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July Hedge Funds: Best, Worst, Biggest

Every year, when Joel Greenblatt kicks off his value and special-situation investing class at Columbia Business School, he makes his students a guarantee. "If they are good at valuing businesses, the market will agree with them, typically within two or three years," says Greenblatt, who has been an adjunct professor since 1996.

While he can't make any such guarantees to investors, his track record lends validity to this thesis. Using an über-concentrated deep-value approach, the hedge fund he founded in 1985 produced 34% average annual gains, after fees and expenses, for the first decade. At the end of 1994, Greenblatt and his longtime partner, Rob Goldstein, concluded that their growing asset base would impede future returns because their approach was so narrow. They returned shareholders' money and stopped taking outside investments—though they kept their staff and continued to manage their own capital.

The author of The Little Book That Beats the Market diversifies much more in his newest fund offerings. Photo: Ken Schles for Barron's

In 2009, at the behest of investors, their Gotham Asset Management firm put out the welcome mat again, this time with a far more diversified approach. The current strategy is, on the surface, pretty simple. Buy more than 300 high-quality names trading at cheap prices, and short more than 300 stocks on the other end of that spectrum. The stock that ranks first on these attributes gets the largest weighting in the portfolio, while the second-best stock gets the No. 2 weighting, and so on.

"That's quite a bit different from the six to eight holdings we had once upon a time," says Greenblatt, 56. At the same time the original, highly focused strategy had limited capacity, it also came with extreme volatility. "Rob and I would wake up some days and lose 15% or 20% of our net worth," he adds. "Now it's more like 15 or 20 basis points." (A basis point is 1/100th of a percentage point.)

After being shuttered in 1994, Gotham had no plans to build a better mousetrap. Greenblatt, who has five children, immersed himself in education. He began teaching at Columbia and helped start the Success Academy Charter Schools; it now operates 32 schools, primarily in underserved areas of New York City. He joined the investment board of his alma mater, the University of Pennsylvania, and wrote investment books for the masses, including The Little Book That Beats the Market.

It was during this extended hiatus from managing outside money that Greenblatt and Goldstein began researching a ranking system that used just two variables—return on invested capital and earnings yield. "Benjamin Graham said, 'Buy cheap,' and Warren Buffett said, 'If you can buy good businesses cheap, even better,' " he observes. "We had integrated that approach into our investing many years prior, and I wanted to prove that those two concepts, cheap and good, could do well."

In back-testing, the strategy produced 19.7% average annual gains from 1988 through 2009 for stocks with market capitalizations over $1 billion, versus 9.5% for the Standard & Poor's 500. "The results were stunning," he says. So much so that he and Goldstein put it to the test in real time, with their own money. Being "roll-up-your-sleeves investors," he adds, they took the idea a step further and, along with a team of analysts, built their own database of stocks from the ground up—going through balance sheets, income statements, and cash-flow statements "with a fine-tooth comb" to come up with their own valuations.

To reduce volatile capital flows, Gotham doesn't charge hedge funds' standard 20% of gains and 2% management fee. Rather, investors in most of its funds can pay either a 2% flat management fee, or a 1% management fee, plus 10% of gains.

Top Longs and Shorts* Top 5 Long Holdings**TickerEnergizer Holdings ENRSanderson Farms SAFMBungeBGAnixter International AXECaterpillarCATTop 5 Short Holdings**Susser HoldingsSUSSTenet HealthcareTHCBob Evans Farms BOBEKennametalKMTThermo Fisher ScientificTMO*Based on Gotham Absolute Return (ticker: GARIX), a mutual fund; other funds' holdings may differ; holdings as of 04/30.

**Each long holding is less than 1%; each short holding less than 0.5%.

Sources: SEC; Gotham Asset Management ENRSAFMBGAXECATSUSSTHCBOBEKMTTMO*Based on Gotham Absolute Return (ticker: GARIX), a mutual fund; other funds' holdings may differ; holdings as of 04/30.**Each long holding is less than 1%; each short holding less than 0.5%.Sources: SEC; Gotham Asset Management

Because of this fee structure—not to mention a more diversified approach—they can offer a similar, undiluted strategy to mutual fund investors. In August 2012, they unveiled the Gotham Absolute Return fund (ticker: GARIX), the first of three long/short mutual funds with varying degrees of exposure. These follow the same script as the hedge funds and are open to individuals, but with a $250,000 minimum. Today, the mutual funds account for more than half of the firm's $7 billion in assets under management.

Gotham's largest hedge fund strategy is 50% net long, meaning that for every dollar invested, roughly $1.15 goes into long holdings while 65 cents goes to shorts; they're able to do this using leverage. Shorts include 3-D printer maker Stratasys (SSYS) and discount marketplace Groupon (GRPN). Both have a negative earnings yield and negative return on invested capital, based on Gotham's estimates.

Working with 11 analysts, led by head of research Adam Barth, the managers are continuously updating their research universe of roughly 3,000 large and small companies. The quality of a business doesn't change overnight, but rankings shift in lockstep with prices. Turnover, nevertheless, is relatively tame. "In general, we own about 45% of the same names a year later, but positions won't be the same size," Greenblatt says, explaining that companies with the best combination of quality and price get the highest weighting. As a stock's price comes in line with its valuation—which is the hope—it moves down the list.

Express Scripts Holdings (ESRX) was one of the fund's biggest positions last year; its stock tumbled to about $50 in late 2012 when the prescription-drug plan company said that high unemployment and the loss of a contract with UnitedHealth Group would hinder 2013 earnings. The stock was recently up nearly 50%, but it still has a home in Gotham's hedge fund because of its 6% earnings yield and return on capital that's well over 100%, based on their estimates.

Another top position last year was Apple (AAPL). It's up 25% in 2014, but is still a large holding due to its "huge returns on capital" and 11% earnings yield. When Greenblatt had a concentrated portfolio, he might have passed on Apple, given the uncertain future of tech outfits. "Some people would say it's another hardware company that will crash and burn; others will say it has its own ecosystem," he says. "I don't know the answer, but I don't own just Apple. I own a bucket of companies like Apple, and over time, I know my bucket is going to work."

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