Distinguished Speaker Series: Joel Greenblatt

hi I'm Jeremy here the co-chair of the distinguished speaker series advisory group of the CFA Society of Chicago and today I'm here to introduce our guest speaker Joel Greenblatt Joel services managing principal and Co chief investment officer of Gotham asset management since 1996 he has been a professor on the edge UNK faculty of Columbia Business School where he teaches value and special situation investing he's also a director at Vezina investment management which is a global investment management firm Joel's the author of several books including you can be a stock market genius the little book that beats the market the little book that still beats the market and the big secret for the small investor joel is the former chairman of the board of Alliant Techsystems and NYS he listed aerospace and defense contractor he received his bachelor's and his MBA from the Wharton School at the University of Pennsylvania please help me welcome Joel Greenblatt [Applause] thanks very much can you guys hear me good so I really sent this title in to my head of sales as a joke but and he took me seriously because he knows I'm a jet fan I'm a Mets fan I am a Knicks fan and even Warren Buffett says that most people should just index and I'm a value investor so I guess the question could read should I kill myself and I I I'm really at least in the next few years don't have a lot of hope for my sports teams but whether value investing is dead or not is another question and the answer that you expect me to say is no and I'm gonna say that I'm also gonna say it might be I'm also gonna say I don't know and I'm finally gonna say I don't care so I think I cover everything there before I get there let's talk about the sp500 so the market fell yesterday and we value businesses and I'll explain briefly how we go about valuing businesses but we value all the stocks in the S&P 500 and we've done that every day since we have good data going back to 1990 weighting it according to the S&P 500 and what that lets us do is a contextualize where do we stand today on a valuation basis versus the last 28 years and the answer to that question according to the way we value companies and and I'll go through that briefly is we're in the 25th percentile after yesterday towards expensive meaning the markets been cheaper 75% of the time over the last 28 years and it's been cheaper 25% of the time the Russell 2000 a a little different story that's in the seventh percentile been cheaper ninety-three percent of the time over the last twenty eight years and when it's been here in the past year Ford returns have averaged about flat for the SP which is in the twenty-fifth percentile average would be turns from its other predictions just saying what's happened from this valuation level in the past year Ford returns of average five to seven percent and two year Ford turns twelve to fourteen so that's where we are so sub normal for the SP sub normal returns but not negative the market average nine to ten percent returns during that period so still positive returns and we don't have to get back to those nine or ten percent expected returns but a few ways we could get back to that is if the market would have fall 17 or 18 percent tomorrow then going forward our expected returns would get closer to nine or ten percent but that doesn't have to happen the market could just under earn sub normal returns four to five percent in each of the next three years and three years from now if we had a normal trajectory of earnings we would also get pretty close back to that nine or ten percent expected return so I don't know if you call that valueless but it gives you context you know well it's valueless as to what's gonna happen tomorrow or next month but I think to give you context of where markets are right now it is helpful to us as far as value is concerned according to Russell data value investing did quite well for a long period of time 1980 to 2006 that outperformed the market by about two percent a year since then last twelve years growth has outperformed the market by about five percent a year hence the question sort of you know or at least the worry that value investing is dead and if you looked at the first nine months of this year Russell has an index called a pure value which really takes the four hundred stocks in the Russell 1000 that are closest to value that was up 1.7 percent for the first nine months the Russell pure growth that was up 28.6 so underperforming once again continuing and why some value investors at least it it's corrected a little bit since then but still that dichotomy has been going a long time and they just put a little another nudge into the value vesting world during the first nine months why so it looks like value investing might be dead on the other hand what is value investing Russell defines it amongst other things and Morningstar would define it as low price book low price sales investing to us and and and the answer is if you're talking about well low price book low price sales investing comeback the answer is I don't know okay I usually use the the concept of momentum these are things that have worked in the past another thing that's worked well in the past is something like momentum and it's very clear a lot of research studies that Momentum's worked very well for the last 3040 years and not just in this country but across the globe with one or two exceptions Momentum's worked really well my problem with it is that if it did not work for the next two years it could be that momentum is just cyclically out of favor and all we have to do is be patient and it works over the long term it's cyclical and it didn't work for the next two years but that's fine stick to what it works over the long term plenty plenty of evidence that that has been so but the other choice if it doesn't work for the next two years is that there is more data ability to crunch numbers computer smart people not so hard to figure out a stock used to be down here and now it's up here it's got good momentum and the trade over the next two years has become crowded and the returns have been degraded and that's why it didn't work over the next two years and two years from now I won't know the answer to that question whether it's just cyclical momentum works over the long term it's cyclical you out of favor or the trade is crowded and degrade it I feel the same way about low price book low price sales investing why does a company trade close