I received Joel Greenblatt’s new book last week, The Big Secret for the Small Investor. I was able to devour it in a few hours and The Finance Professionals’ Post agreed to let me review it. Greenblatt is the master at writing pithy investment books with humor. I have read them all. Most are written as if he were addressing his children, which is probably the best way to write investment books in the first place.
The essence of the book is in this passage:
“How do you beat Tiger Woods?…Don’t play him in golf.”
Greenblatt proceeds to tell his reader of the thousands of businesses that are ignored by the Tigers of investing and how the Tigers mostly get it wrong anyway because of their incentive to gather assets and collect fees versus deliver performance for their investors. He shows that choosing mutual funds with assets of over $500 million is basically a mug’s game because funds of that size are going to have to hug an index, so it is usually better to buy the index because the fees are cheaper.
Oh, and if you think the professionals such as pension funds are better at picking investment managers, think again. Greenblatt points to the research that shows that all investors, individuals and professionals, tend to buy funds of managers that have been hot and sell funds of managers that have been cold regardless of that manager’s approach to investing. In other words, all investors tend to buy high and sell low.
“Even a very talented manager who makes excellent stock picks over the long term can trail the market averages for years at a time. In fact, this is almost a certainty with a concentrated portfolio…(but) to beat the market…, you must invest differently from the market…Since almost all investors chase recent good performance and run from recent poor performance, it’s no wonder they have a hard time sticking with even those managers who eventually end up with the best long-term records.
As an example he shows us the return of the best equity mutual fund manager in the Morningstar database over the last decade. That manager runs a concentrated portfolio of stocks and delivered 18% annual returns for the decade while the S&P went nowhere. But, because he ran a portfolio that was different from the index, he naturally underperformed in some periods.
On average, the investors in that fund did not earn 18% per annum. Why not? Because they sold his fund after he underperformed for a little while, and bought his fund after he outperformed. This is the most remarkable part: Because they bought high and sold low, the average investor in that fund ended up LOSING 11% per year.
By the way, if you read Warren Buffett’s Superinvestors speech in the tab above, you will learn the same thing. Value investors that run a concentrated portfolio of best ideas vastly outperform the market in the long run, but will have several years of underperformance. The key to long-run wealth creation is in keeping your emotions in check and avoid cashing out at the worst time.
Greenblatt tells us to invest in the many thousands of businesses that are ignored by the institutions, invest only in businesses that we understand so we can make a reasonable estimate of value, and (here’s the key that he repeats often) invest only when we can invest at prices that are much lower than our value estimate.
“Invest only when you have a Margin of Safety.”