Joel Greenblatt class note 5

Buffett began buying Coke in 1988. Buffett figured out that by buying a great business, he could make afortune. In 1988, Buffett invested $650 million in Coke stock. He paid 15 times trailing earnings. 12 years laterhe was up 10 times his initial investment. Obviously, he knew what he was doing. The uestion then is why Coke is a great business? It was growing, it had high returns on capital and it had a very long lastingcompetitive advantage so five years down the road you are still going to have Coke and its advantages — thesame as when you initially bought the company.

This is how Berkshire did on its investment in Coca-Cola:Coke returned 80% of its invested capital return to shareholders and the P/E expanded from 13 to 40. 1/3 ofithe gain came from P/E expansion.

Coke was growing its operating earnings 12%. Coke sent back $0.80 to shareholders for every dollar invested.MCO could send back $1 or more for every dollar invested. $0.80 for KO vs. $1.00 for MCO returned or 25%more.Now we focus on MCO’s ROC. It’s ROC was infinite because they use almost no capital (chairs, desks andcomputers).

Obviously, Coke had to put 20% of their cash flows back into their business to maintain their growth rate, butMCO even had a better business where they did not have to reinvest anything and those earnings were worthmore. This is a very important way of looking at the world. You can do all your calculations and say 16%annual returns — that is pretty good — not great. But if you look at the world, this is what I think it is going toearn in three or four years, and if it gets a fair multiple at that time based on ROC and earnings growth, I couldget an astronomical rate of return.MCO was a unique business, a considerably great business. If we could have compared this to S&P as a standalone, I guess we would have done that. But most of our money is not made on comparable analysis; it is acheck. Either the comparables are trading much higher and this is a better investment and you want to know why your stock is not trading at those comparable levels.

Book Value per share last quarter. Instead of doing EV/EBIT we will do simple trailing P/E trailing twelve months. Divide that by tangible book value. Why did I multiply ROE by BV/Tangible BV? I am goosing up the ROE because ROE is based on reported book and I am trying to say I really care about looking at ROE and tangible book value.

Linda greenblatt on retail investing

“Whether management get the right denim skirt doesn’t matter, what you have to get right is if management knows how to run a business, are they generating good returns on capital? And if they miss so what? I get another chance next season. And they certainly are not going under in the meantime.

So ABERCROMBIE (ANF) is a case in point if you look at their stock chart and you can go back a year ago you could have doubled your money between then and now. I can’t say that a lot has happened in the business fundamentally that has changed from what kind of business they are running or who their customers was. There was a management change but in my opinion it was not significant, but what was happening for a good year and a half prior is that they were generating negative same store sales (SSS) and negative comp store sales. People throughout the industry could not focus on what type of business they were running.

And they were generating EBIT margins close to 20%, amongst the highest in their peer group.Sometimes the best months for retail sales have been the worst months for stocks. If it is the best month for retail, what happens to interest rates? They go up. And that’s not good for retailers.I maintain that I am not smart enough, and I don’t think anyone really is, to know what the P/E should be. My job is to understand what the EPS [earnings per share] should be. I look for facts. That’s why I measure inventories. I have my people visit stores and malls to see how much the items are marked down and how long the lines are at the registers. I’ll buy a stock if I think the company is going to beat numbers and short it if it is going to miss numbers. It is that simple.

We summarize every publicly held retailer in America. That’s almost 300 companies. We’ve been doing this quarterly for many years. On an individual level, it gives us a great sense of which companies are going to do well because their inventories are well controlled and which ones have potential for missing numbers. It gives us a sense of the profitability of the group going forward. And it also gives us a sense of the future strength of the economy, because retail leads the way. If inventories are depleted what does that mean? It means retailers are going to be ordering faster, and that means the back end of the economy is going to do well. It is a lot of work, but it is really worth it to us.Your DeeBee index measures sales growth vs. inventory growth. Is that how you predict whether a company will beat Wall Street’s earnings estimates?

What do you mean when you say you use a “Crocodile Approach”? Just wait and be patient for the right opportunities. The crocodile can go for almost two years without eating food. It has very small legs and can’t go very fast. It waits by the riverbed. If its prey doesn’t come, it just sleeps all day. You want to be like the crocodile and wait for the prey to come to you. You don’t want to rush off to the prey. You want to wait for the big zebra and grab him and eat it up. With that in mind, I’ve never been afraid to build up a big cash position. You can’t lose money if you’re in cash. That’s why I don’t have many down months. I’ve never used leverage. In fact, some of my investors will be upset with me, but until recently I rarely had much more than 50% of my money invested — both long and short — at one time. That means I am half in cash. I recognize that is too low. It needs to increase. But it’s because of the Crocodile Approach.

