Joel Greenblatt is a portfolio manager at Gotham Capital, a value-focused hedge fund, who had a big hit in 1997 with his whimsically titled book, You Can be a Stock Market Genius. Though written for individual investors, it became a must-have book for many professional value investors.
The book may be summarized best by the title of the first chapter, Follow the Yellow Brick Road—Then Hang a Right, in which Greenblatt writes that conventional professional investors with MBAs in Finance—those with their feet firmly planted on the Yellow Brick Road—do not stand a chance against the wise individual investor. In this regard, Greenblatt shares an investing philosophy with Peter Lynch.
Greenblatt describes in Genius where many values are to be found and why—spinoffs, bankruptcies, restructurings, recapitalizations, etc. Sure, it takes some knowledge to be able to exploit these opportunities, but they are opportunities in the first place because many conventional professional investors refuse to, or cannot, invest in them.
Spinoffs and a Typical, Large, Conventional Portfolio Manager
For example, a typical, large mutual fund manager who is benchmarked to the S&P 500 Index will own the 500 companies in the S&P 500 Index and will usually shun everything else. His portfolio weightings may slightly deviate from the weightings of the 500 companies in the index, but not by much. When one of the 500 companies spins off a subsidiary, that subsidiary will almost always be excluded from the S&P 500 Index. So, if the spinoff is effected by distributing stock to the holders of the parent’s stock, it creates a wave of selling by professional portfolio managers who are benchmarked to the index (i.e. nearly every professional).
The important thing to understand is that the selling usually has nothing to do with the prospects of the company that was spun off. The selling usually is solely because conventional professional money managers refuse to, or cannot, own a company that is not in their benchmark index. When the price drops significantly due to the wave of selling, the company often becomes undervalued and the potential returns become impressive. Value investors understand that a diversified portfolio of these kinds of investments is likely to beat the market with less risk than a conventional portfolio.
The Little Book and Behavioral Finance
In 2005, Greenblatt wrote an investing book for his children. It was titled, The Little Book that Beats the Market. He tried to show how even simple, rules-based, value-investing strategies that his children could understand could outperform the major-market indexes. The rule that is the basis of the strategy in the book is simply this: Look for businesses that are highly profitable AND are trading at cheap prices relative to fundamentals.
Usually the reason that a highly profitable company trades cheaply is some negative news that makes the headlines and stays there for a while. For example, several of the companies that currently pass the Little Book screen are for-profit education companies, which are being lambasted in the media and by student-loan bureaucrats for taking advantage of supposedly unsophisticated students. Who wants to own those? But, Greenblatt’s point, which the evidence confirms, that a diversified portfolio of these types of businesses outperform in the long run because they are so cheap relative to fundamentals and eventually the company escapes from the negative headlines or from whatever else is holding down its stock price. This experience is similar to the experience some behavioral finance (BF) experts had when they attempted to create their own investment firm.
In a different book, Hersh Shefrin explains that Behavioral Finance professors Werner De Bondt and Richard Thaler tried to create a fund that exploited human errors. Thaler explained in a 1988 Wall Street Journal interview:[1]
“It’s scary to invest in these stocks…When a group of us thought of putting money on this strategy last year, people chickened out when they saw the list of losers we picked out. They all looked terrible…”
To which De Bondt added:
“The theory says I should buy them, but I don’t know if I could personally stand it. But then again, maybe I’m overreacting.”
Shefrin used this interview to show that “…these errors are very difficult to override, even when you know about them.”
Thankfully, Value Investing Does not Work in Every Period
One of the more insightful rationales offered for value’s outperformance in the Little Book was that the strategy does not work in every period. When the typical investor takes a one-quarter or one-month view of his portfolio’s performance, a strategy like the one in the Little Book will almost never be followed for long and the abandonment of the strategy keeps prices low, which paradoxically assures its success. In this regard Greenblatt finds value in businesses that share many of the same characteristics as the opportunities that Buffett likes to exploit.
Buffett loves highly profitable businesses that have lumpy revenue and earning streams. Why? Well, the lumpier the revenue and earnings stream, the lower the price that a conventional investor is willing to pay for the business. Conversely, the prices of highly profitable businesses with steady revenue and earnings streams will be bid up strongly by conventional fund managers, often to the point that expected returns are quite low. But, because Buffett has a long-term view, he does not care if the cash flow does not materialize over the next few quarters, as long as it is likely to materialize in a big way sometime over his investment horizon. Then, he can pick off these great businesses at low prices and reap the large cash flow whenever it comes in. This is one reason why Buffett loves the very lumpy property and casualty insurance industry.
Here is video of Joel Greenblatt’s appearance on CNBC Squawk Box this morning talking about the latest edition of Little Book titled, The Little Book that Still Beats the Market:
Greenblatt explains what every value investor knows to be true–value-investing strategies are easy to understand, but difficult to execute, so the paucity of investors who have the ability to stay the course, reap the benefits. It is important for value-investing vehicles to be structured for the long haul in order to avoid the whipsaw of investor emotions. Mutual funds, which are required by law to meet redemptions every business day, just don’t cut it.
[1] This De Bondt / Thaler material came from Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing, (2000) a great survey of the field of behavioral finance written by behavioral finance expert Hersh Shefrin. I plan to use more of the material in this book in future posts on this blog.
