Another review of Joel Greenblatt’s Classic Work
If you’re wondering why I’m putting so much emphasis
on Greenblatt’s book, it’s because not only has it resonated with me as an
investor but it has proven itself over time to be one of the very best
resources an investor can have at his elbow…What follows is probably the best
review of all but the themes will be familiar.
“You Can be a Stock Market Genius” is Joel Greenblatt’s
classic 1997 book. Don’t be dissuaded by the ridiculous title. This is a money making handbook for the
small investor who is willing to get their hands dirty and do a lot of
homework.
Joel Greenblatt is one of the best investors of all
time. I reviewed another book of his:
The Big Secret for the Small
Investor in
this blog post.
The two books have the same philosophical value investing
orientation but are polar opposites in terms of difficulty. The Big Secret is
for passive buy-and-hold investors who don’t want to deal with all of the
homework of actively picking stocks. You
Can Be a Stock Market Genius is a homework-intensive strategy that Joel employed when he
was running his hedge fund from 1985-1995 and achieved 50% annual returns.
No passive strategy will get you 50% returns. No systematic
quantitative approach will get you 50% returns. Achieving that kind of stellar
performance requires a hell of a lot of work and luck. The book is Joel’s
outline of the various hunting grounds that he used to generate those amazing
returns.
The Small Investor’s Advantages
The book opens with an inspiring message. The small investor has advantages over
prominent professionals. Big professionals managing billions of dollars in
capital can’t: (1) concentrate in a handful of small positions, (2) take the
career risk of dramatically underperforming the benchmark (they’ll get fired),
(3) won’t invest the time and resources necessary to investigate weird and tiny
situations that they can’t allocate a significant portion of their capital to.
A small investor can
do all of those things.
In a world where ETFs with 50 positions are considered
“concentrated”, Joel’s definition of “concentrated” is wildly different than
the mainstream view. The mainstream view
is that “risk” is volatility of returns and “risk” can be reduced by holding
more positions. Joel suggests that as few as 8 stocks in different industries
is sufficient to properly diversify a portfolio.
8 stocks would result in so much volatility that it would be
career suicide for any professional investor. Most people can’t handle
volatility. A small investor with the
right temperament can. Unfortunately, most small investors squander this
advantage. We’re never going to beat Wall Street at their own game: namely,
smoothing out returns and reducing volatility (i.e., pain) with fancy financial
engineering.
What we should do is
focus on the advantages that we have: (1) Temperament – If we have the proper
temperament to endure volatility, we can achieve better results. (2) Size – If
we’re willing to focus on areas that are hated and ignored, roll up our sleeves
and do the work, we can concentrate in situations that Wall Street pros can’t.
I did some backtesting of my own a few months ago to test
the limits of concentration. I looked in a Russell 3000 universe with a
straightforward strategy of buying the cheapest stocks on an EV/EBIT basis. I
constructed portfolios rebalanced annually beginning with 1 stock (the cheapest
in the universe) and then just adding the next cheapest. I then plotted the
monthly standard deviation of returns (Wall Street’s definition of risk – which
is a flawed concept, but whatever).
It looks like Joel
Greenblatt is correct. Most of the volatility is meaningfully reduced with a
handful of positions. He offers a caveat, however, and suggests that if you
are going to run a concentrated portfolio, it is best to diversify among a
group of different industries. In today’s market, for instance, it may be
tempting for a value-driven bottom feeder like myself to own 10 retail stocks.
This would be a bad idea.
Wall Street pros and most investors have no stomach for
volatility. We saw a vivid example of this in February. The market fell 10%.
This is a remarkably normal event in the grand scheme of things. I was on vacation
at the time that this happened and couldn’t help but laugh at the insane
overreaction to this little event. It generated headlines like this: “Stocks Plunge and Traders
Panic” – The Wall Street Journal, “Dow falls more than 1,000 in
biggest daily point-drop ever” – thehill.com
If you want to achieve better than average results, you need
a better than average temperament to ignore this nonsense.
