In some respects, Joel Greenblatt (Trades, Portfolio) does not get the attention he deserves. Many investors view Greenblatt as a growth investor, but I think this misrepresents his true philosophy.
Indeed, Greenblatt is best known for his Magic Formula, which probably the best-known strategy and formula that combines value with quality. Without Greenblatt's books, I don't think quality/value investors would be as widespread as it is today (whether or not that is a good thing remains up for debate).
The point is, I think investors can learn a lot from listening to the founder and owner of Gotham Asset Management when he talks about value investing and investing in general. In some of his more recent talks, Greenblatt has been focusing on the topic of behavioral investing and looking at why so many investors underperform the market.
This was something Greenblatt talked about in a talk he gave as part of the CFA’s Distinguished Speaker Series.
The seasoned value investor was recounting a story of how he was able to explain the stock market and value investing to a ninth-grade class, using a big jar of jellybeans.
Jellybean investing
In this simple, but telling experiment, he asked all of the students in the class to count how many jellybeans they thought there were in a jar. The jar was passed around and all the students counted, and did their calculations, to figure out how many jellybeans there were in front of them.
Each child was told to write down how many jellybeans they thought they could see on a small card. After a set period of time, Greenblatt collected all of the cards with the answers written on them. He then went round the class and asked each child to tell the rest of the class what their guess was. The average answer given contrasted sharply with the average response on the cards.
Greenblatt tells his audience that the average answer on the cards was 1,771 jellybeans, and there were 1,776 jelly beans in the jar. Meanwhile, the average answer given when he went around the room and asked each child one at a time how many jellybeans they thought were in the jar, the average response was 850. This simple experiment, Greenblatt says, perfectly sums up the stock market.
Investor influences
Investors are highly influenced by developments going on around them. Even if we try to tune out the noise, other factors will still influence our way of thinking factors such as the rest of the market, sector or fluctuating stock prices.
How many times have you been put off buying a stock just because it is trading at a 52-week high or low? I would think the most value investors, myself included, would avoid stocks trading at 52-week highs, although research has shown that stocks trading at 52-week highs tend to go on to make new highs, while stocks trading at lows tend to go on to make new lows.
So, what is Greenblatt's advice for dealing with these problems? He told his audience that it is vital for value investors to be "cold-hearted jelly bean counters when we’re trying to value businesses and trying to cover our ears and close our eyes and trying to figure out valuation without being influenced by things around us."
He went on to say that the best way to do this is to use "trailing numbers rather than our own projections," because this strategy tends to "work better" and is "very much how the stock market works." That's how you can "go about beating the market," he told his listeners.
Some interesting food for thought from one of the best investors of all time.
Disclosure: The author owns no share mentioned.
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