years into the future, and then of its revenue was recurring and
professor at Columbia Business School comparing it to the companys price on top of that, its management was
in 1996, where he began teaching today. The idea is not to make a precise newly incentivized with stock options.
security analysis the same course prediction, but to find something so Neither Rob nor Joel had a good sense
Ben Graham had taught at Columbia cheap that precision doesnt matter. of the future of the fax machine leasing
decades earlier. We were looking for spreads you industry. But because the company
could drive a truck through, he said. traded at a ridiculously cheap level of
Joel teaches his MBA students to value

four times free cash flow, according money in Gotham Capital, Joel and distribution of Key3Media shares was
to Rob, they did not feel they needed Rob still maintained an extremely intended to precede a full IPO of its
one. Gotham Capital bought as much concentrated portfolio. Because they remaining shares a few months later.
Imagistics stock as it could almost focused on the downside of each
6 percent of shares outstanding position first and foremost, their Gotham Capital calculated that by
within the companys first week as a batting average was outstanding. buying shares of Ziff-Davis, shorting
standalone entity. Two months later, However, they were not immune shares of ZDNet, and collecting
Gotham Capital owned more than 7 to mistakes or bad luck. With huge the special dividend when it was
percent of the company, at average portions of their net worth in each paid, it could create one share of
prices in the low teens. Within a year, position, any loss was particularly Key3Media for less than $3. This price
as margins improved and the market painful perhaps none more so than worked out to less than six times free
took note of just how cheap it was, Key3Media. cash flow. It was ridiculously cheap,
Imagistics rallied to above $20 per Joel later said, given the high quality
In March of 2000, technology company
share. Gotham Capital took its profits of Key3Medias business. Despite
in February 2003 too early as it Ziff-Davis announced a complicated not growing revenues during the
restructuring and spinoff, to be effected
turned out, as the stock would go on ongoing tech boom, the COMDEX
that August. For each share they held,
to double again before being acquired trade show remained the dominant
Ziff-Davis shareholders would receive:
for $42 per share in 2005 by Oce, N.V. show in the technology industry.
.57 shares of ZDNet, Ziff-Davis
It wasnt complicated, you just had to Everyone who was anyone, plus a
publicly traded internet subsidiary; a
do the work, Rob said. You also want mass of nobodies, felt they had to rent
$2.50 per share special dividend; and
to find something where theres a good a booth. Key3Media leveraged this
.5 shares of Key3Media, another Ziff-
chance the market is not going to value power by charging exhibitors $62 per
something the right way. Davis subsidiary that operated the square foot for space that cost $2 per
popular Computer Dealers Exhibition square foot to rent. With low overhead
MISTAKES (COMDEX) technology trade show, and almost no variable expenses,
Even while managing just their own held annually in Las Vegas. The profit margins of the Las Vegas show

approached 80 percent. While Joel and recalled. Since Key3Medias core that closed days before September
Rob knew they were living through a business required very little capital, 11, 2001. After the terrorist attacks,
tech bubble, they took comfort from he and Rob thought the company had business travel ground to a halt,
the fact that the show had not grown the potential to reinvest the free cash exhibitors fled COMDEX for the
along with the rest of the technology flow it generated into other attractive Consumer Electronics Show, citing
sector, and that for every exhibitor that opportunities. They also liked the high prices and arrogant treatment, and
went out of business, another would companys new CEO, Fred Rosen, who all of Key3Medias operating leverage
pop up to replace it at the show. had built Ticketmaster into the countrys started working in reverse. The stock,
largest ticket seller. Rosen was a master having peaked at $13.31 in the first
Gotham Capital made the Key3Media marketer, having had his Ticketmaster quarter of 2001, plummeted. Gotham
stub trade a 10 percent position, and employees sell advertising that covered Capital started selling its shares at
several months later Key3Media IPOd the entire ticket envelope, including $8, but its position was too big to get
at $6 a share, a nearly instant double the flap. Once the advertising space on out of quickly. Gotham Capital finally
for the fund. Within months the stock the flap was sold, he kept selling the unloaded most of its shares below
traded up to $12 and the position space over and over again until each $3. Key3Media eventually filed for
represented a huge part of Gotham envelope ended up with nine separate bankruptcy in 2003. One of Howard
Capitals portfolio. The spinoff trade flaps, each covered with advertising. Marks favorite lines is, Experience
had been a huge success, but Joel and is what you got when you didnt get
Rob did not sell. Instead, they decided Joel thought Rosen would bring the what you wanted, so thats how I would
to keep Key3Media as a longer-term same attitude to COMDEX. Instead, sum it up, Joel said. I always knew
investment. The first batch to six was he brought a few poor decisions and financial leverage worked both ways,
free money, and then we just held it some bad luck. Rosen borrowed a lot of but in this case I learned that operating
because we loved the business, Joel money to make a series of acquisitions leverage worked both ways too.
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engineering and experience in

