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.

Share on Facebook

Many have the impression that Lynch was a rarity: a portfolio manager who did not espouse a value investing philosophy but who consistently beat the market anyway. If that were true, it would mean there were two such investors in recent history: Lynch and Soros. But upon closer inspection, I think we have to scratch Lynch from that rare list. Lynch was a practicing value investor and his bows to value investors such as Buffett, Max Heine, Michael Price, and John Neff and his many references to Ben Graham’s “Mr. Market” are testament to that. There is also this:

Lynch’s Perfect Investment

Lynch wrote thirteen bullet points to describe his perfect investment. I will not fill in Lynch’s details because his headings are self-explanatory; you can read the details at your leisure:

1. It sounds dull—or even better, ridiculous
2. It does something dull
3. It does something disagreeable
4. It’s a spinoff
5. The institutions don’t own it, and the analysts don’t follow it
6. The rumors abound: It’s involved with toxic waste and/or the Mafia
7. There’s something depressing about it
8. It’s a no-growth industry
9. It’s got a niche
10. People have to keep buying (their product)
11. It’s a user of technology
12. The insiders are buyers
13. The company is buying back shares

Clearly, this is a list that Buffett would love. The first eight items on the list imply that the stock’s price will be low relative to fundamentals. Lynch was a bottom up investor who selected value securities to buy in all market environments. He thought it silly to buy or sell a security solely because of a view of what was happening in the market.

When we think of great value investors, why doesn’t Lynch immediately come to mind? 1. Perhaps it was because he did not call himself a value investor, but then again, neither did Ben Graham. 2. Perhaps it was the size of his fund. We tend to think of value funds as small funds and Magellan’s outperformance was remarkable given its size. But Magellan wasn’t always a multi-billion dollar powerhouse. When Lynch took over in 1977, Magellan had only $20 million in assets under management. It was Lynch’s success—because he was a true value investor—that led to the explosion in the size of the Magellan Fund. 3. Perhaps it was the number of companies he owned after the fund grew: he bragged of owning 1,400 companies and the running joke on Wall Street was that Lynch never met a stock he didn’t like. Buffett and many other value investors believe that it is crazy to put your money in your fiftieth-best idea, and they concentrate their portfolios in a few dozen names at most. We also know that there were stocks that Lynch did not like:

“If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train—and succumbing to the social pressure, often buys.”

In fact, the main theme of One Up on Wall Street is that behaving contrary to the “smart money” is good for your financial health. And, what is more contrarian than value investing?

Lynch thinks that the individual investor has a huge advantage over the professional investors on Wall Street who 1. have to put billions of dollars to work; 2. have to answer to investment committees; 3. are incentivized to invest like every other professional on Wall Street and threatened with job loss if they don’t; and 4. have to plan for daily redemption requests. The individual investor does not have to deal with any of that and so she can focus all of her effort on finding bargains and holding them until the rest of the market catches up. Of course, that also means that the individual investor has to be able to read a financial statement and put in the hours and effort to find these bargains.

Share on Facebook