The Big Secret for the Small Investor by Joel Greenblatt

The Big Secret for the Small Investor by Joel Greenblatt

Joel Greenblatt explains why the average investor has an advantage over the pros with this introduction to investing. He covers the different methods for valuing a business, the limits of mutual funds, how different index fund weightings work, the (mis)behavior of investors, and why a long term perspective is so important.

The Notes

• Being a successful investor requires following a few simple concepts but most people won’t do it.
• “The secret to successful investing is to figure out the value of something — and then pay a lot less.”
• Margin of Safety: the difference between price and value, a larger difference means a larger margin of safety that protects investors from big losses due to unexpected events or valuation mistakes.
• “If we invest without understanding the value of what we’re buying, we’ll have little chance of making an intelligent investment.”
• The value of a business is not based on what happens each week or month, but what the business can earn over its lifetime, then discounted to today’s dollars.
• The idea behind valuing a business is to figure out what the future earnings will be and discount them to the present. That requires predicting future earnings and deciding on the appropriate rate to discount the earnings into today’s value.
• But, predicting business earnings far into the future is difficult, some businesses can be too complicated to make predictions on, and different discount rates can lead to a big difference in valuation.
• Small changes in earnings estimates, earnings growth rates, and the discount rate can produce extremely different business valuations.
• So earnings predictions and valuations are usually a guess.
• Relative Value: compare a business to similar companies — to see what they sell for, what price-to-earnings multiple do they trade at, what’s the growth rates, what’s the quality — to judge if it might be cheap or expensive.
• The downside of relative valuation is if an entire industry is mispriced — too cheap or too expensive — every company is often mispriced (See: Dot-com Bubble).
• Acquisition Value: what a business may be worth to another company due to potential cost savings from combining companies.
• Liquidation Value: the value of a business if all assets were sold, debt was paid off, and the remaining cash was distributed to shareholders. Liquidations don’t happen often.
• Sum-of-the-Parts Value: valuing different divisions of the business separately to get a total value for the business.
• Again, valuing a business is difficult.
• The alternative is to compare the potential earnings yield (Earnings/Price) of a company against the risk-free rate — 10-Year U.S. Treasury bonds.
  1. Compare the investment against the risk-free rate. Are you confident in your earnings estimate and does the investment offer a significantly higher return than the risk-free rate?
  2. Compare the investment against alternative investments?
  3. Note: If the risk-free rate is below 6%, Greenblatt uses 6% as a conservative minimum.
• If a company is too difficult to value, skip it.
• “In the stock market, no one forces you to invest. You have thousands of companies to choose from. I tell them the best course of action is to find the few companies where you have a good understanding of the business, the industry, and the future prospects for earnings. Then make your best estimates and comparisons for the handful of companies you can evaluate.”
• “To put the odds in your favor, you have to change the game.”
• How do you compete against the brains on Wall Street? Play a different game.
  • Small Caps: most small-cap companies are too small to move the needle in a big fund and research analysts don’t cover them.
  • Concentration: Since it’s hard to value businesses, stick to the few businesses you have a high degree of confidence in your valuation. Instead of buying your 50th best idea, focus on the handful you’re most confident in.
  • Special Situations: spinoffs, bankruptcy, restructuring, mergers, liquidations, asset sales, rights offerings, options…are usually avoided by average investors and funds. Best to only focus on special situations where the bargain is obvious. (may require more work, more time, and require special knowledge to navigate).
• “Ben Graham in his Intelligent Investor warned individual investors against trying to analyze individual stocks on their own by thinking they can succeed merely by bringing “a little extra knowledge and cleverness” to the investment process. He suggested that instead of realizing “a little better than normal results, you may well find that you have done worse.””
• It’s okay to admit valuing businesses is too hard.
• One alternative is to choose mutual funds:
  • Check the fees of mutual funds. Typically, funds that charge high fees, tend to underperform their benchmark indexes.
  • Check the number of stocks a fund holds. There are limits to how much of a company a fund can own and how much of a fund can be in one company.
  • Returns from a concentrated mutual fund, with a couple of dozen holdings, can vary widely compared to those of a highly diversified fund, with five hundred or more. The more concentrated the fund, the wider the range of potential returns.
  • Even a good fund manager, with a concentrated portfolio, can trail the market for a long time.