to the historic cost of its assets well people aren't giving much of a premium for the actual underlying business that's clear it's likely if you bought a bucket a company selling closer to their book value you will get a more than your fair share companies that are out of favor you know people don't like or aren't valuing the business very highly and I believe that's why it's tended to work over a long periods of time before the most recent pass but once again like momentum it is a correlation with something that's worked well in the past I think it worked well because low price book low price sales investing has correlated with getting more than your fair share of attica favorite companies and if you ask me whether it's going to continue to work I say maybe I'd say possibly likely but I'd mostly say I don't care once again momentum low price book low price sales all these kind of factors that have become popular with people at different investment styles are correlations with what's worked well in the past and might indicate that you're getting more than your fair share of a type of company my first day of class I've taught at Columbia for the last 23 years and my first day of class I promised to my students that if they do good valuation work the market will agree with them I just never tell them when could be a couple weeks could be two or three years but if they do good valuation work the market will agree the market will agree with them stocks are not stocks are ownership shares of businesses that we value and try to buy it a discount they are not pieces of paper that bounce around that we put Sharpe ratios and Sortino Zahn big difference so it is possible that if we're good at doing valuations on businesses the market will will not reward us over the next couple of years but that doesn't mean we're gonna stop doing what we're doing that's what knocks our ownership tiers of businesses and so that is actually causation we're like private equity investors when we think about stocks we're buying the whole business like most investors would and so I don't know about value investing is defined by Morningstar Russell may go in and out of favor or may stop working I don't know but valuation investing that's what stocks are ownership shares of businesses so as Warren Buffett would say value and growth are tied at the hip growth is a portion of how you value something so I think that whole discussion as bad as the statistics are they're not very meaningful to me when I think about being a value investor so let me turn this thing on so let me talk about how we go about valuing businesses and the analogy I usually use that works with most people's let's say you're buying a house and they're asking a million dollars for the house and your job is to figure out whether it's a good deal or not pretty straightforward there are certain simple questions that you would ask to determine whether that's a good deal or not one question you might ask is you know if I rented out this house and none of my expenses you know how much would I get for it and if I could get 70 or 80 $90,000 a year net of my expenses for that million dollar house in a 3% interest rate environment that's seven or eight or nine percent free cash flow yield on the house might indicate that in mine might be you know priced well what's another question I might ask if I were trying to figure out if that's a good deal or not pretty simple question I pretty much know what you'd ask next what are the other houses on the block going for the block next door and the town next door how relatively cheap is this relative to other similar houses and that's what we do by the way we say how cheap is this company relative to other similar companies let's say in the same industry how cheap is this company versus all my choices a company how how cheap is this being priced now in a cash flow basis relative to all my current choices we also have another measure of relative value that we look at and we go back in history and we see how the market has traditionally valued this business versus other businesses and how its valuing it today just another measure of relative value simple way to think about that is if a company has traditionally been premium priced and today it's available at an average price relative to the market it's cheaper than it's traditionally been on this particular measure of relative value would get a good grade if a company has traditionally been bargain priced relative to the market today it's available in an average price more expensive than it's traditionally been on this particular measure of relative value would get a bad grade from us we would never use any measure of relative value all by itself right you can end up owning the cheapest internet stock at the top of a bubble but we use our measures of absolutely cheap on a free cash flow basis how much rent could I get for it relatively cheap to similar companies relatively cheap to all companies relatively chipped it cheap to history as checks and balances against each other and I have a chart that either I turned it off or wrong there it is I only have one slide that was not very Swift anyway so this is a study we did following the criteria I just laid out valuing businesses just like you'd value a house right how absolutely cheap is it how relatively cheap is it in different ways this is a study of the from 1992 to 2012 20-year study we just updated it for the last five years looks the same this is a 20-year study of the 2000 largest companies in the US where we value them from 1 to 2000 along the lines that I just told you with those measures of absolute relative value the x-axis is the valuation percentile all this means is a viewer in the bottom left-hand corner over there in the first percentile you would be the 20 companies that measure cheapest according to those measures of absolute and relative value that I just discussed out of the 2000 largest you're the 20 cheapest you're in the first percentile now the values of businesses don't change daily but prices do so we re ranked daily in that 1% is continually updated if you fell in the 99th percentile that would mean that you were the 20 companies at any particular time that measured most expensive out of the 2,000 largest in the United States pretty straightforward more important is the y axis the y axis is the year forward return on average first stocks in each percentile so with this short literally says is if you fell in the first percentile those