Joel Greenblatt (Trades, Portfolio), leader of Gotham Asset Management and the author of “You Can Be a Stock Market Genius” and “The Little Book That Beats the Market,” gave a terrific presentation at an event in December. It was a great opportunity to learn from a value investing master.
S&P 500 valuation
The guru said Gotham Asset Management values every company in the S&P500 and compares that valuation versus the historic valuations of the index over the last 28 years.
Right now, the S&P 500 is trading at the 25th percentile toward expensive, which means the market has traded, over the last 28 years, cheaper 75% of the time and it has been more expensive 25% of the time. From this valuation, the historic forward returns have been 5% to 7%.
The Russell 2000 (small-cap index) is trading at the seventh percentile toward expensive.
Investing factors and the definition of value investing
Low price-book ratios, low price-sales ratios or momentum are investing factors that have been proven to produce historic above-average returns. Greenblatt thinks this outperformance will most likely remain in the future, but he doesn’t really care about that.
For the guru, “growth and value are joined at the hip.” He said doesn’t like these classifications of value or growth, and doesn’t give to much meaning to them. Stocks, he said, “are ownership share of businesses that we value and try to buy at a discount, they are not pieces of paper that bounce around and we put Sharpe and Sortino ratios on.” So valuation has to deal will all aspects of a business, be it valuing investment assets that are on the balance sheet or the growth prospects in a strong new business line.
Valuing businesses
In regard to valuation, Greenblatt used the example of a house selling for $1,000,000. The investor's job is to say if that is a good or a bad deal. What information could help them make that decision?
- What income would you get net of expenses if you rented the house?
- How are similar houses priced in the same block?
- How cheap is this investment compared to all other investments in your portfolio?
- How has the market valued this asset in history compared to its comparable market and how is it valuing it today?
These are absolute and relative measures of value that, taken together, work as checks and balances to achieve the right valuation. Greenblatt backed this up by saying,  “If you do good valuation the market will agree with you… Valuation is like gravity.”
Is the party over for value investors?
The stock market is crazy: “From '97 to 2000, the S&P 500 doubled, from 2000 to 2002 it halved, from 2002 to 2007 it doubled, from 2007 to 2009 it halved, from 2009 to today it has more than tripled.” Don’t expect the madness to change. If you look within the index to the individual companies, the dispersion is way higher. So, “the market is throwing us pitches all the time.”
Behavioral factors are a reason why active managers don’t outperform on average. Agency problems, institutional imperatives and misdirected incentives cause managers to direct their attention to the short term and make precipitous decisions.
For most people, indexing is the right strategy. But as the move toward indexing continues, Greenblatt said, “As a stock picker, I’m super-excited.” To individual investors, the guru advises finding a strategey "that makes sense to you and stick to it. Be patient!”
Special situations today
Opportunities are still there. It is probably more difficult to do when one is managing billions of dollars. But it in the small-cap camp, it can certainly be done. Greenblatt thinks of the strategy as “not making money by taking risk, but just by doing work.” It is investing in areas where people aren’t looking.
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