http://post.nyssa.org/nyssa-news/2011/05/book-review-the-big-secret-for-the-small-investor.html

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In his latest column (3/2/13), Jason refers to a paper about to be published by the University of Rochester’s Robert Novy-Marx (RNV). The column:

http://online.wsj.com/article/SB10001424127887323293704578334491900368844.html

RNV has written often on the value premium–the item that my investment firm has been trying (with some success) to capture. He has been trying to understand why and where it exists, such as in the following paper that I read a few years ago that relates the value premium to operating leverage (Note: the draft of the operating leverage paper that I read was dated May 18, 2007):

http://rof.oxfordjournals.org/content/early/2010/08/16/rof.rfq019.abstract

In RNV’s latest paper, which was the impetus for Jason’s column, RNV introduces a quality formula to improve the value premium. It seems to be generating a lot of buzz because Jason wrote that DFA’s founder David Booth and AQR’s Cliff Asness are planning to create funds based on RNV’s quality paper. Booth even called it one of those investing ideas that only come along once every twenty years or so.

But, RNV compares his measures with several tools that my firm has used since day one, including those with a quality component, specifically value investing tools based on the work of Fama, French, Lakonishok, Shleifer, Vishny (see F&F and LSV tab above), Haugen, Piotroski, and Greenblatt.

Fama and French (F&F) were not the first to point out that high book-to-market (BtM) stocks (value) trounced low BtM stocks (glamour) in generating returns, but their 1992 paper brought the issue to the forefront because they are staunch defenders of the Efficient Market Hypothesis (EMH), which their paper seemed to discredit. F&F swiped that cognitive dissonance aside by claiming (“hoping” actually) that the extra returns were compensation for risk (that they did not quantify).

LSV and Haugen later showed that value’s better performance was earned with less risk than the market leaving F&F with only hope. In 2000, Piotroski showed that the performance of the F&F model could be further improved with a nine-point measure of quality based on nine financial statement metrics. Piotroski called it an F score. And Greenblatt used a two factor joint measure of quality and price.

When executing its strategy, my firm has leaned on F&F’s BtM research and on Piotroski’s F score in addition to the research from the others mentioned above. I have always thought of our process as a joint value/quality approach, so I find it interesting that many feel as if this is something new. It may be new in that the research is presented in a new way with data through 2011, but this approach has been practiced by many value investors for a while and RNV’s results are not very different from the results of other Value/Quality practitioners. In addition, I have called my process a sorting process and not a screening process, because we sort rather than screen for the best investment ideas. RNV used a similar sorting process.

In the end, however, most of a practitioner’s ability to capture the value premium is going to be determined by whether they have the stomach to enter the order and buy some temporarily ugly looking businesses at the height of their grotesqueness (when their prices are dropping) and to sell those businesses when those prices bounce back to intrinsic value. As cliff Asness once said, a model never loses its nerve. I would add that a model never gets greedy. The ability to manage fear and greed are paramount.

Here is a draft of RNV’s paper to which Jason refers in his column:

http://rnm.simon.rochester.edu/research/QDoVI.pdf

It’s good stuff if only to help explain why so many value investors have beaten the market for so long.

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Good Stuff.

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I liberally copied from the business models used by Ben Graham, Warren Buffett, David Einhorn, Seth Klarman, and Mohnish Pabrai. Those investors started small with family-and-friends capital; employed a value-investing philosophy; invested through a private partnership structure (i.e. a hedge fund); recruited smart investors; and were willing to return capital in order to protect returns when there were few opportunities. So, it is comforting to know that my partnership’s returns are virtually identical to Greenlight’s (Okay, we are doing better than Greenlight YTD). We, like Einhorn, do not believe it is time to go all-in, to understate the issue, but that day may come soon, to the market bulls’ chagrin. We can only hope that investors reward our caution with a flood of capital when the appropriate time arrives.

The Money quote in Einhorn’s second quarter letter:

On the losing side, the consumer cyclical short that hurt us most in the first quarter hurt us again in the second quarter. In this bifurcated market, there are a small number of stocks that seem to be going up simply because they are going up. Stock price momentum investing is not a new strategy; we saw how it worked in the extreme during the internet bubble. One difference between then and now is that during the internet bubble, the market categorized stocks into “new economy” and “old economy.” It was relatively easy to pick out the dangerous stocks. This time the distinction is less clear. A number of the momentum stocks have good stories, but many others really have very little going for them, except for a rising stock price. Earnings disappointments, dilutive acquisitions, slowing growth rates, regulatory problems, heavy insider sales, rising competition and even SEC investigations seem to have no impact on the handful of momentum stocks leading the market at this time. Despite trying to carefully pick our spots and to size the positions appropriately, we continue to have exposure on the short-side to a couple of these freight trains. Though we don’t know when the turn will come, we believe that there is substantial downside to the prices of these short positions.

Amen, brother.

Enjoy: http://cache.dealbreaker.com/uploads/2011/07/Greenlight-Capital-Q2-Letter.pdf

H/T: Santangel’s Review (Link can be found on the right)

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Also on the Post, an interesting analysis by Joseph Calandro, Jr.: http://post.nyssa.org/nyssa-news/2011/05/suggestions-for-modern-security-analysts.html

I plan to write an analysis of the CAPE soon. Normally I do not pay much attention to top-down analyses, but the CAPE is fundamentally sound and has reliably indicated long-term returns for the stock market. Tobin’s Q ratio has also been reliable. These metrics give us the market P/E ratio, or current market price relative to earnings through economic cycles (CAPE), and the market P/B ratio (Tobin). Price means nothing unless it is compared with some indication of value.

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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.”

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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.

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