stocks in the first percentile averaged a 1-year forward return of 38 percent over the next year remember the stocks are constantly updated stocks that fell in our second percentile only the second percentile stocks average a 1-year forward return of 37 percent then we dropped down to the best-fit line which I always say I don't mind missing when we're making extra money and as we measure something more expensive and the percentile drops the year forward return drops and it's pretty linear and if we had missed so badly in percentile one and two and I move those down to the best-fit line that fits about 0.9 percent so if you were sitting in my class at Columbia and I said does anyone see a long short strategy then you might pursue if you could predict ahead of time which stocks would do best second best third best in order and you did not say I guess I'd buy a bunch of stocks up here and short a bunch of stocks down here if you didn't say that I would have to throw you out of class because it's pretty straightforward that's what you should do and by the way that's what we do so this is a bunch of professional analysts and if you're a professional analysts you would look at that chart and say something's very very wrong that's way too good point nine percent and by the way all the metrics I gave you about absolutely cheap relatively cheap everything else backward looking no predictions involved got a 90% fit so why if it's so simple and I just laid it out for you is it so hard to do well the answer is that this is an average over 20 years if what we did and if we did it this way and it looked like this every day and every month and every year and it worked in order like this everyone would do this it doesn't look like this when you're living through it it's quite noisy if I gave you a 2 or 3 or snippet within those 20 years the fit would be nice it would kind of rhyme a little bit with this but it would be like point five five point six it wouldn't be 0.9 right it doesn't work every day in every month and every year but what this chart would tell me is as opposed to a momentum or low price book investing or who knows you know whether we'll continue to work you know the way you would value a house the way you would value any earning asset we can't value Bitcoin okay or gold for that matter but if we have an earning asset or an asset that we expect to have earnings we can perhaps value it and those very simple measures are approximately how the market values those companies over time especially if you buy a bucket of them you'll be right on average and if it's not working in the short-term should we stick to our guns this chart would say yes ok we have to balance our risks we have to do a lot of things but we should stick to our guns valuation is like gravity is is the best way I would put it so you know I have a friend who's an orthopedic surgeon and I he's head of this group of orthopedic surgeons and they have a big dinner every year and you know for whatever reasons he asked me to give a talk about investing for about a half an hour to the learning doctors in the room and take some questions so I gave explained how the stock market worked for about a half an hour and then I said you know any questions first question was market was down 2% yesterday should I get out the second question was oil was up 1% yesterday should I get in my conclusion from those questions was that I had just crashed and burned and they didn't understand anything I had just said about the stock market and I don't know about luckily but a few days later I got asked to teach a ninth grade class all the kids were from Harlem in investing class once a week for an hour teach them about investing and you know these doctors had a lot of degrees and they had to be really smart to get there they were all surgeons and you know pretty successful guys and women but now is asked to teach ninth graders who had no money or interest or background and no degrees yet and I had failed with the doctors so I said yes anyway and I thought I had a few weeks to prepare for the first class and I didn't want to fail with the kids so I thought about it and I walked in the first day of class with a big jar of jellybeans and one of those old-time glass jars and I passed the jar of jellybeans around the room and I passed out three by five cards and I told the kids to count the rows do whatever they had to do write down how many jellybeans do you think are in the jar and so they passed the jellybeans around they did their counting or whatever they were gonna do they wrote down I collected the three by five cards then I went one by one around the room and I said tell me how many jellybeans do you think are in the jar and you can keep your original guest you can change your guest that's completely up to you and I won't one by one around the room and said how many jellybeans are in the jar and I wrote down those answers so here are the results of that test when I averaged the guesses from the three by five cards the average guest was seventeen hundred and seventy one jellybeans and there were seventeen hundred and seventy-six jelly beans in the jar so that was pretty good when I went around the room one by one and asked them that guess averaged to 850 jellybeans and I told the kids that the stock market was actually the second guess okay because everyone knows what they just heard what they just watched what they just read who they just talked to they're influenced by everything around them and they didn't make a very good guess when they were cold and calculating and independent okay their guests turned out to be much better so I think of ourselves as cold hearted jelly bean counters when we're trying to value businesses and trying to you know cover our ears and close our eyes and try to figure out valuation without being influenced by things around us what are the ways to do that is to use trailing numbers rather than our own projections it turns out to work better and that's you know very much how the stock market works and how you can go about beating the market but then again I opened them and I said you know even Warren Buffett you know I give a speech of Google a little less than two years ago and I sorted it this way I said even Warren Buffett said that most people should just index and then I said I agree with him and then I left but then I said you know Warren Buffett doesn't index and neither do I how come okay and the same type of question I get every year when I'm in class at