🔑 #1 - How Joel Greenblatt compounded at 50% per year

I mentioned Joel Greenblatt’s book in a previous post.

For 11 years, between 1985 and 2005, Joel’s investment fund performed at a 49% compounded annual growth rate before fees.

This is an astounding record.

Picking great investments is overwhelming, so Joel created a Magic Formula to help you sort companies that will perform well. I’ll share the formula below.

Some of my favorite learnings from Joel and other legendary investors…

Invest in simple companies.

If you can’t figure out normalized earnings, don’t invest in the business.

We’re naturally drawn to the companies that get the most attention in the media. But those are rarely the easiest businesses to understand.

The market is huge. Just go down the list alphabetically and keep going until you find a business you can understand.

That’s why I love buying simple businesses.

If I buy a plumbing service company, I know exactly what the cost inputs are, and the price outputs as well. I can quickly get my head around what’s missing in the business, and decide whether we are paying a fair price or not.

Write your investment thesis down.

The only way to become a better investor is to treat it like a job.

When you underwrite an investment make a folder with all of your learnings. Then pretend like you’re presenting to an investment committee. Write a memo to yourself on why you think this is the right investment. In your memo include your core assumptions, observations about the financials, and what you think your fair exit price should be.

As the market oscillates, and you consider selling, go back to your memo.

If the core assumptions and thesis have not changed, but the price has dropped. You should probably hold on to the stock.

If a core assumption has changed, or you notice you made a mistake. Then you may consider selling.

If you make a memo for each investment, 10 years later you’ll have a record of how you thought of the investment, and you can analyze where your thinking diverged from the outcome.

Invest in fewer things

There are thousands of public companies, but you only need a handful of investments to be a world-class investor.

My favorite Buffett quote:

I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all.

I love the idea of creating constraints for yourself in an otherwise unconstrained market.

If you follow Buffett’s recommendation, you will be forced to deliberate much harder on any individual investment. Also, will be forced to buy more of the stock if you really believed in it.

Invest in the small caps - There is always room for an opportunity there.

People who become successful investors, grow their fund size. That requires them to invest in larger companies. That means there’s always less competition to make money in smaller companies.

Our strategy is similar. Private Equity wants businesses $10M+ of EBITDA. That means there’s more competition in those businesses. We hunt in the sub $6M EBIT range where things are less competitive.

Margin of safety.

In a previous post, I wrote about intrinsic value.

If you calculate the value of the company, and you’re buying at a price that is 50 cents on the dollar, over the years you will likely win. You will also learn a lot without losing much money along the way.

This is incredibly hard.

It’s not technically hard. It’s emotionally taxing.

It takes immense patience, especially during a bull market. You have to scour and analyze the financials of hundreds of companies to find one that’s trading at 60 cents on the dollar. To build a portfolio, you may need to look at thousands of companies.

The key here is “learning a lot without losing money along the way”.

This may seem like Blasphemy, but in the last 5 years if we were value investing, we would have not been able to touch the big technology stocks. So we would watch our friends get rich on fast growth tech, and we would have to look stupid in front of everyone while we were buying some undervalued industrial stock.

And that’s why value investing sucks. And most people won’t do it.

Because when the champagne is flowing, we want to party. And we also want to invest in fun growth stocks.

Asymmetric bets.

If we invest with a margin of safety, we are likely to be in a zone of an asymmetric bet.

An asymmetric bet is when your downside is limited, but you have a lot of upside potential.

I think about this a lot in my investments.

When I’m buying a business, I want to buy it at a good price. The most important thing in my line of work is protecting my downside. Here’s why:

If I take a huge amount of risk, and end up being wrong. It could put a financial strain on our company. Then if a once in a lifetime opportunity came up to invest in a company, and we didn’t have the capital around to do it, we would miss something that could transform the company.

I don’t worry much about capturing the upside in an investment.

If we buy businesses that generate cash flow at good prices one of two things can happen to create upside:

1- find a leader that creates a lot of upside for the business

This is why I prefer businesses as opposed to real estate.

In real estate can create limited upside in any single real estate property. To grow, you need to go buy more properties.

In business, you can create unlimited upside in any single business.

2- use cash flow to invest.

Even if the business itself does not grow. As long as it creates cash flow that can be distributed to shareholders, we can use the cash flow to invest in other beautiful businesses

To close out this section, I want to share 🔮 Joel’s Magic Formula. It’s a bit dense so if you’re not ready to process this, skip to read about the cool deal review below.

🔮 Joel’s Magic Formula.

1st Key Concept💡 Return on Capital (ROC) = (EBIT) / tangible capital deployed (Net working capital + Net fixed capital)

ROC is an indicator of how efficient the company is in turning your investments into profits.

2nd Key Concept 💡Earnings Yield - Earning yield = (EBIT) / Enterprise value.

