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Robert Stephens, CFA
Robert Stephens, CFA
Articles (417) 

Joel Greenblatt: Don't Forget the Investing Basics in a Bull Market

Focusing on investment principles may be a logical strategy

November 17, 2020

Investor sentiment has improved dramatically since the stock market reached its nadir in March. Company forecasts have become increasingly optimistic, while some stock valuations have risen to new highs.

This situation is encouraging greater risk-taking even among value investors. This may lead to an inefficient allocation of capital in the long run.

Focusing on the basics of investing may be a logical strategy to counter excessive optimism. Value investors such as Joel Greenblatt (Trades, Portfolio) have used a simple investment methodology that focuses on margins of safety and company fundamentals. It may be a key reason for Greenblatt's long-term stock market outperformance.

Focusing on company fundamentals

Rising stock prices can lead investors to become more emotional when allocating capital. For example, they may become fearful of missing out on further stock price gains that have taken place over recent months. This may cause them to ignore risks facing specific stocks, such as weak financial positions or rising competition. Instead, they may view recent stock price momentum as being of greater relevance.

However, in my opinion, company fundamentals are just as important in a bull market as they are in a bear market. Therefore, they should always be a main focus when making an investment decision. A bull market can quickly be replaced by a bear market, as the events in the first quarter of this year showed.

Ensuring that all of your holdings have solid fundamentals is a key requirement in all market conditions. Eventually, the stock market is likely to reward strong company performance through a rising stock price.

As Greenblatt once said, "Over the short term, Mr. Market may set stock prices based on emotion. Over the long term, it is the value of the company that becomes most important to Mr. Market."

Obtaining a large margin of safety

It is tempting to adopt a more laissez-faire attitude toward company valuations in a bull market. For example, the economic outlook may be improving and company forecasts may be increasingly optimistic. Therefore, value investors may accept a narrower margin of safety when purchasing a stock.

However, in my view, it is crucial to demand that a stock trades at a discount to its intrinsic value before purchase. The future is a known unknown. Company profits can easily miss their forecasts. This may mean that stocks with inflated valuations are among those hardest hit in a market downturn.

Requiring a margin of safety for any purchase may mean you miss out on short term stock price growth. However, it may also allow you to avoid rich valuations that are based on weak foundations, such as bullish investor sentiment.

As Greenblatt previously said, "One way to create an attractive risk/reward situation is to limit downside risk severely by investing in situations that have a large margin of safety. The upside, while still difficult to quantify, will usually take care of itself."

Avoiding a short-term strategy

Recent stock price gains can make value investors more inclined to adopt a short time horizon when purchasing stocks. For instance, they may feel they can buy and sell stocks in quick succession to make large profits.

In my view, short-termism can lead to disappointing returns. The stock market can be extremely volatile in the short run, and a positive outlook can quickly change to a more sombre forecast.

Therefore, adopting a long-term standpoint when managing your portfolio could be a prudent strategy. It may help you to apportion capital to quality companies that can deliver consistent returns over the long run.

Greenblatt has always focused on the long-term prospects for stocks. As he once said, "Maintaining a three- to five-year horizon for your stock market investments should give you a large advantage over most investors. It is also the minimum timeframe for any meaningful comparison of the risks and results of alternative investment strategies."

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