Well before he introduced us to his “Magic Formula,” guru Joel Greenblatt (Trades, Portfolio) wrote and published a book on finding winning stocks in out-of-the-way places.
Published in 1999, “You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits” began by arguing a regular investor can beat professional managers who run multimillion-dollar funds, MBAs or Ph.D.s from top business schools and Wall Street experts.
He added, “As strange as it may seem, there is no catch. The answer to this apparent paradox—why you potentially have the power to beat the pants of the so-called market “experts”—lies in a study of academic thinking, the inner workings of Wall Street, and the weekend habits of my in-laws.”
Starting with academic thinking, Greenblatt charged that having a degree from a business school will be no help in beating the market. He pointed to the efficient market, “random-walk” theory, which essentially says the only way to beat the market consistently is with luck.
Because beating the market consistently is not likely, he jumps to the conclusion that all finance professors thus spend their time teaching esoteric subjects.
“In other words, if you muddle through complex mathematical formulas and throw in a little calculus and statistical theory along the way, you stand a pretty good chance of matching the performance of the popular market averages," he wrote. "Wow!”
Based on this misleading stereotype, Greenblatt argued that academic advice will not be useful when trying to beat the market.
His second target, Wall Street “experts,” also uses a stick-man figure. In this case, the manager of a $12 billion equity fund. Called “Bob,” the manager has a “phenomenal” record: Over the past decade he has beaten the S&P 500 by two to three points per year. Although the increment over the benchmark seems slim, Greenblatt told us it is extremely difficult to produce results such as these on a consistent basis.
Why? Because the fund is so large it is difficult to place money effectively. That’s driven home by some simple facts and figures:
- $12 billion divided among 50 stocks means an average investment of $240 million per stock.
- Divided among 100 stocks, the investment would still be a very big $120 million per stock.
- Of the 9,000 companies listed on American exchanges at the time (1999), only 800 had a market cap of more than $2.5 billion.
- Only 1,500 had a market cap greater than $1 billion.
In other words, for professional money managers, there is too much money chasing too few stocks. While investing in a hundred or more stocks does provide some diversification, it’s overkill in reducing risk. Greenblatt summed up the diversification issue with these two points:
- There is little risk reduction available after buying six or eight stocks in different industries.
- Adding more stocks will not eliminate overall market risk.
For fund manager Bob, too much money can be constraining. Greenblatt wrote, “From a practical standpoint, when Bob chooses his favorite stocks and is on pick number twenty, thirty, or eighty, he is pursuing a strategy imposed on him by the dollar size of his portfolio, legal issues, and fiduciary considerations, not because he feels his last picks are as good as his first or because he needs to own all those stocks for optimum portfolio diversification.”
Greenblatt’s third target was his in-laws, who spend their weekends searching in country auctions and unknown antique stores for undiscovered or unrecognized art and antique treasures. They do this successfully, and their secret is they apply their knowledge beyond the usual places. In those obscure places, there is little competition and they can find “inefficiently-priced” bargains.
By now, you likely recognize the in-laws may be just a figment of the author’s imagination, and the process discussed is one that is followed by at least some value investors:
“Finding bargain stocks works much the same way. If you spend your energies looking for and analyzing situations not closely followed by other informed investors, your chances of finding bargains greatly increases. The trick is locating those opportunities.”
As with Greenblatt’s later and more famous book, “The Little Book That Beats the Market,” this is an easy and entertaining read. He and Robert Goldstein founded Gotham Capital in 1985 with just $7 million in capital. Over the following 20 years, they generated average annual returns of 40%.
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