Joel Greenblatt is a Columbia University professor and co-founder of Gotham Asset Management. He’s also the author of the value investing best seller, The Little Book That Beats the Market. In his book, Greenblatt explains how investors can outperform the popular market averages by simply and systematically applying a formula that seeks out good businesses when they’re available at bargain prices.
Last month, Greenblatt sat down with Barron’s to chat about his current outlook and the reasons why investors continue to underperform by continually chasing returns.
Following is an excerpt from Greenblatt’s interview with Barron’s:
Barron’s: Gotham Index Plus is the latest generation of Gotham investing — dramatically different from your previous styles. It’s like Dolly Parton going from country to disco. What’s the idea?
Greenblatt: That’s such a bad image, really. The basic idea is that the best strategy for most people is not only one that makes sense, but also one they can also stick with. To beat the market, you have to zig and zag differently from the market. While value investing works over the long term, and in the vast majority of cases within two or three years, people’s time horizons are shrinking, and they keep chasing returns. They don’t generally know how to evaluate stocks.
Your book told them clearly how to do it.
The Little Book That Beats the Market gave you metrics to buy a group of companies. If you buy a group of them, on average you will end up with a good return. Stocks are not pieces of paper that bounce around, they are businesses that you value and try to buy at a discount. If you are going to buy individual stocks, you need to know how to value companies yourself.
Most people don’t know how to do that or don’t want to do the work, so they get someone else to do it. Unfortunately, the only way they have to judge those managers is how they’ve done over the past one-, three-, and five-year periods. Multiple studies will tell you there is very little correlation between the past one, three, five and the next one, three, five.
So people should really look for managers that follow a process they can believe in and stick with over the long term. Unfortunately, it’s just as hard to pick a good money manager as it is to pick an individual stock. Why? When the market goes up or an active investor outperforms, people pile in. When the market goes down or that investor lags behind, people pile out. They chase returns because that’s all they really have.
Are you repudiating your other strategies?
No. I love our other strategies. We can make lots of money over time with them. But people don’t stick with it. Most people have a difficult time sticking with strategies that underperform from time to time. Gotham Index Plus minimizes that time. It is a way to capture our ability to buy cheap stocks and short overvalued stocks and add that to the base S&P 500 index.
We buy a dollar’s worth of the S&P 500—the underlying stocks in the same proportions as they are in the index. We don’t charge for that part. Then we add 90 cents of our favorite S&P 500 stocks and short 90 cents of our least favorite S&P 500 stocks. With this strategy, you have a lot less tracking error—the divergence between a fund’s return and that of its benchmark—and we can still take advantage of our stock-picking ability.
In 2011, I published a book called The Big Secret for the Small Investor. I always say it’s still a big secret because no one bought it. It talked about a couple of studies, including the best-performing fund from 2000 to 2010, which was up 18% a year even when the market was flat. The average investor in that fund went in and out at the wrong times on a dollar-weighted basis to lose 11% per year.
Meanwhile, the statistics for the top-quartile managers for that decade were stunning: 97% of them spent at least three of those 10 years in the bottom half of performance, 79% spent at least three years in the bottom quartile, and 47% spent at least three years in the bottom decile. So our fund would compromise: Reduce the tracking error but add the benefit of buying cheap stocks and shorting expensive stocks. In a more muted return environment for the S&P 500, that extra additional return should be very attractive to investors.
This long period of low interest rates has distorted markets. What do you see for stocks?
The market looks expensive. It’s roughly in the 21st percentile toward expensive over the past 25 years, meaning 79% of the time during that period the market is more expensive. What usually happens the following year when we’ve been at this level? On average, the market is up between 2% and 7%, so figure a gain of 4% to 6% on average. During those 25 years, the market rose 9% to 10% a year.
Another way to think about this is the market is 12% to 13% more expensive than it has been traditionally. Well, one scenario could be that it drops 12% to 13% tomorrow, and future returns would go back to 9% to 10%. Or you could underearn for three years at 4% to 6%. We’re still expecting positive returns, just more muted. The intelligent strategy is to buy the cheapest things you can find and short the most expensive.
At $44 million in assets, your new fund is tiny. Yet it has much lower fees than your other funds. Are your other fees on the way down, too?
When we started taking outside money again in 2009, I made a few decisions. I’ve sat on many investment boards over the years, and most hedge funds don’t justify their fees of 1.5% to 2% of assets and 20% of profits. We thought reasonable fees were 2% flat.
People thought we were crazy to be so cheap, charging half or less what other hedge funds traditionally charge. We thought the money would be stickier because the lower fees would leave investors with more of the returns. Three years later, when we looked at introducing mutual funds, we realized we were among the few hedge funds that could launch mutual funds without diluting our strategy.
So we charge our mutual fund clients what we charge our hedge fund clients. We have limited capacity because many of the names are so small. With Gotham Index Plus, we don’t charge for the S&P 500 index component, and because they’re all large-caps, our management fee is 1% total.
Your other three mutual funds have trailed their benchmarks. You’ve said to give an investment two to three years to work out. Is the period of underperformance over?
Like I say, value investing works like clockwork, but sometimes your clock has to be very slow. This year, we’re pretty much in line with the market, adjusted for each fund’s equity exposure. We continue with our same process. Last year, part of the issue was that the S&P 500 was up 1% and the equally weighted Russell 2000 was down 10%.
We didn’t have good spreads last year between the performance of our longs and shorts. Valuation is like gravity. Usually what happens is, [the stock price] is like a rubber band—it stretches away from value. If we’re good at valuing businesses, the rubber band will snap back. Our expectations for our long portfolio are very high; we expect very poor returns from our short portfolio. Our strength is knowing what we are doing.
Value investing is back in vogue this year. For how long?
Neither Morningstar nor Russell classify us as value investors—they call us a blend of value and growth. The reason is that many people use low price-to-book or low price-to-sales metrics to define value. We’re neither. We’re cash-flow-oriented investors, valuing businesses and buying them at a discount. So by definition, if we’re good at what we’re doing, it doesn’t stop working.
If we were momentum investors and that’s worked well for 30 or 40 years and didn’t work for two or three years, I’d be questioning if it were a crowded trade, because it’s not so hard to figure out if a stock used to be lower and now it’s higher. I don’t have strong opinions on so-called factor investing and which factors are in and out of favor. It’s completely counterproductive to analyzing what’s going on in the market.
You can read Greenblatt’s full interview with Barron’s here.
For all the latest news and podcasts, join our free newsletter here.
Don’t forget to check out our FREE Large Cap 1000 – Stock Screener, here at The Acquirer’s Multiple:
