This week I’m at the Value Investing Congress in New York, so your friendly neighborhood Gumshoe may toss in a teaser unveiling during these couple days if something jumps out at me, but for the most part I’m going to share some of the ideas from the conference that I find appealing, both for free subscribers and for the Irregulars.
You’re going to see a lot of newspaper articles about David Einhorn’s takedown of Green Mountain Coffee (GMCN), which was impressively thorough (as he always is) and makes me want to stay far, far away from the stock, so I’ll probably share more from the less-covered speakers who probably won’t move stocks by 10% as Einhorn did after lunch today (and frankly, after hearing his data I can’t believe it’s only down 10%, though I confess I’ve never researched that stock at all before).
And OK, that headline above is probably an exaggeration — but it sums up pretty nicely what I thought after listening to Joel Greenblatt speak at the Value Investing Congress this morning, so I’ll focus on him for a moment.
Greenblatt opened up the conference and did something that will probably garner no headlines: He told us that a diversified portfolio of high quality companies that are bought at cheap prices beats the hell out of the market.
Or at least the market as represented by the S&P 500 — which is the real problem. Greenblatt is the author of the Little Book that Beats the Market, which should be required reading in high school and which I think is the finest, clearest and simplest book about the essential concept(s) of investing that I’ve seen — with that concept, which he describes as the “Magic Formula,” being basically, “buy companies that are very profitable for less than you think they’re worth.” So whenever anyone asks me how to learn to invest, I tell them to read that book. (When they ask me how to trade, which to me often means something akin to moving poker chips around the table, I have to say “I dunno”).
And Greenblatt has been on a bit of a crusade against conventional index investing of late — for good reason, it turns out. His presentation compared the results of his own proprietary “value index” of about 800-1,000 companies to an equally-weighted index of the S&P and to the standard market cap-weighted index of the S&P and showed that his metrics, most of which are very similar to the basic value precepts he laid out in the Little Book of buying companies with high earnings yields (meaning they’re inexpensive) and good return on capital (meaning they make real money), are far more effective when dealing with large index-type investing strategies (ie, a somewhat more passive approach that can handle billions of dollars of investor money, not the much more active and focused “special situations” value investing he did when he started posting outsize returns, in a very different world, a few decades ago).
And why? This is the key point for me: Because he said that eschewing market cap-weighted indexes means you get to make random mistakes.
In case you’re not familiar with these basic issues, a market cap-weighted index like the typical S&P 500 index or the many others out there (almost all indices are cap-weighted) is designed to get you exposure to the world as represented by that index by ensuring that you buy more of the bigger companies and less of the smaller companies — nice and logical, but it also means that indexes are essentially buying stocks after they go up and selling them after they go down. That means you’re using a “buy high, sell low” approach that, while it’s better than many active managers, has a clear problem — though it does certainly have some logic behind it, and it does represent the real market in a democratic way, by giving more weight to the companies who are more highly valued by the market.
We all make mistakes, all funds have stinkers and there are no quantitative tools you can use to make sure that every stock you choose goes up, but if you buy the market cap-weighted S&P 500 (as in the Vanguard S&P 500 index, or the SPY ETF for example), you are intentionally making what Greenblatt calls a specific systematic error in investing: as valuations change in the underlying index, you’re tending to put more of your money into the companies that are most expensive. Just turning off that systematic error and equal-weighting the S&P index lets you beat the market by a couple percentage points a year over the last 20 years because it lets your mistakes become random, which should be the simple genius of index investing. (And which is also a harsh thought for active managers — they can’t even beat the S&P, on average, let alone the equal-weight S&P … and yes, that applies to me, too, so I can feel extra bad when my portfolio or my ideas also fail to beat that “systematic error” benchmark, as they sometimes do.)
