Greenblatt: Patience--the Secret to Value Investing

A.J. Dasaro: Hi, this A.J. Dasaro for Morningstar. Joining me today is Joel Greenblatt, chief investment officer and managing principal of Gotham Asset Management, the successor to Gotham Capital, an investment firm he founded in 1985.

Joel is a professor at Columbia Business School and the author of You Can Be a Stock Market Genius and The Little Book That Beats the Market. Today, he is joining me as the portfolio manager for Gotham's three long/short equity mutual funds.

Joel, thanks for being here today.

Joel Greenblatt: Thanks, A.J.

Dasaro: Joel, you've been a successful value investor, and many other investors have been successful following value strategies. If the secret of value investing is out, and everyone knows that it works, can we expect value investing to work in the future or will it be arbitraged away?

Greenblatt: Well, actually the secret to value investing is patience, and that's generally in short supply now. The reason it doesn't get arbitraged away is that in typical arbitrage, the usual explanation is that you buy gold in New York and simultaneously sell it in London for $1 more. And what tends to happen in typical arbitrage, there are professionals out there who see those price difference, and so they'll keep buying gold in New York and selling it in London until the prices converge. That happens so fast that individual investors certainly can't take advantage of it, a few very quick institutional investors can.

But if I told you as a value investor that you could buy gold in New York today and sometime in the next two or three years, it's likely you'll be able to sell it for a profit, but you may lose 40% while you are waiting around for that to happen, it's much harder to find someone to arbitrage that away. Time horizons are actually shrinking over the last 20-30 years even. So, things are actually getting better for value investors, not worse. The world is becoming more institutionalized, there is more access to performance information, it's much easier to trade. So, patience is in short supply, and it really makes it much nicer for patient value investors.

If value investing worked every day and every month and every year, of course, it would get arbitraged away, but it doesn't. It works over time, and it's quite irregular. But it does still work like clockwork; your clock has to be really slow.

Dasaro: Recently in the investment community, we've seen the rise of fundamentally weighted indexes such as the RAFI Indexes. Is this value investing, and can investors benefit from investing alongside these indexes?

Greenblatt: Sure. The answer is, it is not value investing, yet investors can benefit from the fundamentally weighted indexes. They were developed really because there are some natural problems with market-cap weighting.

In market-cap weighting you are putting more weight into companies with the largest market cap, like the S&P 500 or the Russell 1000. So, when companies are overvalued, and their prices are too high, you are automatically putting too much money into those overpriced companies. If companies are bargain-priced, because you are market cap weighting the prices are too low, you are putting too little in.

So you actually don't have to know for a market-cap weighted index whether a company is overvalued or undervalued; you just know if it is overvalued, you are going to own too much of it, and if it's undervalued, you are going to own too little of it.

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So, over the last 40 years, if you did the studies, instead of making systematic errors, which is what you do in a market-cap weighted index, if you equally weighted the index, you would still make plenty of errors. So, in other words, for the S&P 500, you buy an equal amount of number one, the biggest stock, and number 500. So, you put 0.2% in each. You will still make plenty of errors, you own too much of some and too little of others, but you also own too much of cheap stocks and too little of others. You will randomize your errors. Actually it turns out that over the last 40 years, an equally weighted index would have earned about 2% more per year than a market-cap-weighted index, before your trading cost, and that's an indication of how much the market cap weighted index is costing you.

The problem with equally weighted indexes, however, is that if you have to put the same amount of money in stock number one as number 500, not that many people can do it, because stock number 500 is not that big in market cap. And if a lot of people did indexing, like they do for the S&P 500, it would be very hard to keep them equally weighted. Also, prices change daily, so to keep them equally weighted it depends how much trading you'd have to do to go do that.

So, the RAFI Index, for instance, is a fundamentally weighted index, which resizes companies' portion in the index by their size, not by their market cap, but by how much sales they have, how much book value, how much earnings or cash flow they have on average.

So, there is no price component in what they are doing. It's merely a company size issue. And so that kind of index tends to put more money in higher-market-cap companies, but what they are doing is randomizing the errors that a market-cap-weighted index does.

So, they also make random errors. They also get back the 2%. But because companies with a lot of sales tend to have higher market caps, you can actually invest more money in these kind of indexes than an equally weighted index, so the people at RAFI have figured out a way to do it.

But there's no price component in what they are doing, so they are not actually investing, they are randomizing errors.

Dasaro: Joel, your funds follow a systematic fundamental value weighting strategy. What do investors get when they pay for active management in your funds?

