“The Big Secret for the Small Investor”, by Joel Greenblatt

secret

I recently completed The Big Secret for the Small Investor by Joel Greenblatt. I’ve read all of Joel Greenblatt’s books and this is his easiest strategy to implement for the average investor. What’s the big secret and who is Joel Greenblatt?

Who is Joel Greenblatt?

Joel Greenblatt, as I’ve discussed before on this blog, is one of the greatest investors of all time. In terms of investing prowess, Joel delivered 50% returns from 1985 to 1995, at which point he returned all outside capital to his investors and focused on managing his own money with his parter, Robert Goldstein. What do 50% returns look like?  $1 was turned into $51.97 over the 10 year period.performancejoel

Source: You Can be a Stock Market Genius, by Joel Greenblatt

Joel Greenblatt’s Previous Books

In addition to achieving stellar returns, Joel has done small investors numerous favors by outlining the strategies that he uses to make money in his books. Most investors like Joel are highly secretive with their strategies, but Joel has been generous enough to share the strategies that he uses, at least on a very high level. His first two books briefly summarized below:

  1. You Can Be a Stock Market Genius – Written in 1997, this book provides a nice road-map to places in the market that the average investor can investigate to find bargains. They are areas where the large professionals won’t tread due to size, complexity and opportunity cost. This is the approach that Greenblatt used to achieve the 50% returns from 1985 to 1995 described above. Joel encourages readers to look into these areas of the market where the professionals fear to tread. He encourages finding things that are off the beaten path and doing your homework. Areas covered include: spin-offs, recapitalizations, rights offerings, risk arbitrage, merger securities, bankruptcies, restructurings, LEAPs, warrants and options. This is by far the most informative of Joel’s books, but it is also the most difficult to implement. It is geared towards investors who already have a familiarity with the markets and want a road-map to the roads less traveled. At some point, I will review this book in depth on this blog.
  2. The Little Book That Beats the Market – This was written in 2005. Realizing that his original book was at too high of a difficulty level for the average investor, Joel formulated a more simple approach in this book. The little book outlines the magic formula strategy of investing. The magic formula ranks all companies in the market by cheapness (defined as EBIT/Enterprise Value) and then ranks all the companies by quality, or return on invested capital. The rankings are then combined into a list of companies that are both cheap and have high returns on capital. Joel recommends that readers buy 20-30 magic formula stocks annually and then sell after a year unless the stock is still on the list. The book was written so he could explain investing to his kids. As a result, it distills the concepts of value investing in a manner that is very readable. I find it incredible that Joel shared this research with the public. He even generously maintains a free screener at https://www.magicformulainvesting.com/

Why Write the Big Secret?

The Little Book was a best seller and the magic formula was sensational. The magic formula continued to beat the market after the book was written. If Joel outlined a winning strategy that could be easily implemented by small investors and provided them with the tools for doing so, what was the point of another book? The problem wasn’t the magic formula. The problem was human investors.

While the magic formula continued to work after Joel wrote the book, investors implementing the formula failed to achieve the results. During the two-year period studied by Greenblatt, the S&P 500 was up 62%. The magic formula beat the market during this period, earning 84%. However, actual investors choosing from the list of magic formula stocks only earned 59.4%.

In other words, investors took a winning strategy and systematically ruined it. This is likely because they avoided the scariest stocks on the list and went with the ones that had the best story.

If most investors can’t successfully implement the magic formula, should they simply passively index?

Indexing

Index investing works over long periods of time because over the decades the economy will grow, inflation will increase and the combination of economic growth and inflation will translate into higher corporate profits, which will translate into higher stock prices. Index funds are also extremely low cost.

Warren Buffett is in the final stages of a high profile bet with Ted Seides about indexing. In 2008, Buffett bet Ted $1 million (with the proceeds going to charity) that index funds would beat a group of hedge fund investment vehicles (fund-of-funds) hand picked by Ted. It looks like Buffett will handily win the bet. In Berkshire’s most recent letter, Buffett explains why he won. To sum it up: a lot of managers try to beat the market, and mathematically some will beat it and most won’t. The indexes reflect average performance, and mathematically a majority of managers can’t do better than average. Because hedge funds charge such high fees (typically 2% of assets under management and 20% of the profits), it will be nearly impossible for a group of them to beat the market.

Ted Seides tried to explain the reasons for his loss in this Bloomberg article. Reasons cited include: most investors didn’t stick with the index, there are many nuances to the returns of hedge funds, they provide protection during bear markets, etc. To save you the time from reading through the litany of excuses, I’ll leave you with this Upton Sinclair quote:

“It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

What is The Big Secret?

The Big Secret that Joel unveils in this book is simple: index investing works, but it is flawed and there are better passive strategies that can help investors do even better than indexing.

Indexing will deliver returns over the long run and will beat most active managers. I index myself in my 401(k). The portfolio I track here is my IRA that I have specifically dedicated to a concentrated hand picked value strategy.