computer programming. Joel had
plenty on his plate, but the old Ben
Graham bug from college began to
stir once again. Computer processing
and storage technology had advanced
greatly since the late 1970s, so he
decided to ask the programmer to
help him back-test another formula.
This time around, instead of testing
Ben Grahams factors, which only
focused on the cheapness of a stock,
Joel wanted to add an additional factor
that ranked companies by quality.
Checking for cheapness and quality
was Joels quick and dirty whenever
he first looked at a new investment,
and the very same thing he has been
teaching his Columbia MBA students
for years. He was curious to see how
well these two factors would work in
a formula that held more stocks than
Gotham Capital did, and that chose
them from the whole universe of stocks
rather than just the few situations the
fund could cover on its own. It was
really just a research endeavor, Joel
said. I wanted to systematically test
all the principles I had been using and
teaching.
Using the Compustat Point in Time

database of stocks, Joel and the
programmer started with the largest
Gotham Capital had a high batting Over 20 years after closing his Ben companies trading on the major U.S.
average during its life, but that alone Graham fund, Joel had no reason to stock exchanges. After excluding
did not determine its investment regret his decision. He and Rob had certain financial stocks and utilities,
success. What also mattered was proved that they could take their own they assigned a rank to each of the
the magnitude of its losers, and this approach to value investing with 3,500 remaining companies based
depended on how well Joel and Rob its emphasis on conservative valuation on their most recent annual return
limited the downside risk of each techniques and risk/reward and on capital, Joels proxy for quality.
investment. While Key3Media was a apply it better than anyone to the For simplicity, he defined return on
notable mistake, Gotham did not lose universe of special situations. While capital as a companys earnings before
much relative to what it had invested. mistakes like Key3Media were painful, interest and taxes (EBIT) divided by
I tell my class: If you knew how many and Joel and Rob knew their returns the amount of working capital and
mistakes weve made over the years, would eventually suffer as their own fixed capital required by the company.
youd feel very relieved that, if you capital grew larger, their plan was to Arithmetically, return on capital is a
manage your risks well, you can make simply keep doing what they had been good indicator of a companys ability
a ton of mistakes and still get a very doing so well. to generate free cash flow, since to
nice rate of return, Joel said. the extent a company requires a lot
Then in 2002, Joel and Rob were of capital to support its earnings (like
A LITTLE START TO A BIG introduced to a young Wharton Buffetts textile business), it must
PROJECT graduate with a dual degree in continually divert the cash it generates

