In his recent interview with Barry Ritholtz on The Masters In Business Podcast, Joel Greenblatt discussed his not-for-profit charter school, alternative credentials, too big to fail banks, and why investors should focus on causation not correlation. Here’s an excerpt from the interview:
RITHOLTZ: Let’s pivot to your bread and butter — value investing. You famously gave away the magic formula, which has a wonderful long-term track record. But as we’ve seen over the past five years, value investing has struggled. What’s going on in in value land?
GREENBLATT: Well, you know, I gave a speech, you know, in the last year called this “value investing debt.”
GREENBLATT: And my answer was yes, no, maybe and I don’t care.
And the reason for that is it really depends on how you define value. If you define it like Russell or Morningstar where it’s low price book, low price sales investing, it’s had a tough time, an — an extraordinary time.
Last five years, growth — the way they define it at Morningstar or Russell — has outperformed value by 11 percent per year. Last three years, it’s 17 percent per year growth outperforming value. The last 12 months, it’s about 43 percent. These are phenomenal numbers. These are numbers bigger than during the five years before the top of the Internet bubble. These are slightly bigger, slightly bigger to discrepancy between growth and value.
So your question is — is very good. If you define value like we do, which is figure out what a business is worth and pay a lot less, that’s what I define as value investing. And, you know, Ben Graham would say leave a large margin of safety, then that’s never really going to go out of style. We — we look at companies like we’re a private equity firm. No private equity firm buys a business because it’s a low price book or little price sales. They’re really looking at cash flows.
GREENBLATT: OK. So while in a period like this where anything that’s somewhat out of favor, even though it’s not low price book, low price sales, they rhyme together. And if people are willing to pay growth at any price, then that’s not going to be a good period for any style of value investing.
But if — and the question is is value investing dead or is it going to continue, it comes down to how you define it. And people will always come back to valuation. It’s based on cash flows and how much those cash flows are going to grow over time. As Buffett would always say, growth and value were tied at the hip. They’re part of the same equation, figuring out value. So once again, we’re talking about definitions.
RITHOLTZ: So one of the interesting …
RITHOLTZ: I don’t want to call it post mortems, but analyses on why growth has been doing so well relative to value over the past 10 years, is that in an era of low inflation and very low rates? Capital intensive industries like tech and growth, it’s a very inexpensive input to them versus high inflation or higher rate regimes. Value is presented an opportunity to shine because it apparently needs less capital. What — what are your thoughts on those sort of analyses of — of value versus growth these days?
GREENBLATT: Right. Well, that’s a great question. And so if you’re talking about low price book investing, of course, it’s — it’s very relevant. If you’re talking about cash flow-oriented investing, it gets a little bit more nuanced. So let me describe it this way.
For many, many years before the last decade or so, stocks stuff that were low price book, low price sales tended to outperform the market for a period of 30, 40 years. And what that meant is that if you were buying a company close to its book value, meaning you aren’t giving much of a premium to the value of the business underlying the purchase, then if you put a bucket of company selling at low price book, you were tending to get more than your fair share of companies that were out of favor. So it correlated well with more than your fair share of companies that were out of favor and maybe too out of favor and so you could get an excess return.
Same way as momentum has worked for 30, 40 years, not just in this country, but across the globe. Let’s say it didn’t work for the next two years. It could be that it’s just cyclically out of favor. It works over the long-term, you just have to be patient or it could be momentum doesn’t work over the next two years because the trade has become crowded and it’s degraded. And that’s why it didn’t work.
Two years from now I would know the answer. Is it — is momentum just cyclically out of favor or it was the trade now because it’s not so hard to figure out a stock used to be down here and now it’s up here? Has it become crowded and degraded because everyone knows about it?
Two years from now I would know the answer. So the way I’d answer your question is this. Low price book, low price sales momentum are all things that, in the past, had correlated with good returns. We really look for causation. And since stocks for ownership here is a business and we’re valuing them just like a private equity investor would, OK, and that’s based on cash flows, you know, are the intangibles earning money? They’re not earning money. Those are questions that translated the cash flow and how much am I paying for that cash flow and how much am I paying for that growth.
And so, you know, what we’re looking for is valuation of a business, taking all those things into account and trying to buy it at a discount. And it’s possible the market doesn’t recognize that. And, you know, if you look at the last year, if you bought every company that lost money in 2019, 2020 is — is a little messed up because of COVID and the second quarter had weird earnings, so let’s just look at the companies that lost money in 2019.
If you bought every company that lost money in 2019 that had a market cap over $1 billion, and so they’re about 261 of those and you bought every single one of those companies, you’ll be up 65 percent so far this year.
GREENBLATT: OK? So, you know, in that kind of market, that’s kind of frothy at that end where people are going to say, hey, this company is going to be the next Google, Microsoft or Amazon. I don’t think the froth is in the Google, Amazon and — Amazon. Those are some of the best businesses we’ve ever seen in our lifetime.
To a large extent, they — they — I don’t quibble with their valuations. I actually — we own a big chunk of those companies. We — we think they’re great businesses. But there are hundreds of companies with — that rhyme with them. So it’s really not looking at indexes or how do we classify value and growth, it’s really looking stock by stock, valuing them try to buy at a discount. And that’s causation.
And so that causation might not be popular in the next year or two, but I’m not going to stop doing that. That’s what stocks are (inaudible) shares the businesses. So that’s the best way I can answer your question.
We’re looking for causation not correlation. We’re not looking for that low price book, low price sales momentum of correlated. No private equity firm buys it.
If I came to you and said, hey, listen, I have this real estate strategy, I’m just going to buy all the houses that were up the most in the last three months.
You kind of look at me like I was nuts. And so although it’s correlated with good returns in the past, that’s not what I would continue doing even though it’s correlated. I’m looking for causation. That’s where I can put it.
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