Steve Forbes interviewed Joel Greenblatt about his latest book “The Big Secret For The Small Investor” in which Greenblatt refines the ideas presented in a previous book called “The Little Book That Beats The Market.” These are the notes from that interview.
About the book.
• Six years ago, Greenblatt wrote a book called “The Little Book that Beats the Market” which offers a simple formula to find stocks that, according to him, will beat the market in the long term. After finishing the book, Greenblatt was worried that people could not get it right. Since he was trying to help, he set up a web site that does the job for the investor. Getting the names of the companies is one thing, but managing the investing process quarter after quarter turned out to be pretty hard. Greenblatt and his partners have done a lot of research since the first book and came out with something easier to do: “The Big Secret for the Small Investor”.
• When people invest in index funds like the S&P 500 or the Russell 1000, they will beat roughly 70 percent of the mutual fund managers due to the index funds' low fees and because most managers do not add any value. Analyzing the performance of the managers that beat the market, it is not possible to find any correlation between past results and how they will do in the next 3, 5 or 10 years. That is why many advisers recommend index funds for investors that do not know how to pick individual stocks
on their own.
• The regular indexes like the S&P 500 or the Russell 1000 cost investors around two percent a year, because they are cap-weighted indexes. Contrary to what many academics maintain, the markets are not efficient. Over the short term, the stock market is emotional and some stocks are overpriced and some underpriced. A cap-weighted index will buy too much of an overpriced stock and too little of an underpriced one. Thus, these indexes systematically take the erroneous path.
• Greenblatt and his partners created a “Value Weighted Index” in which the cheaper the stock the more weight it has. The index is more diversified than the S&P 500 or the Russell 1000, and it has the same volatility and beta. Yet, over the last 20 years, the index would have earned seven percent more annually. It is very simple — just put more weight on the cheaper stocks.
• Over the last 20 – 30 years the access to information and the computing power have grown exponentially, and there are much more people working for hedge funds who try to outperform the market. It would seem that the individual investor would have an ever tougher time trying to beat the market, but this is not the case. The reason is that the world has become much more institutionalized. Greenblatt told the story about an investor he had in his partnership, one of the first fund of funds in the late 80s. At the time, he was writing quarterly letters. The fund of funds said they had to report more often and asked for monthly returns. Greenblatt agreed and after the first month he reported back that the partnership was up 1.1 percent. Joel Greenblatt got a call from the fund of funds — other managers in which the fund of funds had invested in had an average return of 1.2 percent and they wanted to have Greenblatt’s viewpoint toward the partnership’s underperformance. Greenblatt politely asked to be called again in a year. He would have liked to ask to be called back in four or five years though.
• People now look at daily, weekly and monthly returns. They get analysis over the month or quarter. It is really difficult to maintain a long-term horizon. Greenblatt considers that investing in the stock market over a four- or five-year time frame is necessary to assess a manager’s performance.
• When a fund manager underperforms the market in the last six months, a year or two years, a typical fund investor would take out the money and would put it with someone else.
• If you look at the top 25 percent performers over the last decade:
– 97 percent of them spent at least three years in the bottom half.
– 79 percent spent at least three years in the bottom 25 percent.
– 47 percent spent at least three years in the bottom 10 percent.
• In the decade of the 2000s, the top performing mutual fund was up 18 percent a year, and the average investor in that fund lost 11 percent a year. Every time the fund underperformed, people left; every time the market went down, people left; every time the fund outperformed the market, new investors scrambled to get in just after the outperformance. With these wrong decisions, the average
investor ended up losing 11 percent a year.
Investing in individual stocks.
• Greenblatt invests in stocks according to the follow steps:
• In Greenblatt’s opinion, a portfolio between 500 and 800 stocks would reduce volatility, but annual returns would be 2 or 3 points less. This kind of portfolio would still beat the market by 6 or 7 percent a year.
• The key is to decide which path an investor is willing to stick with. Most people prefer lower volatility and when they underperform for a year or two, they bolt from their funds or strategy. Hence, it is very important to know yourself, if you really have a 10-year investment horizon, you would better choose the more selected (smaller) portfolio.
• This strategy will underperform and outperform the market. It is for the long term and it does not work every day, every month, nor every year.
• In “The Little Book That Beats The Market” it is mentioned that the strategy does not work with financials and utilities. Greenblatt and his partners have now developed a methodology for valuing these companies and their domestic index now includes them.
International funds.
• The international index does not have financials because of all the different regulations around the world and the uncertainty on the banks’ portfolios.
