In today’s Observer author William Green has an interesting excerpt from his new book The Great Minds of Investing on Joel Greenblatt:
…Mr. Greenblatt is always searching for a “systematic way” of “doing better.” In 2003, this led him and Goldstein to launch a $35 million research project to prove the effectiveness of the principles they had used at Gotham to identify “cheap and good” companies. They hired a “computer jockey” who backtested what would have happened over 17 years if investors had bought stocks with a high earnings yield and a high return on capital. They concluded that these two metrics provided a “magic formula” for outperformance. Mr. Greenblatt revealed this finding in The Little Book that Beats the Market, which he wrote for his five children. It has since sold well over 300,000 copies.
In response to his readers, he set up a free website to help investors use this formula. But when he studied their accounts, he found that many of them couldn’t resist overriding the system: “They piled in when the strategy was outperforming. When it was underperforming, they stopped doing it.” These irrational tendencies caused them to underperform over two years when the strategy beat the market by 22 percentage points.
Mr. Greenblatt responded by developing another approach that was intended to protect investors from themselves. In 2012, he and Mr. Goldstein launched a series of mutual funds that take long positions in about 300 undervalued stocks while shorting about 300 overvalued stocks. Each company is ranked, so the biggest position on the long side is the cheapest stock; the biggest short position is the priciest stock. It’s a systematic approach that’s designed to remove emotion from the process of picking cheap stocks. By diversifying broadly, Mr. Greenblatt aims to reduce volatility, so that investors find it “less painful” to stick with the strategy over the long term.
For Mr. Greenblatt, much of the joy of investing lies in the cerebral challenge of devising these strategies that defy the odds and beat the market. “I always found it a fun process,” he says, “to solve the puzzle.” And as an added bonus, there’s also the rebellious pleasure of proving his college professors wrong once again.
Of course, I’m of the view that the acquirer’s multiple does better for the reasons I’ve set out in Deep Value and Quantitative Value. Read a summary here on Greenbackd.
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