least for the last six or seven years someone raises their hand at Columbia and says you know hey congratulations professor Greenblatt on a nice 37-year career or whatever it's been a great job but you know now there are more hedge fund manners there's more hedge fund managers there's more computers there's more analysts there's more ability to crunch numbers there's plenty of evidence to show that active managers don't really add value over time you know more or less the nature of the question is isn't the party over for us you know it's just so much harder now than when you start it out so my students are second year MBA ice rough lis 27 years old on average and so what I say to them is ok I'll tell you what why don't we go back you know 20 years when you guys learned how to read ok let's take a look at the most followed market in the world that would be the United States let's look at the most followed stocks within the most followed market in the world that would be the S&P 500 stocks and let's take a look at what's happened since you guys learned how to read 20 years ago and I tell them from 1997 to 2000 the S&P 500 doubled from 2000 a 2002 had halved from 2002 to 2007 it doubled from 2007 to 2009 in halves and from 2009 to today it's more than tripled which is my way of telling them that people are still crazy and also way understating the case because the S&P 500 is an average of 500 stocks if you lift up the covers and look at the dispersion going on amongst those 500 stocks between which are in favor at any particular time and which are out of favor and how often that changes that doubling halving doubling halving doubling halving of an average of 500 stocks is really smoothing the ride under the covers it's is really pretty crazy so if you believe what Ben Graham said that this horizontal line is fair value and this wavy line around that horizontal line or stock prices and you have a discipline jelly bean counting way of valuing businesses you know and buying them when they're far enough below that horizontal line and if you're so inclined to sell or sell short stocks when they're above the law and the markets throwing us pitches all the time okay the reason active managers don't outperform we know a lot of them they're behavioural their agency problems I said on a lot of big investment boards and while everyone is patient you know they're run by people those people have three-year benchmarks and you know if someone's charged US equities so they're in charge of real estate they're in charge of private equity or whatever they have a three-year benchmark and I'm not saying the good places throw you out of there when you didn't beat the benchmark I'm just saying they don't throw your parade when you didn't beat the benchmark and there's an agency problem and it's not going away good news for value investors so when people ask me about you know the future of value investing and it's our definition of value investing you know active management in an intelligent way I tell them that most people you know are very don't know how to value businesses so if you don't how to do that you should do it and then I tell them about a book I wrote called the big secret and I always say it's still a big secret because no one bought it and I tell him a couple studies in that book one study looked at the best performing was done by Morningstar looked at the best performing mutual fund I wrote it in 2011 so it looked at the decade 2000 and 2010 the best performing mutual fund a hundred percent long US equities for that decade was up 18% per year the market was flat during the decade so beating by 18 percent a year was pretty good the average investor in that fund though managed to lose 11 percent a year on a dollar weighted basis and you all know how they did it right after the market went up after the market went up they piled into the fund after the market went down they piled out of the fund after the fun outperform they piled in after the fun underperformed they piled out and they turned that 18 percent annual gain into an 11 percent dollar weighted loss institutions are no better I showed a study of the top quartile institutional managers for that same decade 2000 and 2010 so the ones who ended up with the best 10 year record here are the stats on those guys 47% of those who ended up with the best 10 year record spent at least 3 of those 10 years in the bottom decile of performance so 3 plus years in the bottom decile so you know no one stayed with them 79 percent spent at least 3 plus years in the bottom quartile and every one 97 percent spent at least 3 years in the bottom half so to beat the market you have to do something different than the market your returns are going to zig and zag differently so even if you were smart enough okay you don't know how to value businesses fine maybe you're good at picking managers but even if you were smart enough to pick that manager who's gonna end up having the best 10 year record almost no one stays with him so when I think about the future of active management I would say you know versus passive you know the active versus passive I would say that is a business not very optimistic I still continue to be a move to passive then we continue to be I'm not saying that active won't outperform for the next few years but then it won't a few years later so most people won't capture that and they're starting to catch on to that so I think they'll continually a move to passive I think they'll still be a feet crunch for active but as a stock picker I'm super excited you know the more people who quit and stop trying to do this market is throwing these pitches all the time we have these opportunities so the good news I'm very optimistic as a stock picker the business of active management you know might might be so what I don't know but it will continue to challenged as it should you know and as always not everyone can outperform the those who are skilled to either value businesses or to find managers and have the discipline the big secret by the way so you don't have to buy the book not that you could I can't even give it away so the the big secret is patience okay find a strategy that makes sense to you and have the discipline to stick with it that's few and far between actually my partner and I looked at this because we run my partner Rob Goldstein join me in 1989 and I took a look at the the mutual fund flows we run some mutual funds and we watch them go in and out exactly at all the wrong times you