• There are not many databases that follow international companies and they do not feel comfortable using any one of them. Therefore, they created an international investment team that created a proprietary international data base. So far, they have homogenized 26 countries.
ETFs
• They have thought about ETFs. There are some tax advantages for the individual investor, the problem is that ETFs have to post their portfolios every trading day. Greenblatt’s mutual funds teams have been doing a lot of valuable work on their databases and factors. They do not want to give all this away by posting their trades and portfolios on a daily basis.
Business schools do not teach Benjamin Graham.
• The Columbia Business School (where Joel Greenblatt teaches) and a few other around the country teach Benjamin Graham and value investing. Most universities are still teaching the efficient market model, and that is good news. If most people think that it is not possible to beat the market, value investors have a better opportunity and less competition.
It is very interesting to see how investors can become their worst enemies by switching funds or strategies. Joel Greenblatt offers a system that is like investing in a index fund. Managing the whole
process requires time and a control system. If you do not want to deal with a continuous buying and selling, Greenblatt can take care of it. If interested, you can visit: formulainvesting.com.
Another way an individual investor can take advantage of Joel Greenblatt’s concept is to use the magic formula as an initial screener and then select those companies that make more sense to each investor for further analysis. Greenblatt does not believe in this approach, but who knows, maybe a good idea will come out from it.
Readers must do their research and analysis and reach their OWN conclusions and decisions. All the contents on this article are for informational purposes only. If any reader decides to trade in stocks or
any other investment vehicle agrees to do it at solely (his/her) own risk. None of the material presented here should be interpreted as a recommendation or solicitation to buy and or sale any security. The reader agrees to assume full responsibility for any and all gains and losses, financial, emotional or
otherwise, experienced, suffered or incurred.
The interview.
Steve Forbes Interviews Joel Greenblatt
About the book.
• Six years ago, Greenblatt wrote a book called “The Little Book that Beats the Market” which offers a simple formula to find stocks that, according to him, will beat the market in the long term. After finishing the book, Greenblatt was worried that people could not get it right. Since he was trying to help, he set up a web site that does the job for the investor. Getting the names of the companies is one thing, but managing the investing process quarter after quarter turned out to be pretty hard. Greenblatt and his partners have done a lot of research since the first book and came out with something easier to do: “The Big Secret for the Small Investor”.
• When people invest in index funds like the S&P 500 or the Russell 1000, they will beat roughly 70 percent of the mutual fund managers due to the index funds' low fees and because most managers do not add any value. Analyzing the performance of the managers that beat the market, it is not possible to find any correlation between past results and how they will do in the next 3, 5 or 10 years. That is why many advisers recommend index funds for investors that do not know how to pick individual stocks
on their own.
• The regular indexes like the S&P 500 or the Russell 1000 cost investors around two percent a year, because they are cap-weighted indexes. Contrary to what many academics maintain, the markets are not efficient. Over the short term, the stock market is emotional and some stocks are overpriced and some underpriced. A cap-weighted index will buy too much of an overpriced stock and too little of an underpriced one. Thus, these indexes systematically take the erroneous path.
• Greenblatt and his partners created a “Value Weighted Index” in which the cheaper the stock the more weight it has. The index is more diversified than the S&P 500 or the Russell 1000, and it has the same volatility and beta. Yet, over the last 20 years, the index would have earned seven percent more annually. It is very simple — just put more weight on the cheaper stocks.
• Over the last 20 – 30 years the access to information and the computing power have grown exponentially, and there are much more people working for hedge funds who try to outperform the market. It would seem that the individual investor would have an ever tougher time trying to beat the market, but this is not the case. The reason is that the world has become much more institutionalized. Greenblatt told the story about an investor he had in his partnership, one of the first fund of funds in the late 80s. At the time, he was writing quarterly letters. The fund of funds said they had to report more often and asked for monthly returns. Greenblatt agreed and after the first month he reported back that the partnership was up 1.1 percent. Joel Greenblatt got a call from the fund of funds — other managers in which the fund of funds had invested in had an average return of 1.2 percent and they wanted to have Greenblatt’s viewpoint toward the partnership’s underperformance. Greenblatt politely asked to be called again in a year. He would have liked to ask to be called back in four or five years though.
• People now look at daily, weekly and monthly returns. They get analysis over the month or quarter. It is really difficult to maintain a long-term horizon. Greenblatt considers that investing in the stock market over a four- or five-year time frame is necessary to assess a manager’s performance.
• When a fund manager underperforms the market in the last six months, a year or two years, a typical fund investor would take out the money and would put it with someone else.
• If you look at the top 25 percent performers over the last decade:
– 97 percent of them spent at least three years in the bottom half.