EBIT: Earnings Before Interest & Tax

Enterprise Value: Current Market Cap + Cost to pay off debt

This ratio means how much money you can expect per year for each dollar you invest.

So in summary:

🔑 Return on Capital tells us how good the company is

🔑 Earnings Yield tells us how good the price is

How to use Joel’s magic formula

• Look at the smallest group of companies on a stock exchange (above $50M Market Cap)
• Rank the companies by highest ROC
• Rank the companies by highest Earnings Yield
• Invest in top 30 companies based on these factors, spread your buying over 5 years
• Rebalance by end of year. Sell losers 51 weeks in (capture loses). Sell winners 53 weeeks in (get long term cap gain treatment).

🔑 A Cool Solar Company

A few months ago, I met the owner of a fast growing solar company.

The business will do $3 Million of cash flow this year.

This is pretty incredible on its own merit, but get this, he only started it a year ago. 🚀

I thought it may be useful to you to share how I think about this deal.

About this business…

The owner, let’s call him Jim, started his career selling roofing repair door to door.

Actually, before that he went to a religion school and was trained to be a minister which is neither here nor there, but interesting nonetheless

He saved up some money selling roofing repair and decided to strike out on his own.

Over the next 3 years, he built a nice business generating a few million a year in revenue, and $200-500k per year in profits.

Then he learned about residential solar installation. 💡

He liked it immediately for a few reasons:

1. the same subcontractors who install roofing can install solar panels
2. his roofing sales team can sell solar
3. the price point, and profit of solar is much higher than roofing
4. solar units can get 100% lender financed at 3% over 25 years

What I liked about the business.

✅ Generates good free cash flow

✅ Doesn’t require a lot of investment to grow

✅ The government just approved 10 years of tax rebates for solar

Some things that concern me.

🚩 Short Operating History

We like to acquire companies that have 15+ years of operating history.

The primary reason is simple…A company that has stood the test of time has experienced good and bad economic conditions and weathered the storm.

Also, I’ve had some experience starting companies in the past.

In the first two years, it’s chaos, and everything is held together by duct tape.

By year 15 of a business, you have a lot of employees with institutional knowledge and systems.

This means the owner could leave and it would likely be ok.

🚩 Source of customers

40% of the customers came through online marketing and their sales team.

60% of customers came through third-party sales orgs.

Even though this is a big part of the industry, to me it felt risky. If another installer comes around and undercuts us a few cents on price, we may lose a large number of customers.

From researching the market, I learned that many of the larger players that have been around for a long time do 100% of their sales and marketing in-house. It allows them to control the sale to make sure the customer is getting what they were promised.

🚩Team & Structure

When we first started looking at the business, the broker suggested that the company had an incredible executive team and that the owner was working 15-20 hours per week.

We hear this a lot from brokers who want to sell a business because they know that’s what we want to hear. We like to trust but we also verify.

In this case, the owner was very involved with the business.

We’re ok with the owner being the leader. But then the owner needs to work with us and keep running the company for a few years after we acquire it.

How did I research this market?

Our process is always evolving, but I thought it may be helpful to share how I go about researching a new market.

The challenge with residential solar is it’s a fairly nascent market. It’s been around in its current form for 15 years.

This is in contrast with an industry like plumbing that has been around for 1,000+ years.

Why is that important?

An older industry is going to have more infrastructure around it to teach you how to succeed. That includes consultants, owners who have retired and are advising now, investors, private equity, banking, recruiters, courses…everything.

When I’m doing research I talk to all of the people above.

Here’s how I went about it:

• found Facebook groups for solar installers and posted asking for help
• google around and set-up 15+ calls with consultants
• worked our network to ask for solar consultants peers may recommend
• looked for owners that would talk to me

You end up talking with a lot of people that don’t quite have the experience level you need to advise you on the purchase. But you also get some gems. And I really appreciate everyone who volunteered to speak with me..

Ultimately I spoke with 3 separate people that were founders of businesses that do $200M+ year in solar. Between the consultant and these owners, I learned everything I felt I needed to be able to make a preliminary decision.

Ultimately we did not end up investing.

I’ll never invest in a company that has been around for less than 5 years. Doing the research on this company further cemented that decision in my mind.

Our business is one of taking on asymmetric bets (as I wrote about above).

We need to underwrite a zero percent chance of losing our money.

If a business has been around for less than 5 years, there are too many both known and unknown risks. The known risks we can underwrite, and plan for.

The unknown risks are the ones that only time, and changing economic environments can test. We only want to invest in businesses that have been challenged and have thrived.

We continue to be highly interested in solar. If you have a friend who’s interested in a partner or acquirer of their business, please reply to this email.

Thanks for reading. If you got value from today’s newsletter, consider sharing it with friends.

Have a fantastic week,

~ Sieva

‍