Joel Greenblatt (Trades, Portfolio) is no stranger to value investing. The renowned hedge fund manager has achieved impressive returns by buying value and shorting bubbles. Greenblatt, who, in addition to being the co-chief investment officer of Gotham Capital, is an adjunct professor at the Columbia School of Business, recently sat down for an interviewĂ with Wealth Track. During the interview,Ă he dispensed some words of wisdom on the topic of investing.
Inherent bias
If value investing is so simple, why doesnât everyone do it? After all, many famous value investors, includingĂ Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), have said repeatedly that one does not need to be a genius or have incredible mathematical abilities to succeed in the game. The problem for most fund managers is they are judged on time horizons that are too short to accommodate the long term.
This naturally incentivizes money managers to be biased toward strategies like growth and momentum, where results are typically realized on a much shorter time frame (even if they are not always good.) Moreover, trend-following strategies are much more palatable to the clients of these money managers than contrarian strategies that pit the investor against the direction of the overall market. This is Greenblattâs central point:
âMake your decisions based on the long term. Most people are judged over very short periods of time, and so are most fund managers - you donât want to pick stocks of companies that arenât going to do very well over the next few years, but sometimes those are the best prospects thereafter, once they have gone through the tough period. Thatâs why youâre getting the bargain. And so if youâre focused on whatâs going to happen three to four years from now, youâre kind of alone.
Itâs called âtime arbitrageâ - just waiting for the market to agree with you. What happens in the short term can be very ugly. Time horizons are actually shrinking, theyâre not growing⌠and so the opportunity set is quite nice for people who view stocks as ownership shares of businesses that they value and try to buy at a discount. It sounds ridiculously simple, but itâs a nice world for stockpickers.â
Buy value, short bubbles
While past performance is no guarantee of future returns, historical data can help investors recognize when the market is expensive or cheap relative to previous years. After identifying the overall level of the market, you can then look at which individual stocks are particularly out of line within the indexes, which is exactly what Greenblatt does:
âWhere do we stand today versus the last 28 years? Based on our data, we sit in the 16th percentile towards expensive over the last 28 years. That means the market has been cheaper 84% of the time and more expensive 16% of the time. And this isnât a prediction, but what we can do is go back in time and say from the 16th percentile in the past, what has happened over the next year or two... Of course your opportunity set is not just what is in front of you today, but what might be in front of you nine or 12 months from now, or even two years from now.
So should you be patient and hope for better opportunities? That I canât help you with, but what I can tell you is that for the Russell 2000 weâre in the fourth percentile...when itâs been here in the past year-forward returns have been -2% to -4%, and we short those stocks. We donât short the index, we short the most expensive stocks in that expensive index.â
Disclosure: The author owns no stocks mentioned.
Read more here:
- Boeing: Not Out of the Woods Yet
- What Effect Will a Ban on Stock Buybacks Have on the Market?
- Following the Smart Money: Tips for Value Investors
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