– 79 percent spent at least three years in the bottom 25 percent.
– 47 percent spent at least three years in the bottom 10 percent.
• In the decade of the 2000s, the top performing mutual fund was up 18 percent a year, and the average investor in that fund lost 11 percent a year. Every time the fund underperformed, people left; every time the market went down, people left; every time the fund outperformed the market, new investors scrambled to get in just after the outperformance. With these wrong decisions, the average
investor ended up losing 11 percent a year.
Investing in individual stocks.
• Greenblatt invests in stocks according to the follow steps:
– Evaluate how much cash flow he gets for the price he is paying. He uses his own definitions of cash flow and price. He uses the enterprise value and then makes all kind of adjustments for debt.
– He used EBIT as a proxy for cash flow. For the new mutual funds, they calculate what the real free cash flow is.
– The most important factors he uses to rank companies is the return on tangible capital and the earnings yield, i.e., the reciprocal of the P/E ratio.
– They look at trailing free cash flow, not forward. The rationale is that if a company earned a 15 percent earnings yield, most people think that these returns will not continue in the future, at least not for a year or two, and they are willing to sell it to you cheap. These are out-of-favor companies with high earnings yields and returns on capital, but are worried about the near future. Healthcare stocks show up on their lists because everybody is worried about what is going to happen under Obamacare. There is a company called Game Stop (GME) that everybody thinks it is the next Blockbuster. They sell games. If any of these out-of-favor companies do a little or a lot better than expected, then there is a chance for high returns.
These are the stocks that institutional managers avoid and overcompensate for. If the low expectations come in then, hopefully, the price does not go down much.
• “The Little Book That Beats The Market” suggests using a portfolio of 20-30 stocks. Greenblatt suggests that over time a more concentrated portfolio can probably make 2 or 3 extra points a year. The investor would need to wait for five or ten years for those enhanced returns to appear. These kind of portfolios have greater volatility too.
Portfolio size.
• In Greenblatt’s opinion, a portfolio between 500 and 800 stocks would reduce volatility, but annual returns would be 2 or 3 points less. This kind of portfolio would still beat the market by 6 or 7 percent a year.
• The key is to decide which path an investor is willing to stick with. Most people prefer lower volatility and when they underperform for a year or two, they bolt from their funds or strategy. Hence, it is very important to know yourself, if you really have a 10-year investment horizon, you would better choose the more selected (smaller) portfolio.
• This strategy will underperform and outperform the market. It is for the long term and it does not work every day, every month, nor every year.
• In “The Little Book That Beats The Market” it is mentioned that the strategy does not work with financials and utilities. Greenblatt and his partners have now developed a methodology for valuing these companies and their domestic index now includes them.
International funds.
• The international index does not have financials because of all the different regulations around the world and the uncertainty on the banks’ portfolios.
• There are not many databases that follow international companies and they do not feel comfortable using any one of them. Therefore, they created an international investment team that created a proprietary international data base. So far, they have homogenized 26 countries.
ETFs
• They have thought about ETFs. There are some tax advantages for the individual investor, the problem is that ETFs have to post their portfolios every trading day. Greenblatt’s mutual funds teams have been doing a lot of valuable work on their databases and factors. They do not want to give all this away by posting their trades and portfolios on a daily basis.
Business schools do not teach Benjamin Graham.
• The Columbia Business School (where Joel Greenblatt teaches) and a few other around the country teach Benjamin Graham and value investing. Most universities are still teaching the efficient market model, and that is good news. If most people think that it is not possible to beat the market, value investors have a better opportunity and less competition.
It is very interesting to see how investors can become their worst enemies by switching funds or strategies. Joel Greenblatt offers a system that is like investing in a index fund. Managing the whole
process requires time and a control system. If you do not want to deal with a continuous buying and selling, Greenblatt can take care of it. If interested, you can visit: formulainvesting.com.
Another way an individual investor can take advantage of Joel Greenblatt’s concept is to use the magic formula as an initial screener and then select those companies that make more sense to each investor for further analysis. Greenblatt does not believe in this approach, but who knows, maybe a good idea will come out from it.
Readers must do their research and analysis and reach their OWN conclusions and decisions. All the contents on this article are for informational purposes only. If any reader decides to trade in stocks or
any other investment vehicle agrees to do it at solely (his/her) own risk. None of the material presented here should be interpreted as a recommendation or solicitation to buy and or sale any security. The reader agrees to assume full responsibility for any and all gains and losses, financial, emotional or
otherwise, experienced, suffered or incurred.
The interview.
Steve Forbes Interviews Joel Greenblatt