into replacing its capital. Next, they that, as well as it worked, it had been a formula could compete well with
took that list of companies and ranked deliberately simplified to make it easier his human expertise on a risk-adjusted
them by earnings yield, defined as for readers to follow. For example, the basis, he chose to pursue it. And if that
EBIT divided by enterprise value. Magic Formula weighted quality formula could be improved, he would
That was Joels proxy for cheap. Then and cheapness equally for the sake improve it.
they combined the rankings, so that a of convenience. The one-year holding
stock with a return on capital ranking period was also an accommodation So Joel and Rob set out to make the
of 100 and an earnings yield ranking of to simplicity, and to ensure the most Magic Formula a little more magical.
200 would receive a combined ranking favorable tax treatment on capital We really started doing this in earnest
of 300. In the back-test, they bought gains. Moreover, the metrics the Magic to make money for ourselves, Joel
a basket of the most highly ranked Formula used were only shortcuts to said. The two partners knew that
stocks, held them for a year, sold correctly valuing companies. whatever they came up with would
them, and then repeated the process. work well. But they did not think it
The Magic Formulas success was would work as well as they now believe
The result: From 1988 to 2004, owning also humbling: Joel and Rob could it does. Nor did they realize that a
a portfolio of about 30 stocks that had not help but notice that from 1988 Little Book would turn into such a
the best combination of return on to 2005, the Magic Formula a Big Project that would take up the
capital and high earnings yield would project Joel once described as goofing rest of the decade. We didnt realize
have returned 30.8 percent a year, around had achieved annualized what we were getting into, how big a
before taxes and transaction costs, returns that competed very well with deal it was, Joel said. We love what
versus an overall market return of 12.3 their day jobs at Gotham Capital. On we came up with, but its more than we
percent. As Graham said of his own the one hand, it was not a precise thought we were biting off.
formula, it seemed too good to be true comparison, as the Magic Formula
that such a simple formula could work experienced longer stretches of short- A FIVE-YEAR
so well. But it did, and for essentially term underperformance than Gotham IMPROVEMENT PROJECT
the same reasons as Grahams. The Capital. On the other hand, Joel and The Magic Formula used only two
formula did not know anything or Rob were long-term investors, and saw factors to rank stocks: latest 12
make predictions. Nor was it a very that the Magic Formula had a lot of months earnings yield and return on
good picker of stocks only about 50 potential. capital. As well as these two simple
to 60 percent of its top-ranked stocks factors worked, Joel and Rob believed
went on to outperform the market. The People often feel uncomfortable that others could work even better.
formula worked because it selected whenever simple quantitative evidence With the Compustat Point in Time
stocks of good companies that already calls human expertise into question. database at their disposal and without
incorporated negative expectations Ignaz Semmelweis, whose 19th century the need to simplify things for the
about the future. Buying them so experiments showed that doctors could layperson, they experimented with
cheaply was, on average, a good bet. drastically reduce patient mortality different factors, including some
simply by washing their own hands, that would make a traditional value
Joel called his new formula the Magic was ignored and died in disgrace. investor cringe. The temptation when
Formula, and it became the basis Bill James, who pioneered the use youre doing something quantitatively,
for his second book, The Little Book of statistical techniques to evaluate and you have an ability to back-
That Beats the Market, published in baseball players, worked in obscurity test, is to find what worked and use
2005. The book sold over 300,000 for years. Even the early proponents of that, Joel said. I cant say that we
copies worldwide and was translated index fund investing, like Jack Bogle, werent tempted and didnt try a lot
into 16 languages. Joel even started a spent years trying to convince investors of stuff, because when you have this
website, www.magicformulainvesting. that most actively managed mutual capability you do. To their surprise,
com, to help individuals implement the funds underperform. many non-value factors, including
Magic Formula for themselves. It was price momentum and other trading
gratifying to Joel and Rob to see that Joel had abandoned a formula in favor
signals, turned out to work quite well,
a simple formula, incorporating only of human expertise once before. But
according to back-tests. However, after
a fraction of the techniques they used he only did so because he thought he
much experimentation, they settled on
to analyze companies, could work so could outperform the formula and
a small number of factors, all variations
well. The Magic Formulas success was he had. Now, faced with evidence
on the valuation metrics they had
even more intriguing in light of the fact that a diversified portfolio chosen by