know we could see live the the world's worst money flows okay just chasing whatever the last returns were and it's uncanny it's pretty amazing and it happens to everyone and we sat down to try to figure this out and we actually came up with the strategy a few years back to try to address the the the drive to passive and part of addressing it was to sort of partially give up and so what we did is we set up something we called Gotham index plus and what we did was we said you know for better or worse most people use the S&P 500 as their work for whether they beat the market so we said you know what we're gonna start there and so if someone gives us a dollar in this mutual fund we just recreate the S&P 500 bottoms all the stocks in the S&P 500 we don't think we're charging for that part it's pretty easy to do but then you buy 90 cents more of our favorite SNP stocks on top of that and we short a 90 cents of our least favorite we balance those risks we don't let smoke we don't want to drive tracking error because number one actually people don't mind tracking air if they always win okay so we did try to preserve some of that but same token when I underperform during periods so what we did was we obviously made the 1990s zero beta in let small stocks really Drive the return and we actually matched our portfolio a little better so we weren't as extreme in the 90 cents we like we bought the cheapest short the most expensive subject no why why are people buying these things these stocks down here and these stops are either losing money or trading at fifty or hundred times cash flows why are people buying them because they think 2023 2024 is gonna be awful okay and you know what's gonna be down here Tesla or something like that say oh you don't get it you know the world's changed whatever and I would call something like Tesla the Tyrian tyranny of the anecdote there will be some winners in this group on here you know that are losing money and people are paying or you know trading it 100 times and people will know the name of that winner in other words I call it the tyranny of the anecdote because some winners will know their names because they won but it's the world's investment strategy to try to find your winners from down here there was a famous Damon Runyon line you know guys else was based on you know his writings and he said the race is not always to the Swift to the strong but that's the way to bet and so you really don't want to be betting on trying to find the winners in here and then why are people being so nice to us why are they giving us seven eight nine percent free capital yields and a three percent in straight environment it's pretty clear that's last year's number people don't think the next year to be quite as good these are systematically avoided stocks because when you're an active manager you're trying to make money in the next few years whether you're patient or not your clients aren't beside your good stocks you want to make money you're happy hunting-grounds is not usually in those companies that people don't it doesn't mean they'll do badly but just not quite as well so they're systematically avoided meanwhile they're gushing cash huge returns on capital and so that's what we like but that you would imagine an unbalanced folio so in that ninety ninety an index plus what we do is we bounce fundamental so you'll see why do they like these down here even though Tesla may not be earning money yet their sales are growing as other fundamentals are going well so we try to match see that are our Long's that we like have just as good sales growth as our shorts and that's how we're trying to address it it's almost an impossible challenge you know so far so good and having fun trying to design something and I wrote an essay about this index blessing and I said the strategy that's best for you is not only one that makes sense but one you can stick with so if you have you know one of the problems with value investing and deep value investing is it works over very long periods of time if you're good at valuing businesses it's just very noisy you don't have a lot of people staying with you and a lot of people capturing those returns so that's why it'll keep going that's the great news for active managers but it's also the challenge anyway I'm gonna stop there and maybe hopefully you'll have some fun questions and challenge me on some of the things I just said so thank you is there a mic going hello how would you regard the dispersion in today's environment between say the on the x-axis between opportunities on the left and the right how would you characterize it in today's environment versus previous environments dispersion is always there it's not materially different when I updated over the last 5 years looks a lot like this the longer you bring out your horizon obviously the less dispersion you'll have the shorter periods of time can get very dispersed and the idea is to balance your risks on the long and short side so you don't have too much in bow and balances easy things to do or not be long point 5 beta stocks in short 3 beta stocks you know that's the way to go broke in fact in the little book I didn't put a chart like this but it was similar you know where the cheapest did better than the second better than the third and so everyone said hey why don't you just buy these and short these and I did that for everyone and I cheated a little I didn't rebalance over the course of the year and if you just bought the cheapest and and shorted the most expensive without adjusting right in the year 2000 you would have lost all your money eventually it was right and this is exactly how it came out you know all those crazy internet stocks did crash and burn and the stocks that had been avoided those you know great money churning out businesses that had high returns of capital but we're growing a little slower and no one wanted them those ended up you know having spectacular returns but while you were waiting you lost all your money and zero doesn't compound well I'm sure you did the math to pass the CFA and so so you have to balance your risk and and there are always a lot of dispersion in the short term thank you for speaking to us by all value investors think we are cold calculating bean-counters I believe we cannot permanently suppress psychology so on those lines how do you handle the emotional aspects of investing specifically regret do you employ checklists for your buy or sell decisions or any other heuristics that you