Joel 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
Steve Forbes: Joel, good to have you with us.
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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 to report more often. So could you give us monthly returns?” So I said, “Sure, I’ll tell you the monthly returns as they come in.” And sure enough, after the first month that this fund had money with us, we reported back that we were up 1.1%, which we thought was pretty good.
But I got a call from the fund of funds and they said, “Well, you know, we have a lot of other managers that do similar things to you. And the average one of those was up 1.2% last month. To what do you attribute your underperformance?” And I politely told the fund of funds to call me back in a year.
I probably should have told them to call me back in four or five years, but I don’t think they would have stuck around so long. So I figured I’d settle for one year. But the world has become much more institutionalized since then. People look at daily returns, weekly returns, monthly returns. They get analysis over the month or the quarter. It’s very hard to keep a long term horizon. When you’re investing in the stock market, four or five years is a more reasonable time frame to judge anyone’s performance.
Forbes: So you get hyperactivity, which research shows does not lead to better returns?
Greenblatt: Exactly. What happens really is, is that if you underperformed in the last six months, year or two years, people chase performance. So they take money out of you and put into someone else. Another statistic I wrote in the book, which I think is the most telling, is if you look at top performers over the last decade, the top 25% of managers that have outperformed – came out with the best record for the last ten years – 97% of those top managers spent at least three years in the bottom half of performance.
79% spent at least three years in the bottom quartile of performance. And almost half, 47%, spent at least three years in the bottom 10% of performance. So all their investors left if they did that, but these are the ones who ended up with the long-term record. Most people leave them, most people don’t stick around for long enough.
One another thing I write up was that in the decade of the 2000s, that ten year period, the top performing mutual fund was up 18% a year. The average investor in that fund lost 11% a year. That was the best one.
Why is that? It’s because every time the fund underperformed, people left. Every time the market went down, people left. Every time it outperformed, people piled in right after the outperformance. Right after the market went up, people piled in. So with all the investor’s market decisions, the average investor – the average dollar weighted investor in that fund over the last decade, the best fund – ended up losing 11% a year.
Rear View Mirror?
Forbes: Now you make the point that if you go for value – and we’ll define your definition of value in one second – over the last ten years: 600, 700 basis points above the S&P. Are you guilty of rear view mirror investing, saying what worked in the past will work in the future? We know with money managers that doesn’t work.
Greenblatt: Right. Well, if I had spun the computer a million times to figure out what might have worked, that is true. But we have a couple simple factors that we use; that’s the way I invest in individual stocks. It’s really looking at, “How much cash flow do I get for the price I’m paying?” I don’t use simple earnings, I use our own definition of cash flow. I don’t use simple price, I use something called enterprise value, that we make all kinds of adjustments for debt.
Forbes: Let’s go to that. Define what you call “price to cash flow.”
Greenblatt: Well, in the last book I wrote, I used EBIT – earnings before interest and taxes. For our new mutual funds, we actually go figure out what the real free cash flow is. EBIT was a proxy and it worked quite well in back testing. We actually do the work ourselves and figure out what real free cash flow is. So if we have pension liabilities, or tax assets, and tax liabilities, we just really pick it apart.
But the concept is very simple. It’s, “What is the real free cash flow of this business?” And we’re not looking forward, we actually look backwards. So we can talk about that in a second – how can you make money by looking backwards? Because the value of a company comes from its earning going forward, so if you have something that you can look at history, right?
Reading history books shouldn’t be able to make you money. Well, here we’re just using simple factors based on what’s already happened. And we can talk about in a second why that works. But we’re looking at trailing free cash flow to the price we’re paying. The all-in price we’re paying, including all the liabilities of a company.
And the other thing we use in the mutual funds is really just our definition of return on tangible capital. And if you read through all of Warren Buffett’s letters, he really focuses very keenly on how good a business it is. And one of the factors that he looks at, most importantly, is a business that can earn high returns on tangible capital.
Forbes: Now explain why looking at the past is predictive of the future, and then we’ll get to a number of securities you should hold. But first, why is the past predicting the future?