  • Fund managers have career risk so they tend to invest not to lose. They aren’t willing to risk their job on the chance of underperforming the market for years. So they settle for mediocre returns, which underperform the fund’s benchmark after fees.
  • “Most mutual fund managers are effectively shut out from their best chances to beat the market.”
  • Most fund managers fail to beat the market.
  • Newly hired managers typically had good recent performance while fired managers had poor recent performance. Research shows that fired managers go on to outperform hired managers.
  • Picking good fund managers is hard. Investors tend to pick managers with good recent performance and avoid those with poor recent performance, and the poor timing leaves them underperforming in the long run.
  • “Investing with the managers who have performed the best and attracted all the money is probably a great way to win the last war, just not a great strategy for beating the market going forward.”
• “…to beat the market…you must invest differently than the market. At a minimum, you can’t invest in exactly the same stocks in exactly the same proportion as a market index and still beat it!.. Even if a…strategy is sensible, stocks fluctuate at different times and in different ways, so long-term outperformance due to a strategy that differs from the index is almost always accompanied by lengthy periods of underperformance.”
• Greenblatt’s not a fan of using benchmarks to judge “good performance.” An investor or fund manager should be judged on their ability to produce meaningful returns above the risk-free rate after adjusting for risk (where risk is not volatility) based on an evaluation of their investment process. “This does not guarantee, however, that his returns will be better than the market’s. It only means that he has the talent to consistently add value above and beyond the risks taken.”
• “…markets are emotional. They often go to extremes of pessimism and optimism, and prices can and often do fluctuate wildly and significantly over short periods of time. (If you have doubts, a look at the range of prices for the individual stock of your choice over any fifty-two-week period should quickly confirm this!) But Graham pointed out that the long-term value of a business can’t possibly change as often and as drastically as changes in stock prices seem to indicate.”
• Markets are likely to reflect emotion in stock prices in the short term as people get excited about a company or dejected about a company.
• Cap weighted indexes create the effect of owning too much of the overpriced stocks and not enough of the bargain stocks.
• Equal weighted indexes randomize stock pricing errors since every stock is given the same weighting.
• Fundamentally weighted indexes weight stocks based on sales, earnings, book value, dividend yield, number of employees, or any other business metric. The weighting is an attempt to more closely represent the economic impact of each business. Market cap plays no part in the weighting.
• Value weighted indexes are a fundamentally weighted index that uses “value” metrics like the price to sales, earnings, book value, etc. with a goal of owning more of the bargain stocks and less of the overpriced stocks.
• “We’re practically hardwired from birth to be lousy investors.”
• We fear losses more than enjoy gains. Which leads to panic selling. It’s a survival instinct.
• The herd mentality drives us to seek comfort in groups. We buy when the crowd buys and sell when they sell.
• We put more weight on recent events — leads to avoiding recent poor performance and embracing recent good performance — buying high and selling low — of funds, stocks, etc.
• We think we’re above average, overconfident in our ability to pick stocks, funds, managers, etc.
• The goal should be to build a strategy that fits within your behavioral shortcomings but still takes advantage of the misbehavior of others.
• “The only reason the value strategy works is that we are systematically setting ourselves up to buy companies that most people don’t want.”
• Value strategies, like all strategies that work in the long run, don’t work every year. If it did, everyone would do it and it would stop working.
• Time Arbitrage: “…as the market has become more institutionalized and performance information and statistics have become more ubiquitous, the advantages for those who can maintain a long-term perspective have only grown.”
• Advantages of the individual investor:
  • No clients to answer to.
  • No short term performance updates to worry about.
  • No career risk — who’s gonna fire you?
  • Can pick the strategy they’re best able to stick with.
  • Can set the allocation that best fits their aversion to risk.
• “The main point is to have the right general principles and the character to stick to them.… The thing that I have been emphasizing in my own work for the last few years has been the group approach. To try to buy groups of stocks that meet some simple criterion for being undervalued—regardless of the industry and with very little attention to the individual company.… Imagine—there seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience, it seems to stand up under any of the tests that I would make up.” — Benjamin Graham, from An Hour with Benjamin Graham

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Source

https://novelinvestor.com/notes/the-big-secret-for-the-small-investor-by-joel-greenblatt/