Joel Greenblatt is a very successful value investor and the founder of Gotham Capital, which offers four diversified long/short equity mutual funds. He has written several books on value investing identified in the notes below.
1. “One of the greatest stock market writers and thinkers, Benjamin Graham, put it this way. Imagine that you are partners in the ownership of a business with a crazy guy named Mr. Market. Mr. Market is subject to wild mood swings. Each day he offers to buy your share of the business or sell you his share of the business at a particular price. Mr. Market always leaves the decision completely to you, and every day you have three choices. You can sell your shares to Mr. Market at his stated price, you can buy Mr. Market’s shares at that same price, or you can do nothing.
Sometimes Mr. Market is in such a good mood that he names a price that is much higher than the true worth of the business. On those days, it would probably make sense for you to sell Mr. Market your share of the business. On other days, he is in such a poor mood that he names a very low price for the business. On those days, you might want to take advantage of Mr. Market’s crazy offer to sell you shares at such a low price and to buy Mr. Market’s share of the business. If the price named by Mr. Market is neither very high nor extraordinarily low relative to the value of the business, you might very logically choose to do nothing.”
Joel Greenblatt is a genuine Graham value investor. Benjamin Graham’s value investing system has only three essential bedrock principles. The first bedrock principle is: Mr. Market is your servant and not your master. The value investor does not try to predict the timing of stock market prices since that would make Mr. Market your master. The value investor buys at a bargain and waits for the bipolar Mr. Market to inevitably deliver a valuable financial gift to them. This difference transforms Mr. Market into the investor’s servant.
For a value investor, value is determined using methods that produce a fuzzy but very important benchmark, which is called “intrinsic value.” It is perfectly acceptable that the result of an intrinsic valuation is fuzzy and that approaches can vary bit from investor to investor. It is also acceptable that the intrinsic value of some businesses can’t be reliably determined since they can be put in a “too hard” pile to free up time for other things. There are many thousands of other businesses to invest in that are not in the too hard pile. Admitting that the intrinsic value of some businesses can’t be reliably determined is also very hard for some people to accept.
Joel Greenblatt makes a key point here: “Prices fluctuate more than values—so therein lies opportunity. Why do the prices fluctuate so widely when values can’t possibly? I will tell you the answer I have come up with: The answer is I don’t know and I don’t care. We could waste a lot of time about psychology but it always happens and it continues to happen. I just want to take advantage of it. We could sit there and figure it all out, but I like to keep it simple. It happens; it continues to happen; the opportunities are there.
I just want to take advantage of prices away from value.. If you do good valuation work and you are right, Mr. Market will pay you back. In the short term, one to two years, the market is inefficient. But in the long-term, the market has to get it right—it will pay you back in two to three years. Keep that in mind when you do your analysis. You don’t have to look at the next quarter, the next six months, if you do good valuation work—.. Mr. Market will pay you.”
Here again is this idea that predicting that prices will fluctuate, and that eventually they will rise to intrinsic value or above, is not to predict when that will happen. Gotham’s philosophy is: “We believe that although stock prices often react to emotion over the short term, they generally trade toward fair value over the long term. Therefore, if we are good at identifying mispriced businesses (a share of stock represents a percentage ownership stake in a business), the market will agree with us…eventually.”
The Mr. Market metaphor is hard for many people to grasp. For this reason some people are never really comfortable with the value investing system. This is not a tragedy, since value investing is not the only way to invest successfully. There are other successful investing systems. For example, there is factor-based investing, which calls itself value investing, but isn’t Graham value investing. There is also activist investing, which can be combined with value investing. There are other investing systems like merger arbitrage. Benjamin Graham style value investing is not for everyone, but anyone who is an investor can benefit from at least understanding the system.
2. “Buying good businesses at bargain prices is the secret to making lots of money.”
“Graham figured that always using the margin of safety principle when deciding whether to purchase shares of a business from a crazy partner like Mr. Market was the secret to making safe and reliable investment profits.”
“Look down, not up, when making your initial investment decision. If you don’t lose money, most of the remaining alternatives are good ones.”
