Joel Greenblatt: The Magic Formula
There are three main lessons that Greenblatt provides about value investing:
- Value investing works
- Value investing doesn’t work all the time
- Point no. 2 is one of the reasons why point no. 1 is true
Investing in good businesses that are cheaply priced will outperform the market over the longer term. This value edge doesn't go away because the underperformance period can be long and severe enough to discourage investors from sticking to the approach.
Although many managers understand the superiority of value investing, they too face trouble using such an approach because of the shortening time horizons in sustaining unsatisfactory performance. The institutions have become increasingly likely to reclaim investments from below average managers. This means that managers who stick to a value approach tend to lose significant assets at some point. The inability of investors and managers to invest with a long-term horizon establishes the opportunity for time arbitrage. It is an edge in an investing approach that needs the long-term holding commitment periods.
Greenblatt believes the efficient market hypothesis gives an erroneous model of how the market really works. According to him, a more appropriate model is that prices trade around fair value, but broad divergences occur because of large swings in investor sentiments.
He believes that the biggest mistakes investors make while selecting managers is using past performance as the guide. He speaks of practical data demonstrating that there is no meaningful correlation between past and future manager performance. He suggests that managers should be selected on the basis of their investment process and not returns.
Greenblatt believes that stock indexes are a better investment choice than mutual funds because of their lower fees and more tax-efficient structure. Despite these advantages, Greenblatt thinks that most popular stock indexes are structurally flawed.
His Wells Fargo trade demonstrates the concept that options can be underpriced in situations in which the fundamentals command a high chance of a large gain or loss. This means it has a binary outcome scenario. In this trade, it was uncertain whether Wells Fargo would survive a serious real estate downturn. Even if they did, its fee income indicated a far higher price. This binary outlook made a long-term long option position an extremely impressive trade. The broad lesson is that options are mainly priced off of mathematical models that do not consider certain fundamentals.
He advises managers to guard against letting assets size grow to the point where it hinders performance. The first ten years of Gotham Capital exhibit an impressive track record. Greenblatt could have easily grown his fund by multiples, accumulating heavy management fees in the process. Rather, he chose to return all assets to investors to keep the size small enough so that it did not impede the ability to execute the strategy or hamper performance.
