A interview with value investor and Columbia University Graduate School of Business professor, Joel Greenblatt. In this interview Joel discusses how small investors can beat professional fund managers using value investing techniques from Joel’s book, The Big Secret for the Small Investor.
Joel Greenblatt: Value Investing For Small Investors
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Joel good to have you with us. We had you on a little over a year ago but since then you've come out with a new book called The Big Secret. And this follows another book that you had. Why. Two books or Investor Advice. Could you get it all in the first book which is called The Little Book That Beats the Market.
Well it's not even as good as that. This is really my third book. So excuse me. So 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 and 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 so. And 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 and keeping track of the taxes and everything else. It turns out most people don't know. It's kind of hard to do it yourself and I haven't found it hard with my own kids so I learned a lot. We did a lot of research since the first book and learn 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.
Now before we get to that new funds you maintain that the individual investor can beat the big guys as you put it. How can that be.
Well it's 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 percent of the managers and that's pretty powerful it's because of their low fees and that most managers aren't really adding value. So one logical thing to do would be to say well I know only 30 percent 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 10 years of those managers records there's really no correlation between how they do in the next 3 5 10 which is really what you're trying to figure out. So that's why you know most you know many at least advisers have recommended and possibly rightly that index funds for the individual investor doesn't know how to pick stocks on their own. He's may be 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 as it turns out even though they beat most active managers they're still very seriously flawed and they do something that cost investors about 2 percent a year. And that really is is that their market cap weighted indexes which means they put more weight into the larger market caps. And so that infrastructure the losers.
Right. So if you believe like Ben Graham or Warren Buffett that the market sometimes emotional it's not efficient like so many professors have professed over many years. It's not efficient. That means that if the market does get emotional over the short term that 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 based on market cap which is essentially price. So it sounds crazy but it actually systematically doing the wrong thing at every point. Whenever there's an inefficiently priced stock and so there's an easy way to correct that. And there are actually equally weighted indexes instead of putting putting more in the larger market cap companies that actually puts an equal weight. So if you have the S&P 500 it will 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's an equally weighting but those errors are now random not systematic. Like a market cap weighted index so you actually get back to 2 percent a year and 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 to 2 percent from those two. And since we're value investors and have been done a lot of research on value investing over a long period of time we created an index that we call valuated which just means the cheaper something is the more weight we put into it. And it's actually more diversified than you know the S&P 500 or Russell 1000 index has the same volatility has the same beta yet over the last 20 years you would earn 7 percent more a year following that strategy and it's ridiculously simple just put more weight in the cheaper options before we get to that.
You make the point. The reason why 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. So that's a really great point. Picture is.