used all along at Gotham Capital. The companies at a time, use just a few had valued companies over the last
precise factors are proprietary, and simple factors, and have incredibly low 20 years based on normalized free
there are more of them than the Magic turnover, Joel said. cash flows and earnings, not proxies
Formula used, but they are all factors for these numbers, and Joel and
that a value investor would recognize, They kept surprising themselves with Rob wanted to build an investment
and all are based on historical data. We how well some of their back-tests process that incorporated these with
learned how to do what we wanted to performed, producing significant the same precision. Over the years,
do in the first place, Joel said. We look long-term outperformance over the we have developed a way to analyze
at absolute value and we apply various S&P 500 even with the backward- and value companies that we think
measures of relative value to make sure looking data from Compustat. Every dovetails closely with the way stocks
that a stock is cheap. Theres no better time we did a little more research, we are eventually priced, Joel said. Our
way to say it: If you can figure out just became convinced that this was a goal was to capture this advantage
what somethings worth and pay a lot great way to manage money, Joel said. through a systematic process.
less, it doesnt matter what the market To test whether it made sense to use
does in between. If youre pretty good predictive rather than historical data as With growing confidence in their
at it, eventually youll make money. inputs to their formula, they decided value factors, Joel and Rob now
to run a few experiments. In one, they knew what they wanted to measure.
Mindful of the pitfalls of back-testing pitted the formulas historical inputs However, it was one thing to know
even simple value factors, Joel and from Compustat against inputs taken what factors to use. It was another
Rob took care to make their tests from a commercial database of sell- thing entirely to measure them across
as conservative as possible. They side analyst forecasts. Their historical a wide universe of companies. At
deliberately handicapped themselves, inputs won. Another experiment tested Gotham Capital it took Joel and Rob
giving the market a few days head their formula against some of the best a lot of time and work to determine
start to absorb new information like stock-specific analysts in the world: the relevant metrics for just one
an earnings release before making themselves. They ran an experiment company. It required a large number
trades. They assumed extra-high in which the model generated stocks of sometimes small but necessary
trading costs and made intentionally for them to buy, and then they went adjustments, taken from all three
harsh assumptions about the amount through it and took out those stocks financial statements, to get right. To
of capital theoretically being managed. they just knew had to be potential calculate these same valuation metrics
They also made sure to turn their value traps. The humans failed. When for thousands of companies would be
portfolios as little as possible, much we tried, we did not do a good job, a monumental task. It was something
less than traditional quantitative Joel confessed. And were pretty wed never done before, Rob said.
traders. The less a portfolio turns, good analysts. Even a stock in which We had always been investment-
the more convincing the back-test he had personal experience, Kos specific. The Compustat database,
results, because there is less scope to Pharmaceuticals (later acquired by while a quantum leap better than
invent and data mine decisions that Abbott Laboratories), the maker of paper, pencil, and a DEC10 computer,
happen to work. They also avoided Niaspan for cholesterol, fooled him. proved frustratingly incomplete for
having too many factors, a tell-tale sign The model told him to buy it, but he this project. We just said, You know
that a back-test is simply being fitted knew that Niaspan was about to go what? If were going to do this right,
around data. They avoided look-ahead off-patent, so he overruled the model. we need our own database. We gotta
bias (i.e. using data that wasnt really And the thing doubled in six months. do this work ourselves, Joel said.
available at the time they were making They say a little knowledge can be
decisions), and avoided survivorship dangerous, Joel said. So they hired a team of financial
bias by accounting for companies analysts, many with accounting
that went bankrupt. They took full Most of these new factors required backgrounds, and trained them
account of liquidity and transactions accurate measurement of a companys in Gothams method of analyzing
costs. They measured risk, to make financial performance and valuation. If financial statements. The team is up
sure any outperformance was true Joel and Rob were going to put their to nine analysts now, with more on the
alpha. Finally, they tested back to own capital to work using a formula, way, and is led by Adam Barth, Gotham
the late 1980s. There arent many they didnt want merely proxies for Asset Managements Director of
ways to mess with returns over a 20- the right numbers they needed Research. Starting with all U.S-based
year period if you select hundreds of the right numbers. Gotham Capital publicly traded companies, Adams

team first eliminated companies that these adjustments when building the As difficult as it was to build the U.S.
didnt conform to the firms models, database, but has also continued to database, the international database
or whose financial statements were do so on an ongoing basis every time was even harder. The team had to start
suspect. For the rest of the coverage a company in the coverage universe completely from scratch, gathering
universe, the team worked from has an earnings release, filing, or even lists of publicly traded companies from
primary sources press releases, just a press release. Adjustments like exchanges all over the world. They
SEC filings, even phone calls to the these are the less glamorous side of then had to homogenize accounting
companies themselves to gather valuation, but are nonetheless essential. systems from 26 different stock
the information needed to measure Notwithstanding the technology markets, to ensure that the relevant
normalized free cash flow, valuation, involved, real people are needed to financial data were calculated similarly
and other metrics, and to re-measure do this work. Were able to sort it out for each company that made it into
them on an ongoing basis. When a better than any computer program is the database. It was overwhelming. A
tricky accounting issue arose, the team ever going to, Adam said of his team. huge, ridiculous job, said Joel.
would meet together and decide how to We figure out all the items. Theres no
treat it. The decisions went into a thick way a computer programmers going to Storing and organizing these data in a
manual curated by Adam and became be able to take these things and make useful way required computer software
the shared intellectual property of the them make sense all the time, given all that could not be purchased off the
group for the next time a similar issue the different ways of depicting items. Our shelf. It had to be built entirely from
appeared. The team not only made analysts go through every single one. scratch by a team of programmers
and mathematicians Gotham hired
specifically for the job. The team
includes an MIT chess champion and
several programming competition
winners. We were looking for brilliant
guys, and they were in various places.
We were really just basing it on their
level of ability and intelligence, and
they all have a little bit different skills,
Joel said. The database program
these developers designed allows the
financial analysts to enter data and
make notes on why they make certain
adjustments with great efficiency in
a simple interface. But to do it well
wasnt so easy, Rob said. The end
result: a coverage universe of 3,000 U.S.
stocks, and nearly 1,200 international
stocks, with Gothams distinct financial
measurements calculated for each one.
With a database of their own that

