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We recently spoke with one of the most impressive members of a new crop of value investors who started their funds this decade and have had to navigate through one of the toughest market environments in nearly a century. How has Joel Greenblatt disciple Brian Gaines, founder of Springhouse Capital, done in this difficult period? His fund is up 17% per year, net of all fees and expenses, since inception in 2002.

We present highlights of our interview with Brian Gaines:

The Manual of Ideas: Tell us a little about the genesis of your firm. What goals did you have at the outset, and what operating principles have guided you since then?

Brian Gaines: The way Springhouse started was slightly unusual in that I never sat down and had any grand plans to start a firm. I had worked for Gotham Capital as an intern and then full-time during my second year of business school at Wharton and had plans to join them upon returning to New York in the fall of 2002. Upon arrival, Joel Greenblatt sat me down and asked if I wanted to start my own fund, which would be seeded initially with their capital. I could work out of their offices, use their infrastructure, and focus all my time on company research. For anyone who loves picking stocks as much as I do, this was a dream scenario.

MOI: In one of your guest lectures at Columbia Business School, you presented a case study of the video rental industry. What struck us was your ability to “follow the story” and keep discovering new opportunities in the sector as your work on one company led you to look into its competitors, and so forth. One of your major investments in the space ended up being in Netflix (NFLX), a major disruptive force in the industry. What motivated you to invest in a company like Netflix and how did you decide when to sell?

Brian Gaines: Netflix is a prime example of an idea that came from researching another idea. We had an investment in Movie Gallery (MVGR), which subsequent to our investment went on to leverage up and buy Hollywood Video. Throughout my research on Movie Gallery, Netflix kept popping up as a clear competitive threat. I always think back to the CEO of Movie Gallery saying in 2004 that Netflix would never be more than a niche service and that people liked going to the video store too much.

As an aside, CEO’s often speak in absolutes, but we have learned to be wary of individuals, including investors, who view the world in absolute terms. Yes, there were some people who liked going to the video store but there were many people who would sooner go to the dentist.

As for investing in Netflix, the important thing for us was we never paid for the growth. When we first invested, we were paying around 5-6x operating income if you backed out the growth portion of the subscriber acquisition costs and made a fair assessment of what it would cost to maintain the subscriber base. Basically, on a story where you had clear evidence in early entrance markets like San Francisco that the product was taking well, you were able to get the growth for free. This was a good example of where we thought we had excellent downside protection with more than 50% upside. We were able to invest very successfully in Netflix on two separate occasions when the market refused to give credit for growth. When the market was willing to give any credit for growth, which was happening at a rapid pace, we elected to exit.

MOI: What books have you read in recent years that have stood out as valuable additions to your investment library?

Brian Gaines: I tend to read and re-read more of the business history books as it is always useful to compare and contrast past periods to today’s times. Books like Barbarians at the Gate, The Vulture Investors or Merchants of Debt are consistently great reads. Market Wizards also provides some interesting comparisons to today’s markets. I recently read Lords of Finance about central bankers following World War I and through the Great Depression and it was fascinating.

MOI: More recently, Joel Greenblatt has been associated with so-called “magic formula” investing in companies that trade at high EBIT-to-EV yields and earn high returns on capital employed. However, those who have followed Joel for a long time know that he has been adept at identifying all sorts of pockets of inefficiency in the public markets, including spinoffs, equity stubs, and LEAPs. What types of situations have you found to be particularly fertile hunting grounds over the years, and where are you finding the most interesting opportunities right now?

Brian Gaines: It’s been a crazy seven years since we started, so the opportunities have really run the gamut. Many of the areas you mentioned, spinoffs and equity stubs, have definitely contributed to returns. Distressed debt entered the picture in 2008, but has since exited. One particular area that has proven fertile has been ideas where the subtleties of accounting prevent the average observer from understanding the true earnings power of the business. At its core though, it all comes back to finding mispriced securities. As we talk today [in early September], I have never been more lacking in long ideas than in my entire investing career. It is easy to find ideas with 50% upside, but it has been extremely difficult to find ideas with good downside protection. If you find an idea with 50% upside and 50% downside, why not just flip coins as you’ll save commission dollars? We try to find situations where we believe the downside to intrinsic value is less than 20%, even under dire circumstances. We accept that the trading value may blow through our target and we don’t spend time trying to predict the trading ranges. If there is one lesson that 2008 and early 2009 should, but likely won’t, teach us all, it is that you can’t predict where the market will value firms in the short-term.

Disclosure: No positions.