Here’s a great article published at Forbes recently regarding one of our favorite value investors, Joel Greenblatt. The article is written by Jack Schwager, author of the Market Wizards series, in which he recounts his interview with Joel Greenblatt for one of his books. Schwager recalls some of the insightful parts of the interview included Greenblatt’s successful investing strategy and his three golden rules of value investing.
Here is an excerpt from the Forbes article:
To answer this question I will invoke the wisdom of Joel Greenblatt, one of the foremost experts on value investing. I interviewed Greenblatt in my book Hedge Fund Market Wizards. Joel Greenblatt is currently Managing Principal and Co-Chief Investment Officer of Gotham Funds and previously was the portfolio manager for Gotham Capital, which in the course of its 10-year track record achieved an average annualized compounded return of exactly 50.0% (before incentive fees). The outperformance was remarkably consistent: The lowest annual return during the entire period was positive 28.5%.
In our interview, Greenblatt said, “The power of value investing flies in the face of anything taught in academics. Value is the way stocks are eventually priced. It requires the perspective of patience because the market will eventually gravitate toward value.”
He then went on to explain research he conducted on a value formula he used.
“We also divided the formula rankings into deciles with 250 stocks in each decile. Then we held those stocks for a year and looked at how each of the deciles did. We repeated this process each month, stepping through time. Each month, we had a new set of rankings, and we assumed we held those portfolios (one for each decile) for one year. We did that for every month in the last 23 years, beginning with the first month of the Compustat Point-in-Time database. It turned out that Decile 1 beat Decile 2, 2 beat 3, 3 beat 4, and so on all the way down through Decile 10, which consisted of bad businesses that were nonetheless expensive. There was a huge spread between Decile 1 and Decile 10: Decile 1 averaged more than 15% a year, while Decile 10 lost an average of 0.2% per year.”
In response, I had what seemed to me to be an obvious question: “Since there is such consistency in the relative performance between deciles, wouldn’t buying Decile 1 stocks and selling Decile 10 stocks provide an even a better return/risk strategy than simply buying Decile 1 stocks?”
I thought I was being perceptive. Greenblatt quickly disabused me of that notion.
“My students and hundreds of e-mails asked the exact same question you just did. The typical comment was, ‘I have a great idea Joel. Why don’t you simply buy Decile 1 and short Decile 10? You’ll make more than 15% a year, and you won’t have any market risk.’ There’s just one problem with this strategy: Sometime in the year 2000, your shorts would have gone up so much more than your longs that you would have lost 100% of your money.”
This observation illustrates a very important point. If I wrote a book about a strategy that worked every month, or even every year, everyone would start using it, and it would stop working. Value investing doesn’t always work. The market doesn’t always agree with you. Over time, value is roughly the way the market prices stocks, but over the short term, which sometimes can be as long as two or three years, there are periods when it doesn’t work. And that is a very good thing. The fact that our value approach doesn’t work over periods of time is precisely the reason why it continues to work over the long term. Our formula forces you to buy out-of-favor companies, stocks that no one who reads a newspaper would think of buying, and hold a portfolio consisting of these stocks that, at times, may underperform the market for as long as two or three years. Most people can’t stick with a strategy like that. After one or two years of underperformance, and usually less, they will abandon the strategy, probably switching to a strategy that has done well in recent years.
It is very difficult to follow a value approach unless you have sufficient confidence in it. In my books and in my classes, I spend a lot of time trying to get people to understand that in aggregate we are buying above-average companies at below-average prices. If that approach makes sense to you, then you will have the confidence to stick with the strategy over the long-term, even when it’s not working. You will give it a chance to work. But the only way you will stick with something that is not working is by understanding what you are doing.”
Greenblatt’s narrative can be boiled down to what I term Greenblatt’s three rules of value investing:
1. Value investing works.
2. Value investing doesn’t work all the time.
3. Item 2 is one of the reasons why Item 1 is true.
Investing in good businesses that are priced cheap—Greenblatt’s approach modeled after Buffett—will outperform the market over the longer term. This value edge does not go away because the periods of underperformance using a value approach can be long enough (a few years) and severe enough, to discourage investors from sticking with the approach. Although many managers may realize the merit of value investing, they too will have trouble using such an approach because of the shortening of investor time horizons in tolerating subpar performance. The fact that institutions have become increasingly likely to redeem investments from managers who turn in below-average performance for periods as short as one year, let alone two years, means that managers who stick to a value approach risk losing substantial assets at some point. The inability of so many investors and managers to invest with a long-term horizon creates the opportunity for time arbitrage—an edge in an investing approach that requires the commitment to long-term holding periods.
You can read the original article at Forbes here.
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