measured financial data the way they
wanted to along with the user
interface to go along with it Joel
and Rob still felt they were missing
a piece that would allow them to
turn their project into a real-world
investment strategy. Although they
resist the quant label, this is the part
of the project that required advanced
mathematics. Joel and Rob needed
a program that would take the risk
management constraints they had

decided on regarding liquidity, think well do at least as well. They also fascinating to me is that weve been
position size, industry concentration, realized that the system they had built able to get very diversified portfolios
and stock market exposure and solely to manage their own money cost with no loss in return, Joel said. I
use it to generate trades and account much more than they thought it would. dont see many individual stockpickers
for trading costs. It was essentially We figured out that if youre going to that have better numbers, taking into
a problem of optimization, the do it, youve got to do it really well, and account the volatility benefits that we
mathematical idea of maximizing that turned out to be very expensive to have.
something given various constraints. do, Joel said. Their research convinced
It makes perfect sense to anyone who them that each strategy had substantial In addition, because each strategy holds
its explained to, but you need very excess capacity (beyond the capital a massively liquid portfolio, in Robs
good math skills to actually implement they would invest themselves) before words, Gotham Asset Management
it in a very systematic way, Rob said. returns started to suffer. We saw that can offer liquidity terms to investors
To do so, they had to design their it was scalable and decided that we can that are superior to competitors. Each
own optimization software, again from run our own money this way, as well strategy features attractive fees as well.
scratch. You can buy an optimizer, but as a limited amount of outside capital, We wanted to charge very reasonable
you dont actually know what its doing. Joel said. In 2010, they created Gotham fees relative to the traditional hedge
So we built one, and its not easy to do. Asset Management. fund model, Joel said. We are not
The guy who built it had won a Putnam going to be asset gatherers, we are
Prize. The result was a system that GOTHAM ASSET going to be return gatherers.
allowed theory to be put into practice. MANAGEMENT
Gotham Asset Management offers
Weve developed a system based upon Institutional investors in stocks have a
several different strategies to
whats the best between what we think wide spectrum of investment choices.
institutional investors. Each strategy
is an ideal, and what can be achieved, At one end of the spectrum are the
uses the firms proprietary database,
Adam said. Gotham Capitals of the world: funds
valuation factors, and technology to
run by active managers who seek large
After years of back-testing, building target different geographies, market
outperformance in a concentrated
a database and an optimizer from exposures, and levels of diversification.
portfolio, usually at the expense of
scratch, and then testing portfolios Some of the strategies are relatively
increased risk, limited capacity, and
using real money, Joel and Rob concentrated, holding a number of
high fees. At the other end, there are
reached a decision: They would stocks typically associated with a
the index funds of the world: low-cost,
allocate most of their own capital classic active manager. Others hold
lower-risk funds that can manage a lot
to these new strategies, and replace hundreds of stocks and essentially
of money.
the concentrated value and special function as significantly enhanced
situation style that had worked so well Joel and Rob are convinced that indexes. Two of the strategies are
for them. Ones not better than the Gotham Asset Management can bring long-short partnerships, established in
other, theyre different Joel explained. together both ends of the spectrum. mid-2009.
But this I feel more comfortable It can generate significant long-term
Gotham Asset Managements
putting my own money in because outperformance and manage diversified
strategies have performed well over
its widely diversified. Risk-adjusted I portfolios with lower risk. Whats been