“We use EBIT–earnings before interest and taxes–and we compare that to enterprise value, which is the market value of a company’s stock plus the long-term debt that a company has. That adjusts for companies that have different ratios of leverage, different tax rates, all those things. But the concept is still the same. We want to get more earnings for the price we’re paying. That was sort of the principles that Benjamin Graham taught, meaning that cheap is good. If you buy cheap, you leave yourself a large margin of safety. Warren Buffett had a twist on that and said, ‘Gee, it’s nice to buy cheap things but I also like to buy good businesses.’
So if I could buy good businesses at a cheap price, it’s better than just cheap… We rank all companies based on their return on capital and we also rank all companies based on how cheaply we can buy them relative to their earnings. The more earnings, the better. Then we combine those rankings. And the companies that have the best combination of that ranking go to the top. So we’re not looking for the cheapest company. We’re not looking for the highest return-on-capital company. We’re looking for the companies that have the best combinations of those two attributes.”
The second bedrock principle of Benjamin Graham’s value investing system is that assets should only be purchased when the price of the asset creates enough of a bargain that it providers the buyers with a “margin of safety.” What Joel Greenblatt means when he says “look down” is that you should think about Warren Buffett’s first and second rules on investing: don’t lose money and don’t lose money. The right amount of margin of safety will vary based on the investor involved, but it should be large enough to cover any mistakes. One common margin of safety is 25%. The margin of safety for a company for which intrinsic value can actually be calculated (i.e. not in the “too hard” pile) should be so big that a really smart person can do the valuation in their head.
In the quotes above Joel Greenblatt describes how it is possible for value investing to evolve over time, as long as the three bedrock principles stay the same. Charlie Munger convinced Warren Buffett that quality (a good business) when combined with a bargain price was even better than just a business bought at a bargain price. Value investors like Greenblatt spend a lot of time thinking about Return on Equity and Return on Capital. These are the concepts that allow them to differentiate the earnings power of one company versus another. Determining value by only a database screen that sorts based on book value and price tells you nothing about the quality of the earnings power of a business.
3. “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”
“Most people don’t (and shouldn’t) invest by buying stocks and holding them for only one month. Besides the huge amount of time, transaction costs, and tax expenses involved, this is essentially a trading strategy, not really a practical long-term investment strategy.”
The third bedrock principle of Ben Graham value investing system is that a security is an ownership interest in an actual business rather than a piece of paper to be traded based on person’s view about the views of other people, about the views of other people [repeat]. To value a stock, a value investor must understand the underlying business. This process involves understanding the fundamentals of the business and doing some relatively simple math related to the performance of the business.
“A number of years ago I was trying to explain to my son what I did for a living. He is 11 years old. I spoke about selling gum. Jason, a boy in my son’s class, sold gum each day at school. He would buy a pack of gum for 25 cents and he would sell sticks of gum for 25 cents each. He sells 4 packs a day, 5 days a week, 36 weeks or about $4,000 a year. What if Jason offered to sell you half the business today? What would you pay?
My son replied, ‘Well, he may only sell three packs a day so he would make $3000 a year.’ Would you pay $1,500 now? ‘Why would I do that if I have to wait several years for the $1,500?’ Would you pay a $1? ‘Yes, of course! But not $1,500. I would pay $450 now to collect $1,500 over the next few years, which would be fair.’
Now, you understand what I do for a living, I told my son.”
Joel Greenblatt is not thinking in all of this: “I think others will pay me more than $X for this business”, because that is trying to predict the psychology of potential buyers. Warren Buffett once described the stock market as a “drunken psycho.” The financier Bernard Baruch similarly said once that “the main purpose of the stock market was to make fools of as many people as possible.” Emotions and psychological errors are the enemy of the value investor. Graham Value investors stay focused on the value of the business and only look at the stock market when they may want to have it be their servant.
4. “Periods of underperformance [make Graham Value Investing] difficult – and, for some professionals, impractical to implement.”
“Over the long term, despite significant drops from time to time, stocks (especially an intelligently selected stock portfolio) will be one of your best investment options. The trick is to GET to the long term. Think in terms of 5 years, 10 years and longer. Do your planning and asset allocation ahead of time. Choose a portion of your assets to invest in the stock market – and stick with it! Yes, the bad times will come, but over the truly long term, the good times will win out – and I hope the lessons from 2008 will help get you there to enjoy them.”