might use Thanks well that's actually a great question so well I'm not gonna go there but a lot of times they say most good investors have a screw loose so let's leave that out on the side well when I first started out I was doing very concentrated portfolios and I did that for quite a long time several decades and there we had concentrate by country and I mean six to eight stocks were 80% plus of our portfolio okay when you know the business is really well you know the best way to think about these are actually businesses you know Warren Buffett has a you know I'm gonna you know paraphrase here but he said imagine that you had a business that you sold for a million dollars and now you want to reinvest the money intelligently in you know the city that where you live and let's say there's hundreds of businesses and you analyze them and you find you know six or eight that you know are run by good people have good prospects you know nice returns on capital you know all good things in a nice future and you did that research and you divided that million dollars amongst those six to eight businesses in your city that you know you liked all those elements to most people would kind of call you a prudent person you know you're dividing you did your research but when it comes to the stock market you can get daily quotes on those businesses academics would tell you you're insane you know you're taking way too much risk it's volatile and so you really have to think in those terms you know I mean read as much Buffett as you can but bottom line is if you want to stay unemotional actually think what you're doing think of business stocks as ownership shares of businesses it's very very helpful if something happens in Greece and you own a chain store in the Midwest okay are you gonna sell it at half price the next day because something happens in Greece you're probably not gonna think about it but in the stock market you know you're gonna get a much lower quote and bad things will happen you'll think it's relevant in some way and and you know no one who actually owned the business would do anything about that so it's better to think of businesses I mean stocks as ownership shares of businesses is one way to keep yourself sane the way we have very diversified portfolios now because when you go long short and put on leverage you need diversified portfolios and so when we used to own how do I stay sane we used to own six or eight names and every couple years when you would wake up Rob and I and we'd lose twenty or thirty percent of our net worth in a day or two it wouldn't happen like clockwork all the time that was just the way it works when you own six or eight things something's not going right for your business or you were wrong on a pic and that just has to happen even if you're right most of the time you're gonna be wrong and you're good and that's gonna happen every couple years most people can't handle that but that's just part of the game it has to happen it's mathematically impossible most not to happen that way that the market or you'll just be wrong on some when you're that concentrated and and you have to sort of know what you own and be very cold and analytical and it's helpful when you actually think I just own a small group of businesses now when we have hundreds of stocks on the long side and short hundreds of stocks we're trying to be the insurance company we're trying to be right on average and when we actually have more diversity this is a flaw and a lot of hedge funds it turns out you know rather than by let's say three four hundred of this the cheapest over here we usually weight them based on how cheap they are and short three or four hundred why wouldn't we just do the top 50 or 100 and short the bottom fifty or hundred I mean the Alpha generation is pretty linear so why wouldn't we do that well number one these stocks all the way down here these are extremely in favor stocks they're quite volatile you know a lot of money losers and they're up up there these stocks are extremely out of favor much more volatile you have less of them more volatile when you go long short and put on leverage I would say wait and you have less stocks getting aberrational e bad returns is another euphemism for losses you know when you go long short and put on leverage you could get what you didn't expect more often when you just have a few volatile names and you could have some negative compounding turns out negative compounding is bad as you all know the math and so when you go long short and have more names up here and more names here you have less extreme names on average you have more names you know so less extreme names less volatile more names less volatile another way of saying you get what you expect more often that's why insurance companies don't insure five guys no matter how good their underwriting is someone you know steps off a curb and messes up your numbers you can tell I don't sell insurance so you when you go long short put on leverage you get what you expect more often you spend less time negative compound you actually end up with higher returns even though the Alpha generation is linear when you go more diversified you end up with slightly higher returns and a lot less volatility so there's no trade-off so that's not really the math that most investors look at it's not what typical hedge funds look at they're actually very under most of them are very under diversified even though this is factual this is what happens so these guys did beat these guys but by adding some of these guys you can actually make more money by keeping less volatile and so it's one way to so now our bad days to be honest in our diversified portfolios and we underperform by 20 or 30 basis points so that's how we stay sane that's our bad day as opposed to losing 20 or 30 percent of our net worth so we trained ourselves over many years to be a you know by being concentrated investors for so long so it's it's complicated I would say that the best idea is to think of stocks as ownership shares of businesses and really believe that really don't you know when I got on a very big Investment Board and my first memo I wrote with the chairman of the committee said oh this is a great memo you should hand it out and then I almost got shot and my suggestion and you know I hadn't been there I hadn't been it was like a really big board and hadn't been on one yet it's about 15 years ago and my suggestion was stop reporting your returns to everybody else so that you just