Greenblatt: Right. That’s actually a wonderful question. And frankly, a very logical and obvious question to ask. How can you look backwards and then figure out what’s going to happen in the future? And in fact, we’re really not doing that.
What happens – we were talking about before how people have a very short-term horizon. And the big secret for the small investor is that they can keep a long-term horizon. So why would the market allow us to buy a company cheap, relative to its earnings? We called it an “earnings yield.”
In other words, why would we get a 15% earnings yield from one company and only 5% for another? Why is the market giving us this bargain? Generally the companies, if you look backwards, that earned a 15% earnings yield – most people don’t think that’ll continue in the future. At least the next year or two won’t be as good as their most recent past.
So they’re willing to sell it to you cheap, relative to its past earnings. They think the next one year or two will be down from where it is, so they allow you to buy it at a bargain, relative to past earnings. You’re buying out of favor companies. They earn high returns on capital, you’re getting a high earnings yield, but people are worried about the next year or two – that they won’t be as good. So they discount.
Forbes: So Obamacare comes along, dump the healthcare stocks?
Greenblatt: Exactly. That’s a perfect example. Healthcare stocks show up on the list now because everyone’s worried about what’s going to happen under Obamacare. We have a company called GameStop that keeps coming up on our list because everyone thinks it’s the next Blockbuster. They sell games.
Buying Bad News
Forbes: So look at the news and companies that look like they’re going to get a hit.
Greenblatt: Well, we really do it by the numbers. So if you get a high earnings yield now, that means there are very low expectations for the companies that you’re buying. Even though they’re getting high earnings yield, there are low expectations for the future.
Forbes: So you’re not buying a company that’s going broke?
Greenblatt: Exactly. You get high free cash flow now. You think the next year or two might not be as good, or there’s a lot of uncertainty. So you buy them with low expectations built in. And if they do a little better – or a lot better – you have the chance for asymmetric returns on the upside.
And those are precisely the stocks that institutional managers who worry about doing well in the next year or two systematically avoid and overcompensate for that, because they don’t want to be there. So if there’s uncertainty about the business, or you kind of know it’s not going to be as good in the next year or two, institutional investors systematically avoid those stocks.
You don’t pay a lot for anything. So if they do a little better, or a lot better, you have a chance for asymmetric returns. If the low expectations come in, you didn’t pay for high expectations so hopefully you don’t lose very much.
You don’t lose very much on the companies where the news doesn’t get a little better than expectations, and you make a lot on the companies where it’s a little better, or a lot better. On a surprise, you can end up making a lot of money. And it’s very systematic, and those factors have actually gotten stronger because of the institutional bias now in the market.
Why Small Portfolio?
Forbes: Now as you know, sometimes even though you do brilliant analysis a stock can still become a dog and stay a dog. Yet you say you get a better return with a relatively small handful of securities – 20 to 30. You also have a fund where you can offer much more, but you get less of a yield. Why would 20 or 30 do better than, say, 500?
Greenblatt: Well, we really think of it as underwriting this systematic risk that people are avoiding the stock. If you insure 1,000 lives next year, you probably could take a pretty good guess that about – just pick to a number, 6% aren’t going to make it through the following year. And you can underwrite that risk. It might be 5.8%, it might be 6.3%, but you can pretty well guess what that number is going to be.
When you underwrite 100 lives, one or two guys going way one or the other could give you a different outlook. Now over a ten year period? That, and you can actually do a little bit of underwriting with those hundred lives. You can not insure some and insure others, and maybe do. But still, two or three or four people going the wrong way in any particular year can really change your results and your expectations.
We look at it the same way as stock investing. With a more concentrated portfolio, over time, you can probably make two or three points more a year. But you probably have to wait around five or ten years for those extra two, three points. And in the interim, it’s going to be a very volatile ride.
We can actually do it with 500 or 800 stocks with much less volatility. We do two or three points less, still beating the market by 600 or 700 basis points a year. But the key is, what will you stick with? Most people can’t live with the volatility. When they underperform for a year or two, they leave. So if you know yourself, and you truly have a ten year horizon, it may be a better bet to take the more selected portfolio. We actually have a mutual fund that has a more selected approach.
