Greenblatt and Asness on Periods of Underperformance for Value

Tobias CarlisleStudy1 Comment

Fascinating note from Forbes on the underperformance of Joel Greenblatt’s mutual funds that implement the Magic Formula:

[I]nstead of trying to paint Gotham’s year-to-date returns as indicative of any obvious flaw in strategy, it’s likely a far stronger data point to use as a read on the overall market. Its struggles should cause a bit of alarm for the ordinary investor. Oftentimes, the best investors over a market cycle underperform during times of what Nobel laureate Robert Shiller calls ‘irrational exuberance.”

During the peak of the dot-com bubble, the financial press wondered aloud whether Berkshire Hathaway BRK.B +% Warren Buffett lost his touch as wax-winged firms like Webvan dramatically outperformed ‘old economy’ stocks. When bubble burst, Berkshire then enjoyed one of its great spells of outperformance. There are countless similar stories. In a 2014 essay for Institutional Investor, AQR’s Cliff Asness recalled launching his hedge fund in 1998 with a similar strategy to Gotham’s funds:

We were long cheap stocks and short expensive stocks, right in front of the worst period for value strategies since the Great Depression… Not long cheap stocks alone, which simply languished, but long cheap and short expensive! We remember a lot of long-only value managers whining at the time that they weren’t making money while all the crazy stocks soared. They didn’t know how easy they had it.

In watching Gotham’s performance tail off this year — returns outperformed initially leading to big asset inflows — it’s hard not to wonder whether it reflects a similar bout of over-exuberance, or extreme overvaluation in some sectors. Gotham, through a spokesperson, declined to comment or give color to any particular sectors or stocks that have driven underperformance.

However, a look through Gotham’s public filings indicates it has minimal exposure to the cratering energy sector, or on-the-ropes coal, commodities, and metals producers. The firm’s Absolute Return Fund reported a 15% exposure to the under-performing industrial sector, and an ownership of semiconductor stocks, potentially causing returns to tail off. A 5% exposure to healthcare has also likely missed the boat on this year’s M&A wave.

But it is more likely that the short portfolio has driven underperformance, even in a flat market. Per Bloomberg data, it is the bubble-prone Internet sector that’s leading the S&P 500, gaining 57% year-to-date, followed by home entertainment systems and construction materials. Those three sectors would likely capture big 2015 winners such as Netflix NFLX +1.63% (up 133%), (up 73%), Martin Marietta Materials (up 42%), and Vulcan Materials (up 39%) — all of whom sometimes find themselves the target of short sellers, or bouts of overvaluation.

Perhaps, Gotham’s performance indicates there’s a looming upward correction in industrial and semiconductor stocks and a downward move in high flying internet and social media stocks. After a rocky start to the first half of 2015, marked by a tumble in businesses sensitive to global commodity prices and economic growth, perhaps more challenges are in store if high multiple stocks also turn south.

In that instance, expect Gotham to recover. The fund after all explicitly states its is likely to underperform broad markets over quarterly and yearly periods. “If there were an investment strategy that worked every day, every month and every year, eventually everyone would follow it and it would stop working,” Gotham states in its fund prospectus.

“Though for months, quarters and even longer this strategy may underperform one benchmark or another, this is the only way we know how to invest. In fact, we strongly believe that short periods of underperformance are a major reason why more people do not adopt our logical, disciplined approach,” it adds, citing research that shows over the past decade 96% of the top quartile managers spent at least one three-year period in the bottom half of performance rankings, and 79% spent three years in the bottom decile of performers.


Source: Value Guru Joel Greenblatt’s Performance Could Be A Sign Of Overheated Stock Market

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One Comment on “Greenblatt and Asness on Periods of Underperformance for Value”

  1. “If there were an investment strategy that worked every day, every month and every year, eventually everyone would follow it and it would stop working,”

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