The Ben Graham value investing system is designed to underperform during a bull market and outperform doing falling and flat markets. This is very hard for many people to handle so they are not candidates to be successful value investors. Seth Klarman, who is one of the very best value investors, writes: “Short–term underperformance doesn’t trouble us; indeed, because it is the price that must sometimes be paid for longer-term outperformance.” Few investors have the fortitude to endure this period of underperformance referred to by Joel Greenblatt. Investment managers with a Graham value investing style work hard to attract the right sort of shareholders who won’t panic and ask to redeem their interest in a fund at the worst possible time. Value investors who manage funds typically spend a lot of time trying to educate their limited partners about how value investing works.
Warren Buffett has created the better solution in that the structure of Berkshire does not allow redemptions by limited partners. Berkshire investors can sell their shares to someone else but they cannot ask for their ownership interest to be redeemed for cash. Bruce Berkowitz said once about Berkshire Hathaway: “That is the secret sauce: permanent capital. That is essential. I think that’s the reason Buffett gave up his partnership. You need it, because when push comes to shove, people run … That’s why we keep a lot of cash around…. Cash is the equivalent of financial Valium. It keeps you cool, calm and collected.”
5. “Companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits.”
Benjamin Graham style value investors who have evolved their value investing system to include an optional quality dimension understand that a moat is necessary to maintain high returns on capital. To understand moats I suggest that you read this essay (the 2013 updated version especially) and even if you have read it already I suggest you read it again. The concept of a moat is the same concept that individuals like Michael Porter talk about when they refer to a barrier to entry or sustainable competitive advantage. If you do not have a moat, the supply of what you sell inevitably increases to a point where the price of your product drops to a point where there is no long term industry profit above the cost of capital of the business. Increased supply from competitors is a killer of value for a producer of goods and services. A moat is something that puts limits on that supply and therefore makes a business more valuable. Moats, like people, come in all shapes and sizes. Some moats are strong and some moats are weak. Some moats protect things that are very profitable and some don’t.
6. “You have to know what you know—Your Circle of Competence.”
People get into trouble as investors when they do not know what they are doing. This idea is not rocket science and yet people ignore it all the time. This is true whether the situation involves any combination of risk, uncertainty or ignorance. There are a number of behavioral biases that contribution to this problem including overconfidence bias, over optimism bias, hindsight bias and the illusion of control. The right approach for an investor is to find areas in which you are competent. Charlie Munger puts it this way: “Warren and I only look at industries and companies which we have a core competency in. Every person has to do the same thing. You have a limited amount of time and talent, and you have to allocate it smartly.”
The idea behind the Circle of Competence filter is so simple it is embarrassing to say it out loud: when you do not know what you are doing, it is riskier than when you do know what you are doing. What could be simpler? And yet humans often don’t do this. For example, the otherwise smart doctor or dentist is easy prey for the promoter selling cattle limited partnerships or securities in a company that makes technology for the petroleum industry. Really smart people fall prey to this problem. As another example, if you lived through the first Internet bubble like I did you saw literally insane behavior from people who were highly intelligent.
7. “Remember, it’s the quality of your ideas not the quantity that will result in the big money.”
Value investors understand that investment outcomes are determined by magnitude of success rather than frequency of success. This is the so-called Babe Ruth effect. This is one of the greatest essays on this investing principle ever written. Fail to read it at your peril. Michael Mauboussin writes: “being right frequently is not necessarily consistent with an investment portfolio that outperforms its benchmark…The percentage of stocks that go up in a portfolio does not determine its performance, it is the dollar change in the portfolio. A few stocks going up or down dramatically will often have a much greater impact on portfolio performance than the batting average.” Venture capital returns are especially driven by the Babe Ruth effect.
8. There is no sense diluting your best ideas or favorite situations by continuing to work your way down a list of attractive opportunities.”
The best investors who “know what they are doing” understand that investing decisions should be made based on an opportunity-cost analysis. And some investors, as a result, decide to concentrate their investments rather than diversify. Charlie Munger has his own take on this same idea: “Everything is based on opportunity costs. Academia has done a terrible disservice: they teach in one sentence in first-year economics about opportunity costs, but that’s it. In life, if opportunity A is better than B, and you have only one opportunity, you do A. There’s no one-size-fits-all. If you’re really wise and fortunate, you get to be like Berkshire. We have high opportunity costs. We always have something we like and can buy more of, so that’s what we compare everything to.”