do what you think smart long-term and you don't worry about how you compare to all the other guys on the lead table of who did the best and who did the worst so no one really liked that idea and it might not be realistic and but that's the way you should think about investing you know don't listen to what the guy sitting next to you how many jelly beans he thought there were just being cold and calculating as best you can oh yeah yeah loved you can be a stock market genius and I'm just curious if you could compare and contrast the opportunity set and special situations back in the early 90s when you wrote that and today sure well I still teach that I have five kids I taught the ones who are willing to listen to to do the same types of things the opportunities are still there and in my class every year at Columbia I say you know what happens to people who are good at finding off the B path investments you can be stock market genius was about a special situation investing mostly valuing special situation investing looking for things a little bit off the beaten path like spin-offs or companies going through some extraordinary transaction where it got a little more complicated looking at places off the you know beaten path I opened a book with talking about my in-laws who used to live in Connecticut and and they would spend the weekends going to tax sales and country auctions looking for you know bargains they collected sculpture and art and and and other antiques and let's say they saw found a painting that they liked and what I said was their question wasn't is this guy going to be in the next Picasso okay that's really hard to do their question was is there a painting by the same or that's similar style that just went up for auction for two or three times with this one they can buy that's a much easier question to do so they really were gonna get their bargain from looking you know off the beaten path in a place other people weren't looking they weren't gonna get it from being so good at predicting okay and so that's what I called special situation investing and and those opportunities still exist and I asked my students what do you think happens to people get good at doing that and a lot of the answers is they get so rich they have to they don't have as many opportunities in that area so there's a new generation that could always look at these small off-the-beaten-path opportunities some of them come in big sizes but there's always an opportunity for people running several hundred million dollars to invest quite well and I almost call that investing you know not making money by taking risks just doing work doing more work in a place that other people aren't looking and so that's you know when I wrote in the book in 97 I said you know when you get to 250 million dollars give me a call I actually did get a couple calls and one guy who made the Forbes 400 wrote me a thank-you note so that was nice but bottom line is that's still there I think the opportunity sets even bigger because the world's gotten a little bigger than toward 50 million but so there's great opportunity always for that smaller cap as far as the larger cap stuff there are more people looking but people are very emotional people have a lot of agency problems when they get pretty big like that and so you know that might have gotten a little harder I really don't think so I think we go through these cycles where when I was just describing the sp500 the biggest market in the world doubling halving doubling halving there's a lot of emotion still out there you just had maybe have to be a little more disciplined to take take advantage of it and so I am not concerned that those opportunities won't continue to exist you know pretty much forevermore as long as we all remain human which I think we will yeah right we don't disclose that but it doesn't matter too much so the question was how do we wait our various valuation metrics that I discussed and while we don't disclose it I will disclose it doesn't matter all that much these are all things when you are valuing the house you're looking at all these things and as long as they're all substantial parts of it you end up doing pretty well okay thank you mr. Greenblatt for a great session a quick question on this a long short strategy how do you go about sizing for example equal weighting or valuating or other better more intelligent way you go with it the reason I ask is on hit rate base you could be like 60 percent or even 80 percent right how about but how about on P&L basis you could maybe on the the wrong side would be so wrong at it cancel out on the right ones so you don't equally weight but as you might imagine the more cheaper something is the bigger discount to our sessemann of value the more will want to own of it and we scale it based on how cheap it is hit rate really isn't where we make most of our money you know our hit rates about two thirds you know two thirds of the time just doing this simple stuff you end up out performing the market are two-thirds of your picks it's just the the nature you know of buying these guys that are out of favor already low expectations already built in usually just like people think of typical value investors and when the bad news comes in you didn't pay for good news so you tend to hold up a little better okay it's just when the companies do a little better or lot better than the low expectations I don't have to do great just a little better than the low expectations or a lot better you end up with a lot of asymmetric returns you end up with a lot of big winners and we actually make more money from that asymmetry I wish I knew which ones we're gonna be the asymmetric winners so we just buy them all and while we make money from our hit rate and while we make money from that asymmetry in the risk/reward which is sort of what investing is all about right you know just bet a little and and and have a lot of upside one of my favorite lines from my book was you know if you don't lose money most of the other alternatives are good so you're really trying to minimize that and so we make more money actually more money from H symmetry than we do from hit rate just FYI so thanks for the question over the last twenty eight years it's on the twenty-fifth percentile yeah yes I did right so the question was have I looked at the value universe or the growth universe and the answer to that is no because I really don't care the way that Morningstar or Russell classified value and growth is