I can tell you who is good on my inventory list but they might already have a high P/E. At the top is American Eagle Outfitters (AEOS, $29). It just reported sales up 37% while inventories are up only 14%. That bodes well for future margins and profits. But a large amount of that is reflected in stock price. I own it, but I’ve been reducing my position. American Eagle has got great management. They’ve beefed up their staff over the last couple of years. They just hired some good people for a new concept that they will be announcing soon. It will give them another leg of growth. They are firing on all cylinders. Nordstrom (JWN, $55) also had good results, with sales up 9% and inventory up only 2%. That’s the best in the department store category. The problem is that those results are already factored into the stock price. Remember, the concept of who is going to beat earnings and the stock price are two different things.

Linda Greenblatt (LG) — it was at 7x but our target was 10x — 11x EV/EBIT. ROIC was high teens after-tax.One thing I can say is that when Linda buys stuff, it is cheap; it is beat up. You will see, in the nextexample, she is not buying the company at 17x earnings with fully built out stores with no newconcepts. There are reasons it is cheap at that time.

It shows how well you can do if you focus on your niche by staying within your circle of competence.

 Analysis of competition

 Whole consumer sector

 Retail — monthly flow of store sales. Frequent information flow.

 Same store sales comparison

 Store growth and ROIC of stores.

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Both companies earn $2 per share in cash. With company 1, you don’t have to replace tangible assets soyou would prefer the business with goodwill. Less tangible assets means more investment to replace thoseassets in order to keep the business running as is. I (investor) paid a premium over the tangible assets of $5because of the high Earnings Power Value of the business. Once I have paid that premium, I own the businessand the greater returns will allow me to grow with less investment in fixed assets. I don’t have to keep payingthe premium over tangible net assets. (WEB explained this in his 1989 annual report).

Current Assets — Current Liabilities = Working Capital (CA-CL = WC).

What you need to generate EBIT is in your NWC plus Fixed Assets — — — Return on Invested Capital (ROIC or

ROC). EBIT / (NWC + FA) or operating income/invested capital.

Which is the Better Business?

GUM STORE

Jason opens a gum store for $400,000 which includes WC + Inventories + FA and building-out the store.Every year he makes EBIT of $200,000. He makes $200,000/$400,000 = 50% Return on capital (ROC).

JUST BROCCOLI

Now he has a friend named Jimbo who opens a store, Just Broccoli, and he made $10,000 for each store heopens. $10,000/$400,000 = 2.5% ROC.

Who would you give money to expand? Give $$ to Jason because of higher ROC.

You want to ask how much it costs to expand and how much will you make on the investment?

Be in a business earning high ROC. Borrow 10% to make 50% — -that is a good deal.

Look at pretax rate to simplify. Compare pretax return to pretax return.Your goal as an investor: you want businesses that are earning high returns on capital and returnsabove your cost of capital.

What to Focus on:

1. First I am looking for good businesses. EBIT/(NWC + FA) or EBIT/Tangible Assets. This is what the business is earning pre-tax or pre interest cost or benefit.

2. Then a bargain price: EBIT/EV or my earnings yield. This is what I am paying for those pre-tax earnings. $100 paid but earning $9, so the yield is 9%.

3. Is the earnings stream growing, declining or staying the same? How confident am I of this? I focus on normalizing earnings two to three years out instead of all the little problems in the near-term. Projectmy EBIT two years out — will it be at risk, will it be growing or shrinking? Hard stuff. Project my EBIT two or three years out. This is where your circle of competence is important.

4. How much am I paying relative to my normalized earnings? If the 9% yield is growing quickly — it could be a good buy. If it is a business with high ROIC then good. Am I getting a good price? How much am I paying? Am I getting a good return?

5. If I am unable to normalize earnings, then pass on the opportunity or set aside.

How much is the business earning to make an acquisition? How much of a dollar of sales drop to operating

earnings — the bottom-line.

EBIT/(Net Working Capital) + Net Fixed Assets or EBIT/investment capital.

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capital is defined as equity plus long-term debt

ROE indicates how well a company is doing with the money it has now, whereas ROC indicates how well it will do with further capital.