joel greenblatt photoJoel Greenblatt interview with Steve Forbes, followed by the transcript. The interview is about 26 minutes long, and focuses on Greenblatt’s latest book, The Big Secret for the Small Investor: A New Route to Long-Term Investment Success

The Big Secret for the Small Investor: A New Route to Long-Term Investment Success

Steve Forbes: Joel, good to have you with us.

Joel Greenblatt: Thank you.

Forbes: We had you on a little over a year ago, but since then you’ve come out with a new book called The Big Secrets. This follows another book that you had. Why two books for investor advice? Couldn’t you get it all in the first book, which was called The Little Book That Beats the Market?

Greenblatt: Well, it’s not even as good as that – this is really my third book. I wrote a book six years ago called The Little Book That Beats the Market, and it really gave a very simple way for people to beat the market. I actually ended up, after I finished the book, getting worried that people would kind of screw it up, and I was really trying to help people.

There aren’t great data sources and everything else. So we actually set up a website to do everything for them, except that I made a little mistake. It actually ended up being pretty hard. I tried doing it with my kids and managing a portfolio of 20 or 30 securities, keeping track of the taxes and everything else.

It turns out it’s kind of hard to do it yourself, and I even found it hard with my own kids. So I learned a lot. We did a lot of research since the first book, and learned some more things. And came out with something that I guess is even easier for people to do, and also takes advantage of our latest research.

The Flawed Indexes

Forbes: Now before we get to that – and you’ve got some new funds – you maintain that the individual investor can beat the big guys, as you put it. How can that be?

Greenblatt: Well it’s pretty interesting, from the research we did in the book. Most people know that the typical index funds – the S&P 500, and the Russell 1000 – if you invest in those, they beat most managers, roughly about 70% of the managers. And that’s pretty powerful. It’s because of their low fees, and because most managers aren’t really adding value.

So one logical thing to do would be to say, “Well, I know only 30% of the managers beat the typical index, so how do I find those guys?” And it turns out, if you look back over the last three, five, and ten years of those manager’s records, there’s really no correlation between how they do in the next three, five, ten. Which is really what you’re trying to figure out.

So that’s why many advisors have recommended (and possibly rightly) that index funds, for the individual investor who doesn’t know how to pick stocks on their own, are maybe a good opportunity for most people. So we set out to do something a little better. And as it turns out, the regular indexes, the S&P 500 or the Russell 1000, are seriously flawed.

Even though they beat most active managers, they’re still very seriously flawed. They do something that costs investors about 2% a year, and that really is that they’re market-cap weighted indexes, which means they put more weight into the larger market caps.

Forbes: Shortchange the losers.

Greenblatt: Right. So if you believe, like Ben Graham or Warren Buffett, that the market is sometimes emotional – it’s not efficient like so many professors have professed over many years – that mean that if the market does get emotional over the short-term, some stocks are overpriced and some are underpriced. And a market-cap weighted index, if a stock is overpriced, it buys too much of it automatically. And if it’s underpriced, it buys too little of it automatically, because it’s basing it on market-cap, which is essentially price.

So it sounds crazy, but it actually is systematically doing the wrong thing at every point, whenever there’s an inefficiently priced stock. And there’s an easy way to correct that. There are actually equally weighted indexes – instead of putting more in the larger market-cap companies, it puts in equal weight.

So if you have the S&P 500, it’ll put as much weight in stock number one as it will in stock number 500. It still makes plenty of errors, in other words; it is unequally weighting, but those errors are now random, not systematic like a market-cap weighted index. So you actually get back the 2% a year.

A few people have come out with something called fundamentally weighted indexes. It’s just another way to weight stocks without using price. And therefore, the errors in those indexes are also random, and you get back the 2% from those, too. And since we’re value investors, and have done a lot of research on value investing over a long period of time, we create an index that we call “value weighted.” Which just means the cheaper something is, the more weight we put into it.

And it’s actually more diversified than the S&P 500 or Russell 1000 index. It has the same volatility and has the same beta, yet over the last 20 years you would earn 7% more a year following that strategy. And it’s ridiculously simple. Just put more weight in the cheaper companies.

Too Much Short Term Focus

Forbes: Before we get to that, you make the point that the reason there is such opportunity for the individual is that in the investor world, you believe it’s become more short-term focused. Which means buy high, sell low.

Greenblatt: That’s a really great point. Big picture is that when you look back at what’s happened over the last 20, 30 years, there’s been more access to information. There’s been more computing power, there’s been more people going on to Wall Street to high-paid hedge funds, and proliferation of mutual funds and everything else. So there’s a lot of smart people actually trying to “beat the market.”

So you would think that it would be getting tougher and tougher for individual investors to outperform the market. And what it turns out is our simple value factors have actually gotten stronger over the last 20, 30 years. And the reason for that is that the world has become much more institutionalized.

I’ll just tell a quick story I tell in the book. Which was that in the late’80s, I had an investor in my partnership, one of the first fund of funds. These are funds that actually pick managers, and you’re asking them to find their expertise to pick the best managers and they put that all together in a fund. So one of the first that was put together in the late ’80s, or at least that I knew about, asked to invest in our partnership.

At the time, I was writing quarterly letters, and that seemed to be fine for my investors. But the fund of funds said, “Well, we have

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