But it’s really for people who are a little bit braver. Meaning they understand what we’re doing. We’re buying above average companies, but only when they’re available below average prices. And that makes sense to them, and they’re willing to stick it out for five or ten years.
Most people aren’t like that. Most people would rather have a bit of a smoother ride, give up a point or two in returns, still with excellent returns, and take a more diversified approach. So there’s something for everybody. They both make sense. The tradeoff between the extra risk you’re taking –
Forbes: So you have four relatively new funds today. One, in effect, is your version of a domestic index, and one is your version of an international index. Somebody said, “That’s not index, that’s quant,” and you say you don’t care – it’s the principle that counts. You have two other funds that could be more of a rollercoaster?
Greenblatt: A little bit more of a rollercoaster. But yes, they have between 75 and 100 stocks in general. So we have international and domestic index-like funds, and then we have international and domestic select funds, with 75 to 100 stocks.
Forbes: And you make the point that – at least in the last thing I read – your domestic is doing better than the market. Your international is underperforming, and you say, “Well, that’s what the real world is like. You can have periods of underperformance.”
Greenblatt: That’s exactly how it works. If we had a strategy and wrote books about it that worked every day, and every month, and every year –
Forbes: Bernie Madoff.
Greenblatt: Exactly. Everyone would do it, and everyone did do it. And it’s not real, it doesn’t happen. So we’re long-term investing. It doesn’t work every day, every month, and every year. Most people can’t stick with it, I totally admit that. But that’s why it works. And so what I spend my time doing in the books is explaining why it works.
Financials & Utilities
Forbes: Now the last time we met, you said your way of trying to get value does not work with financials and utilities. You think you’ve found a way to do those two industries now?
Greenblatt: Oh, that’s a great question, thanks for asking it. For our indexes, we do now include both utilities and financial. We developed our own methodology for valuing those. And we insert them into our broad indexes for the company. So the domestic index does include financials and utilities.
We do not include financials still internationally, because of all the different standards where banks are regulated all across the globe. And there is some trickiness to the black box nature of what is exactly in those bank portfolios that we don’t feel comfortably internationally doing yet. That’s another project for down the road. But domestically, we feel very good about the regulatory environment.
Forbes: Now are international statistics other than financials something you can rely on now?
Greenblatt: That’s also a very good question, I appreciate you asking it. There aren’t many databases that purport to follow international companies. We’ve looked at them all. We are not comfortable using any of them. The data is not anywhere nearly as good as what’s available domestically – and we do our own database domestically also.
But internationally, it’s almost impossible to invest with the commercially available data. And so we ended up putting together an investment team that actually created our own database for international. And we’ve homogenized 26 countries now, with the way that we look at cash flow, the way that we look at evaluation of companies and returns on capital. And we do that work ourselves.
And so I think that’s something very unique. Even though our select international is underperforming, our index is performing in line with the index. We’ve only been doing it for about six months, and we think over the long-term – at least four, five years – we should have extraordinary outperformance. That’s what our hope is, anyway.
Magic Formula ETFs?
Forbes: Any prospect of ETFs?
Greenblatt: We’ve thought about ETFs, and there are actually some nice tax advantages for individual investors in ETFs. The problem with it is that you have to post your portfolio on a daily basis. We’re doing a lot of proprietary work on our database and our factors that we think add value over time. And so we don’t want to give those away to the rest of the world by posting our trades and our portfolios on a daily basis.
So if you really think that you can add value, unfortunately, the way ETFs are structured now, you don’t want to really be giving that away to the rest of the world. Especially if you think what you have is really excellent. So while we would like to do ETFs – and there are some nice tax advantages for individuals – we can’t. We try to be as tax efficient as we can in our other strategies, but not quite as good as an ETF. But those are the reasons; I don’t think we’d have the outperformance if we posted the ETF.
Forbes: Now in your world of indexing, you have relatively high fees. What is it, about 1.25% versus 17 or 18 basis points for the Vanguard? Your turnover would be higher too, wouldn’t it, or not?