However, Joel argues in The Big Secret that even though indexes deliver decent returns over long (i.e., 10-40 year) stretches of time, they are fundamentally flawed. The flaw as Greenblatt sees it is the fact that they are market cap weighted. The allocation of a stock in an index fund corresponds to the total market cap of the stock in relation to other companies in the index. In other words, stocks in an index fund are all weighted to the current relative valuations of the companies that make up an index. In other words, when a stock goes up in an index, the index buys more of it. If a stock goes down, it is weighted less heavily in the index. From a value perspective, this is the wrong approach.

This also explains the momentum that we see in the late stages of a bull market. As the indexes have a nice run, money pours into index funds. Money then flows to the largest components of the index, inflating their valuations even more. You see this happening today and you saw the same thing in the late 1990s. The irony is that the more we embrace indexing to capture average performance, then the less efficient the markets become. This isn’t a bad thing. It is an opportunity.

The opposite of this occurred in 2008. All stocks declined regardless of the prospects for the company. This was because money was pulled from stock funds with no rhyme or reason, causing all stocks to decline.

These trends go on until they can’t. Eventually the market recognizes the true value of companies. In the short run, massive money flows into and out of index funds can cause inefficiencies. As Benjamin Graham taught us, in the short run the market is a voting machine. In the long run, it is a weighing machine.

Seth Klarman discussed this phenomenon in his recent investor letter:

“One of the perverse effects of increased indexing and E.T.F. activity is that it will tend to ‘lock in’ today’s relative valuations between securities.

When money flows into an index fund or index-related ETF, the manager generally buys into the securities in an index in proportion to their current market capitalization (often to the capitalization of only their public float, which interestingly adds a layer of distortion, disfavoring companies with large insider, strategic, or state ownership).

Thus today’s high-multiple companies are likely to also be tomorrow’s, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings.”

Passive Alternatives to Indexing

If the Stock Market Genius approach is too hard for most, if most investors struggle with the Magic Formula approach due to behavioral errors and passive indexing systematically does the wrong thing — then what can the small investor do?

Due to these issues, in The Big Secret Joel recommends a few passive choices that investors can implement. The passive aspect is key, as all of these approaches avoid buying and selling individual stocks and don’t require any homework.

The passive choices Joel recommends as alternatives to indexing are:

  1. Equally weighted index funds. While most index funds are market-cap weighted, equally weighted funds are exactly as they sound. They buy every stock in the index, but equally weight them. This prevents the fund for systematically buying more of a “hot” stock that is likely overvalued. An example of this kind of fund is the Guggenheim Equal Weight ETF (RSP). In the last 10 years, the S&P 500 returned 58.75%. Over the same period, the Guggenheim equal weight S&P 500 ETF is up 77.11%.
  2. Fundamentally weighted index funds. A fundamental index weights stocks not on market capitalization, but on the size of their business. This can be measured by revenues or earnings. This makes sense, because the size of an enterprise is a better determinant of its true value than simple market cap. It also helps investors avoid the hot stocks of the moment with high market caps while simultaneously having low sales or earnings (like Tesla, for instance). An example of this kind of fund is the Revenue Shares Large Cap ETF (RWL), which weights stocks in the fund based on their revenues instead of market cap. This fund returned 85.12% over the last 10 years, compared to 58.75% for the S&P 500.
  3. Value weighted index funds. Value funds are exactly as they sound: they concentrate the fund’s holdings into the cheapest stocks in the market based on metrics like price-to-book and price-to-earnings. While over the long run these strategies have been proven to work, in the last 10 years they’ve had a tough time. The Vanguard Value ETF (VTV) is up on 30.63% in the last 10 years compared to 58.75% for the S&P 500. Much of the underperformance is attributable to concentration in bank stocks during the financial crisis (they appeared to have low price to book values, but the book value turned out to be fiction) along with lagging the momentum of the market in the last few years. This isn’t the first time that value lagged the S&P. The last time that value strategies experienced this kind of under-performance was in the 1990s. Value went on to perform extremely well in the 2000s, while the indexes lagged due to the high market cap weightings in the technology sector early in the decade. I think history will likely repeat. Another great example of a value oriented ETF is the quantitative value ETF. QVAL implements the strategy outlined by Tobias Carisle and Wesley Grey in their book Quantitative Value. They use quantitative approaches to find value bargains (using the enterprise multiple as the value metric) and then further trim down the list to eliminate potential financial fraud, avoiding stocks with excessive short selling, for instance, and use a variety of quantitative criteria to find quality bargain stocks. QVAL launched in 2014, so it doesn’t have a long enough track record to compare it with the S&P 500, but it is worth your consideration. I would check out the book if you want to learn more.

Conclusions

Joel did small investors a great service by writing this book. I suspect that the passive strategies outlined will outperform indexes over the long run. They are much easier to implement than the magic formula or the homework intensive You Can Be a Stock Market Genius style of investing. Simply buy the funds and leave it alone.

I prefer my own strategy of individual stock selection, but I realize that this is not implementable for most investors. While I think it’s fun, it is a lot of work and most people don’t find it to be all that enjoyable.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

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