How to think about the market
Joel tells two stories in the book that represent excellent
ways to think about the stock market.
The first is a story about his in-laws. His in-laws were
amateur art collectors. They weren’t looking for the next Rembrandt or Picasso,
they were looking for small-scale mispriced works of art. They went to yard
sales and flea markets looking for paintings that were cheaper than their
value. They would find paintings that were at the yard sale for $100 that they
knew were worth $1,000, for instance.
This is a useful way for small investors to think about the
stock market. The professionals need to find the next Rembrandt and Picasso. We
should let them fall over themselves trying to figure out what company is going
to be the next Facebook or Microsoft. Most of them will fail and a handful will
be lauded as geniuses (they were probably just lucky). For us, we can achieve satisfactory results by
merely finding things off the beaten path that is a decent discount against
their intrinsic value.
Joel tells another great story where he went to the best
restaurant in New York,
Lutèce. Joel asked one of the chefs if an appetizer on the menu was good. The
chef replied with: “it stinks.” The message was clear: it didn’t matter what
you ordered off the menu. Everything was excellent because Joel was at the best
restaurant in New York.
The best way to invest in the stock
market is to identify those places that are the best places to invest, where no
matter what you pick, the chances are that it will be good.
The book outlines some key hunting grounds where Joel had
success finding these opportunities.
Spin-Off’s
The goal of investing is to find mispriced assets. You want
to seek out areas of the market where stocks are prone to mispricing.
One area that Joel finds to be replete with mispricings is
spin-offs. Spin-offs are divisions or
subsidiaries of a larger company. The larger company decides to “spin off”
that piece into a separate company.
Why do companies do this? They may think that if they isolate the entity in the market, it will
be able to command a higher valuation. For instance, let’s say (in an
extreme example) that an insurance company owned a financial software division.
Software companies have higher P/E ratios than insurance companies. However,
the market might not appreciate the software company because it is buried in an
insurance company. If they spun it off –
the software company would probably command a higher valuation if it were
isolated.
The larger firm might
also want to separate itself from a “bad” business that is weighing it down.
They might just want to use the spin-off to unload debt on a smaller firm.
There could be tax or regulatory reasons. They might have difficulty selling
the business, so they decide to dump it in the form of a spin-off.
Whatever the reason, spin-offs
are prone to mispricing. This is because institutions and people often sell them for reasons other
than the intrinsic value of the company. Some institutions might
not even be allowed to own it due to small market capitalization, or it doesn’t
fit into their “strategy.” Individual investors probably wanted to hold the
larger business and have no interest in owning something completely different.
In any case, spin-offs are prone to
indiscriminate selling, which creates mispricings and opportunities for smaller
investors like us.
In the book, Joel takes you through several real-world
examples of spin-offs. He explains why the spin-off was pursued and why he
thought it was an attractive opportunity to invest in.
Currently, I own one spin-off in my portfolio: Madison
Square Garden Networks (MSGN). My rationale for holding it is described
here. I became aware
of the opportunity when looking at a list of recent spin-offs back in 2016.
Mergers
Joel then moves onto mergers as an opportunity for
mispricings.
He first addresses the obvious: merger arbitrage. Merger
arbitrage is buying a stock after a deal is announced and trying to earn a
spread between the buyout price and the market price. For example, let’s say a
company is trading at $30 and another company buys it out for $40. As soon as
the deal is announced, the stock will rally to $39. A merger arbitrage strategy
would buy the stock at $39 and wait for the deal to be consummated.
Joel thinks this is a dumb strategy and I agree with him.
The reason is that you are taking on the risk of the deal not going through, in
which case the stock will plummet. Mergers fall apart all the time, usually for
regulatory reasons. Why take on that risk to make a measly 2.5% gain in the example
I provided (in the real world, those spreads are even smaller and keep getting
smaller as more people become involved in merger arbitrage).