Greenblatt: Right. Well I spend about seven or eight pages in the latest book, The Big Secret For the Small Investor, saying, “Well, is what we put together really an index, or is it an actively traded strategy?” And it was a lot of “on one hand and on the other.”
We have 800 to 1,000 stocks in what we call our “valuated index.” And it has more diversity, and it’s more widely distributed than, let’s say, the S&P 500, where the top 20 stocks in the S&P 500 can be 33% of your index. We’re much more diversified than that.
So in that sense, it’s closer to an index. And it’s 800 to 1,000 stocks, so it has the same beta as an index. It has the same volatility as all the other indexes. So in that sense, it’s also similar to index. But indexes have very low turnover in general.
The reason for that is if you have a market-cap weighted index, they actually change every day, because market prices change every day of all the constituents. You just don’t have to trade to get there. You don’t have to trade to get those different weightings in the stocks, they happen automatically as the stock price moves.
Forbes: But you have to look at the value of the stock each day.
Greenblatt: Exactly. We’re looking at value. So we do have to trade. So for a million dollar portfolio, we do about $3,000 to $4,000 worth of trading per day, which adds up to about to 75% to 100% turnover. Which is a little less than most active funds, but still a lot of turnover relative to indexes. So in that sense, it’s closer to an active fund.
Forbes: So in effect, you recalibrate each day?
Greenblatt: We do. We could recalibrate every quarter. In other words, there’s something called the “Russell 1000 Value Index.” And what that index does – and that’s a very well-known value index – but they do something different than us. First, out of the 1,000 stocks in the Russell 1000, which are the largest 1,000 companies according to market-cap, they pick the 650 that have certain value attributes that they look at. Like low price/book, low price/sales – standard value characteristics.
So they pick the 650 out of the 1,000 that have the best value characteristics and then they market-cap weight them. They sort of do something that makes some sense, and then they do something that I think detracts significantly from the returns that you can have, by market-cap weighting that value index.
So we could do something similar by staying true to our value weighting criteria and update quarterly or every six months. But we find that because prices change every day – and because earnings change every quarter and balance sheet information changes every quarter, we could update every three months, or every six months – but we make more money by updating a little bit every day, and that was our goal.
Forbes: Make more money for the investor, right?
Greenblatt: Right, our goal was to make money. So we kept our eye on that goal. And that’s the best thing we could do for investors, and that’s how we went about putting it together.
B-Schools Ignore Graham
Forbes: You’ve said business schools, other than Columbia where you’re an adjunct professor, ignore value investing. Is that true?
Greenblatt: To a large degree, that is true.
Forbes: The other schools don’t teach Benjamin Graham?
Greenblatt: Most business schools do not really teach Benjamin Graham. There are a few around the country that do. But for the most case, people are still being taught the efficient market model, and all the math that goes along with that.
We kind of feel the way Warren Buffett does: that’s good news for us. That if everyone’s told you can’t beat the market – and this is the way to go about investing and it makes no sense to you and everyone’s being taught that – it gives a little more opportunity to value investors if you have less competition actually doing the work.
I constantly get emails and letters from business students all over who have been exposed to Benjamin Graham. And let me just say one thing to thank you and your dad. The way I got involved in value investing in the first place was from an article back in the late ’70s in Forbes magazine that detailed Benjamin Graham’s formula for beating the market.
Benjamin Graham was Warren Buffett’s teacher. And he had a nice formula. And I read that article, I guess it was 30-something years ago, and a light bulb went off in my head. And I said, “This makes total sense.” And I read everything that Benjamin Graham ever wrote, as a result of that article in Forbes.
And it ended up changing my life, and changing my way of looking at the world and changing my way of looking at how to invest. And so it was a meaningful turning point in my studies. I was at a business school, I was at Wharton Business School, and we were learning still efficient markets. And they’re still teaching the same thing over there. But it was a little article in Forbes that kind of put me on the right path, I think.
Forbes: On that note, I think I want to say thank you, Joel. And viewers and unique visitors: keep that in mind.
Greenblatt: Thank you.
Forbes: It will make you rich. Oops, the SEC’s coming after me. Joel, thank you very much.