Greenblatt: Well, we do fundamental research bottom-up in our long/short funds of roughly the 2,000, large and mid-cap range, or maybe the 2,000 largest companies, somewhere in that area. And we go through every balance sheet, income statement, and cash flow statement, making our adjustments as to what we think the difference between what their reporting and what economic reality is.

Then, we're ranking companies based on our measures of absolute relative value of companies. I have a partner, Rob Goldstein, who's been with me since 1989, and that's the only way we know how to value companies--measures of absolute and relative value--and we rank them from 1 to 2,000, based on their discount to our assessment of value.

What I promise my students at Columbia the first day of class is that, if they do good valuation work, I guarantee them the market will agree with them. I just don't tell them when. It could be a couple of weeks, could be two or three years. But I tell them, if they do good valuation work, the market will agree with them.

So, we put together portfolios, and we're very patient with them. Out of the 2,000 largest companies, we're generally buying about 300 stocks on the long side and 300 stocks on the short side. We don't equally weight. The cheaper a company is, the more weight we give it in our portfolio. The more expensive it is, the more weight we give it in our short portfolio. But what we're trying to do is buy the cheapest stocks we can find and short the most expensive.

So, we've actually created three long/short mutual funds. One is called Gotham Absolute Return Fund, which runs roughly 120 long, 60 short. We created a fund that's a 100% long, which is roughly 170 long by 70% short. And then we also created Gotham Neutral Fund. But really, we're doing the same thing in all those funds.

We're buying the cheapest stocks we can find; we're shorting the most expensive we can find. We have a lot of diversity. We don't have too much concentration. We balance our risk. So, we're trying to make a smooth ride for investors, so they actually take advantage of the patience of being a value investor, and we're trying to make it that as easy as possible.

Dasaro: With that many holdings, do you find it difficult to value each individual holding, and how do you avoid investing in a value trap or going short a stock that looks overvalued that actually has really good future prospects?

Greenblatt: Well, that's a great question. It took us the last six or seven years to actually research all of these companies and be in a position to update our research on a quarterly basis as new information comes out, or between quarters when that comes out. So, that's been a very, very big project to be able to do that. And like I said, the cheaper something is the more weight we put into it, so we're really taking advantage of the benefit of that research.

Repeat the last part of your question.

Dasaro: How do you avoid investing in stocks where the numbers may disagree with the story behind the stock?

Greenblatt: Oh, value traps, right. Well, we're very tough on cash flows, is what I would say. Ben Graham said, buy cheap. Figure out what something's worth and pay a lot less. And Warren Buffett, Graham's most famous student, made one little twist that made him one of the richest people in the world. And he said, if I can buy a good business cheap, even better.

So, the stocks that we tend to like earn very high returns on tangible capital, and the stocks that we tend to short are high-priced, but they also don't invest their money very well in their own business.

I wrote, The Little Book, as you mentioned, and the example I give in that book of cheap, we know a company that's trading cheaply relative to its cash flows, but then the question is Buffett's part--a good business. If I could buy a good business cheap, even better. And the example I gave was companies that earned high returns on tangible capital.

So, in simplest form, in the book, I talked about when you build a store, you have to buy the land, build the store, set up the display, stock it with inventory, and all that cost you $400,000. If that store earns $200,000 year, that's a 50% return on tangible capital; that's really nice. If you can open new stores and earn 50% a year, there are not many places in the world you can reinvest your money that way.

Then, in the book, I used an example, and I called that Just Broccoli. That's another store. It just sells broccoli--not a very good idea. Unfortunately, you still have to buy the land, build the store, set up the display, stock it with inventory, and all that still costs you $400,000, it's just that selling broccoli in your store is not a very good idea. So, maybe it somehow earns $10,000 a year, that's a 2.5% return on tangible capital.

So, we tend to like those companies that are not only cheap on various metrics of absolute relative value that we use to value them, but they also earn very high returns on capital. In our mutual funds, that we run like hedge funds, are long/short funds. Our longs tend to have right now the returns on tangible capital on average of over 50%, even though the stocks are very cheap. And our shorts earned almost 40% lower returns on tangible capital, and they're very expensive. So, certainly we own cheap and good, and with short, expensive and not nearly as good.

Dasaro: Joel, we appreciate the insights. Thank you for being here.

Greenblatt: Thanks so much, A.J.

Dasaro: For Morningstar, this is A.J. Dasaro, and with me, Joel Greenblatt, manager of the Gotham Funds. Thanks for watching.