It’s a strategy that might make sense for a big institution
that can hire lawyers and analysts to know for sure whether a deal will indeed
go through, but that’s not something small investors like myself can take
advantage of.
Where Joel does
believe there are opportunities for investors is in the world of merger
securities. Often, a buyout can’t be financed entirely with cash and debt.
Sometimes, strange derivative securities are sold (usually warrants) to fund a
piece of the transaction. Investors will often indiscriminately unload these
merger securities, and this will create mispricings.
The difference between a warrant and an option is that a warrant
is issued by the company. That’s it. Both of them are merely a contract to buy
or sell a stock at a pre-determined price on a future date.
Joel thinks this is a good area of opportunity. I don’t
disagree, but I think that pricing merger securities are beyond the abilities
of most small investors like myself. I’ve never owned an option or warrant in
my life and place it in my “too hard” pile. You might want to tackle it and
more power to you.
Like the spin-off section, Joel takes you through a few
real-world examples of times that he purchased merger securities and did very
well. I think the strategy is too hard to implement for the small investor, but
you might disagree.
Bankruptcies
Emotions create
mispricings. Greed and comfort with consensus create insane valuations for
amazing companies. Revulsion, hatred, and fear create mispricings among “bad”
companies. Nothing generates an “ick” feeling more than bankruptcy.
Joel does not recommend buying stock in bankrupt companies
(that’s in the “too hard” pile”). The reason is apparent: equity holders can
get wiped out in a bankruptcy. He does
believe that the debt of bankrupt companies is often mispriced and offers
incredible mispricings. Unfortunately, distressed debt investing is not only
challenging to research for small investors but frequently impossible for
anyone but an institution to invest in.
He believes that
small investors can invest in companies emerging from bankruptcy or going through a restructuring.
Often, a company went bankrupt only because it was loaded up with too much
debt. They might have a viable business model that was merely being weighed
down by too much debt. After emerging
from bankruptcy or going through a healthy restructure, it may give the company
an opportunity to shine. Meanwhile, the stigma of the bankruptcy creates a
nice discount from intrinsic value.
Options
Most classic value investors (me included) think that
options are an area that is best for most people to avoid. I agree with this
sentiment. Options (and warrants, which are the same thing) are a zero-sum
game. Only one side of the trade wins: either the person who wrote the contract
will win, or the person who bought the contract will win. They can’t both make
money. Zero-sum games are usually areas of the market that are difficult for
small investors to make money.
Joel takes a bit more of a liberal attitude towards options.
While he doesn’t recommend actively trading options, he does suggest using long-term options (LEAPs – options contracts that
mature in over a year) as a way to leverage up the return on a value stock.
A LEAP will experience much more significant price swings than the overall
stock. If a reasonably priced value stock experiences a 20% gain, for instance,
the underlying LEAPs contract will experience a much more significant increase.
It’s a way of leveraging up the bet, with the caveat that if the stock falls
below the strike price, it will expire worthless. More risk, more reward.
Joel does not
recommend that these bets comprise a significant portion of a portfolio, but
argues that they can serve a place to amplify returns.
For me, I put all of this in my “too hard” pile. When I
contemplate buying options or warrants, it sounds to me like someone saying “Let’s
try crack. What could go wrong?”
Conclusions
You should read this
book! My brief summary doesn’t do the book justice. While I gave you the
broad strokes in this blog post, there is nothing like reading the book and
going through the case studies which Joel provides. He provides you with his
entire process: how he found out about a specific opportunity, what he liked
about, where he researched it and how the idea worked out.
The first and last chapters are useful for developing a
template for thinking about
markets. As I stated earlier, the goal
is to find mispricings. That
often means going off the beaten path and finding forgotten and hated corners
of the market. Joel provides a roadmap to a few areas that served him well,
but they are by no means the only ways to do it.
Resources,