the last 20 months, not only against its represents the next step in a lifelong Managements portfolios might suffer
benchmark but also against theoretical rebellion against efficient markets. periods of underperformance that
predictions based on the back- could last for several years. But Joel and
tests. Because the back-tests were No matter how complicated they are to Rob suspect that time arbitrageurs
significantly handicapped, and because execute, Gotham Asset Managements like themselves will benefit even more
the actual portfolios use Gotham Asset strategies are, at the end of the day, in the future than they have in the
Managements proprietary database based entirely on value investing. Joel past because the world of investing
rather than Compustat, Joel and Rob and Rob believe they will work and has become much less tolerant of
are optimistic that the back-test results work well for the same reason Ben uncertainty and pessimism. Its
will continue to prove conservative Grahams formula, Joels Wharton always been this way, but its getting
over the long term. We hope to do study, and the Magic Formula worked worse, because the business has gotten
better than our back-tests, because of so well: They systematically buy stocks much more institutional, Joel said.
all of our proprietary research on the which already incorporate high doses Time horizons are too short. I used
underlying financials, Joel said. of pessimism and uncertainty about the to say that my business was making
near-term future. Even Joel, who made unfair bets. I think the unfair bet today
Joel and Rob spent five years and over his name buying stocks that others is time arbitrage, and thats exactly
$20 million of their own money to build did not want, admits that he feels what we are taking advantage of now
Gotham Asset Management, before revulsion at some of Gotham Asset in a systematic way.
deciding to open it to outside investors. Managements top stocks. The markets
They had to develop their own trading systematic overcompensation for this Perhaps one day someone will invent a
processes and more importantly revulsion is precisely why Gotham formula that can predict which stocks
and in what is perhaps Gotham Asset Management works it can will go up the most every single day.
Asset Managements most significant out-contrarian even the contrarians. For now, Gotham Asset Managements
competitive advantage they built By accurately underwriting this formula gives investors the next
their own proprietary database that overreaction for a wide group of stocks, best thing: the chance to own what
they believe measures the ultimate Gotham Asset Management creates they believe are the cheapest stocks
determinants of stock prices more portfolios that collectively represent every single day. Because of limited
accurately and broadly than anyone outstanding risk/rewards. Were trying computing power and the need for
else. Everyone asks us who else is to realize the benefits of Gothams simplicity, both Ben Grahams formula
doing what we are doing, and we say traditional research and valuation and the Magic Formula sold stocks
nobody that we know about, Joel said. process in a very diversified portfolio, without regard to valuation. Gotham
Joel said. Asset Management always wants to
There is skepticism about why such hold what it considers the cheapest
successful investors would go to all this This investment strategy requires stocks, no matter how much time
trouble, and about whether what they a long-term time horizon and the has passed or how much the stocks
have built will really outperform by as fortitude to wait for uncertainty have appreciated. We are constantly
much as they believe it will. To Joel, and pessimism to be resolved. Joel reweighting towards the cheapest,
however, Gotham Asset Management and Rob realize that Gotham Asset Joel said. Because stock prices change
400 Central Park West, Suite 5T, New York, NY 10025


every day, and new corporate data what the overall market does. What I
10Ks, earnings releases, and so on love about what were doing now is that
are always being released, the cheapest even if the market has another 10 years
stocks in the market can change every of poor returns overall, and we have a
day. Gotham Asset Managements system that just constantly reweights to
strategies rebalance every day to the cheapest stocks, we can still make
account for this. You always have to a lot of money in a market that, on
look at the latest set of facts, with the average, doesnt do well, Joel said.
latest prices, and our process does that
every day and then selects the best Joel and Rob believe the case for
trades, Rob said. The result is not Gotham Asset Management is so
pure buy and hold, but its far from compelling that they have put the
fast trading. The long-only strategies majority of their net worth into its
turn over only once a year on average, strategies. Very few investors have been
and the long-short strategies turn over as good as Gotham Asset Managements
twice that amount, largely because founders at knowing when the odds
they have to rebalance to maintain the favored a really big bet and Joel
desired level of net market exposure as Greenblatt and Robert Goldstein have
prices move. just made another one.
By constantly rebalancing toward

the value investors ideal of owning a
portfolio of the cheapest stocks every
day, Gotham Asset Management is
designed to outperform no matter
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March 2011

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Joel Greenblatt and Robert Goldstein

Santangels Review produces original research on There is no more cost-

Grahams new approach, an apparent

Behind the Santangels Name thinkers, was to choose stocks according

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The article inspired Joel to test

The historical data the three students

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voting control of the target company

The stock of a company subject to a

Joel found another source of great

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still betting just as heavily on more

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the same kinds of macro and futures

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and good growth, Rob said.

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Joel Greenblatt on The Big Short

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engineering and experience in

Using the Compustat Point in Time

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With a database of their own that

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400 Central Park West, Suite 5T, New York, NY 10025

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By constantly rebalancing toward

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