nonsensical to me so I don't care it's you know I I think I went to a whole list of things and I ended with I don't care and I think I'm gonna stick with that you who hasn't liked you okay so I noticed that this chart here applies to the largest two thousand US companies do you do this type of research for international companies in your portfolio diversified portfolio what percentage would be international okay we don't do global portfolios we do do international portfolio so we do US and X US we only do long investing X US the reason for that is that shorting is you really have to balance your when you're when you're shorting and taking on leverage both those things are risky you have to balance your wrist well and when you go international you have different trading costs you have different shorting rules you have different currencies you have different regulatory issues so you keep I could snowball the complications doing long short you know with leverage internationally and we don't really feel the need to take that on we have a big research team and we go you know we don't use like a database or anything we go through every bounce an income statement kick you know what's that deferred tax assets are Penn July ability you know all those things how efficient are they when they earn money how efficient are they when they spend money we're looking at all those things and and so we do that internationally but on the short side like I said it adds a lot more complication a lot of different rules trading costs every everything currencies they get very very complicated so we just do long only just answer your question your process sounds fairly quantitative and using historical data and historical relationships and of course those are things that computers do very well do you what's the role of human beings in your process and do you foresee that you'll get to a point where ultimately a more refined computer algorithm can do it better than humans right so that's a great question so I don't view us as quantitative except for the extent to the extent that to figure out the value of something you need numbers okay but I said there are many things that have correlated with good returns that quants used use like momentum or a low price book or other factors that they use we only look at things that are relevant to valuation we do get very quanti in our risk management you know we're very quanti and how we you know model our trading costs or manage our risk what risks do we want to make sure that our attributes do our portfolios have we use quantity things in risk management in trading in tax management we're doing lots of those things in a quantity way but we're very fundamental in the way we value businesses okay and just like think about its where private equity investors if you want to call them quants then where quants but in my mind we're fundamental investors valuing businesses looking at the data that makes sense for valuation if you're caught up on the fact that we're not making projections and the value of a company's the discounted value of its future earnings what I would say is we looked at making all kinds of projections using other people's projections using our own and we ended up doing better not using them I would love to use them if we were good at it we're not it's hard to improve on this though if I want to make you feel better about that I used to visit companies all the time okay and you know to be a CFO or CEO of public company even if it's pretty small you have to be pretty smart person and I would meet with these guys and everyone I walked away from for the most part I said oh that guy's pretty smart and that woman is pretty smart and that story seemed to make sense with a better assumption however would have been that if that management had been good at allocating capital before I walked in the door the better assumption is they would continue to be good at allocating capital going forward and if the management had not been good at allocating capital before I walked in the door the no matter what how good their story was how smart they sounded the better assumption would be that they would continue not to be very good at allocating capital if you were going to buy a store in town that had a million dollars in sales last year and $150,000 in earnings if you were trying to guess what was going to happen next year my bet would be somewhere around a million dollars and 150,000 dollars in earnings and who and when you want hundreds of things turns out that that's pretty good so it's not that I don't believe the value comes from the discounted value of future earnings I am just saying that on average and this is really you need a big bunch of companies pretty good guess what happened last year is pretty pretty good guess and we don't just look back one year but yes thank you for saying that let me just repeat that right so we test it we started three and a half years ago we're the number one fun out of 1200 funds in large blind you know where the SP is I just thought I'd mention that but we tested it beforehand we added we had about seven 1.1% tracking her against the S&P with 7.1 percent our performance with seven point two percent tracking her so most of our tracking error was due to our performance which I said was the good kind of tracking error we don't mind that we haven't done quite that since we started but the way usually works in an environment where the market goes up 15 20 percent a year and it's been doing that since we started this thing people these are we call these hope stocks down here and and people like hope stocks and you know what's been happening since the market tripled is people take risk and then they get paid for it so they take more risk and more risk and Morris that usually ends pretty badly luckily we're not low priced book low price sales investors on the long side we're cashflow oriented and you know cash flow is a big part of the that's how a private equity firm would valued business and when people get off to miss about the world they do get optimistic about our cash flows and so our Long's end up doing pretty well and we have not been hit while value traditional values gotten hit cash Florent investors like us have not even though our definition of value was figure out what is worth pay a lot less and that and and that's what investing is

Channel: CFA Society Chicago

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Length: 59min 27sec (3567 seconds)

Published: Wed Dec 19 2018