Seth Klarman makes a point here that is similar to the one he made above: “Concentrating your portfolio in the most compelling opportunities and avoiding over diversification for its own sake may sometimes lead to short-term underperformance, but eventually it pays off in outperformance.” Having said this, Greenblatt has moved to a more diversified approach. Gotham’s web site explains: “Our stock positions, which generally include over 300 names on both the long and short sides, are not equally weighted. Generally, the cheaper a company appears to us, the larger allocation it receives on the long side. On the short side, the more expensive a company appears relative to our assessment of value, the larger short allocation it receives. We manage our risks by requiring substantial portfolio diversification, setting maximum limits for sector concentration and maintaining overall gross and net exposures within carefully defined ranges.”
Greenblatt explains his views on diversification in a recent interview with Consuelo Mack. My take on his view (starts at about minute 14:30): what comes with a concentrated portfolio, is outside investors in the fund who lose patience and leave the fund when there is a period of underperformance. If you are investing your own money and have the patience, concentration can work better. He now more focused on being “right on average” for outside investors instead of concentrated investing in about eight stocks.
9. “Even finding one good opportunity a month is far more than you should need or want.”
Fundamental to value investing is the idea that mispriced securities and other assets which fall within your circle of competence are rarely available to purchase at a price which reflects a margin of safety. For this reason, value investors are patient and yet aggressive, ready to act quickly whenever the opportunity is presented. Most of the time the value investor does nothing but read, think, and research businesses and industries. Actual buying and selling of securities and other assets happens rarely. Warren Buffett has a few thoughts on this point which are set out below:
- “You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.”
- “We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.”
- “I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”
- “The stock market is a no-called-strike game. You don’t have to swing at everything–you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, ‘Swing, you bum!’”
- “One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as`marketability’ and `liquidity,” sing the praises of companies with high share turnover… but investors should understand that what is good for the croupier is not good for the customer. A hyperactive stock market is the pick pocket of enterprise.”
10. “If you are going to be a very concentrated investor, you should not use leverage. You can’t leverage because you need to live through the downturns and that is incredibly important.”
Being a successful value investor requires that you have staying power. When you use financial leverage your mistakes are as just as magnified as your successes, and those mistakes can be big enough to make you a non-investor since you may have no longer have funds to invest. Don’t just take it from me. Please listen to these three investors. First, Charlie Munger: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” Second, James Montier: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad. When you are leveraged you can run into volatility, that impairs your ability to stay in an investment which can result in a permanent loss of capital.” Third, Howard Marks: “Leverage magnifies outcomes, but doesn’t add value.”
11. “The odds of anyone calling you on the phone with good investment advice are about the same as winning the Lotto without buying a ticket.”
To be a successful value investor of any kind requires actual work. And since work is necessarily involved, many people will try to avoid it, since that is human nature. Relying on people who call you on the phone with investment advice to avoid work, doesn’t, ahem, work. One way to avoid some of the work is to rely on others, but finding reliable and skilled people to rely on requires work too. Taking the time and devoting the time necessary to get sound financial advice will pay big dividends. This topic reminds me of a man I know who once pleaded with his doctor: “You have to help me stop talking to myself.” The doctor asked: “Why is that?” The man responded: “I’m a salesman and I keep selling myself things I don’t want.”
12. “Almost everyone should have a significant portion of their assets in stocks. But here it comes – few people should put ALL their money in stocks. Whether you choose to place 90% of your assets or 40% of your assets in stocks should be based largely on how much pain you can take on the downside.”
Joel Greenblatt is talking about the “asset allocation” set of issues, which present a number of choices that both active and index investors must face. Stock prices can drop by a lot, and that and that can cause people to panic. Charlie Munger points out: “You can argue that if you’re not willing to react with equanimity to a market price decline of fifty percent two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result that you’re going to get.”
The best way to acquire good judgment so that you don’t panic is to read widely so you are prepared for this sort of result. Unfortunately, many people only learn these lessons by panicking and then missing a subsequent stock market rally while they sit in an emotional foxhole too terrified to participate in stock or bond markets. Unfortunately, many people learn about this so-called behavior gap by actually touching a hot stove. Some people learn the lesson and others never recover fully.