But if you use a value index instead, as they’ve developed at Greenblatt’s firm, you get to beat the S&P 500 by about 7 percentage points (700 basis points) a year with almost exactly the same beta and the same volatility, and with more diversification. Of course, you can’t do it for 0.15% per year in expenses, like you can with an S&P 500 index fund, but that seems like a reasonable performance to pay for. Greenblatt’s Formula Investing funds are somewhat pricey (around 1.25%/year), considering they’re largely quantitative so their costs are low, but so are lots of mutual funds that don’t beat the S&P 500 by 7% annually for a couple decades. Those results are from backtesting, to be sure, and things could change — but they probably won’t.
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And more importantly to the big picture, for those of us who are feeling a bit down in the dumps: Greenblatt looked at the free cash flow yield for the market and for his value index and said that right now the market is cheaper than it has been 94% of the time during last 20 years. So he expects that the Russell 1000 should climb 10-15% from here but that his value index should go up by 25-30% given the historical undervaluation of the cash flow of the companies in the index. Of course, we sometimes have the tendency, as emotional investors, to think that the market dislocations and fear are so bad this time around that the last 20 years are meaningless … but better to buy at historically cheap valuations than at historically expensive ones.
The question someone always asks a value or quantitative investor is, “if everyone knows this, why isn’t it in the price?” — meaning, if everyone knows that the market is inefficient and that companies with high return on capital and great earnings yield will outperform, on average, why doesn’t the market drive up the shares of those companies?
We can’t know that for sure, but his explanation is that short-term thinking by investment managers, who are largely required to beat the market each month or each quarter, and who are watched very closely for even incremental weakness in their performance over a short period of time, means that many big institutional managers are afraid to buy these cheap stocks. And since they’re generally the kind of value stocks that value investors have always dug for with clothespins over their noses and smiles on their faces, the companies tend to not be sexy and not be appealing.
Examples? He said the companies coming up on top of their fundamental indexes now are largely household names that investors either hate or feel bored by, like these:
Hewlett Packard (HP), GameStop (GME), General Dynamics (GD), Best Buy (BBY), Dell (DELL), Wells Fargo (WFC), Aeropostale (ARO), Microsoft (MSFT), Merck (MRK).
There was no “oooooo” from the audience like there was later for Einhorn’s presentation. You’re not going to wow a crowd at a investment conference with those names and anyone can easily pick apart the “story” behind these stocks and claim that their business is going to die — but most of the time, great businesses with huge cash flow (like most of these) and sustainable profitability don’t die, so if you can create a good list of cheap stocks like these and make sure the errors come from the random bad apples that every system finds, and not from a bad system, the returns can be very impressive. And if you have 800-1,000 stocks in your index, you can afford to make mistakes as long as you don’t set it up so that the ones most likely to be expensive mistakes are also the ones that you invest in more heavily each quarter.
On the flip side, Jim Chanos, the well-known short-side analyst, spoke later today — and he particularly called attention to GameStop as a wonderful exemplar of a type of “Value Trap,” a company whose obsolescence — as for Kodak, or Virgin Music, or Blockbuster — is going to come far more quickly and abruptly than the value investors who are piling in to the shares because of the seemingly low valuation believe. So there’s certainly another side to every individual story, I’ll try to share a few more of his “Value Trap” ideas in the weeks to come since he puts a lot of big investment themes (China, iron ore stocks, integrated oil companies) into the “potential value trap” category and he’s a really, really smart guy who happily thinks differently than the rest of us … and I know I personally get tempted by low prices and have a tendency to sniff at those traps myself.
Greenblatt’s relatively new mutual funds, which my family does also have some money parked in, are the Formula Investing Funds — there are four, with two US and two International (for each category there’s one more diversified fund and one more “select” and focused, though the strategy is otherwise more or less the same). They are “no load,” but they’re also expensive in terms of expense ratios — and while I think they’ll likely outperform the market over the next five years quite handily, I have no idea whether they’ll do so this year, or whether the system might suddenly stop working. And there are ideas in ETF land that come after the same basic idea, though not using their proprietary index — things like the dividend-weighted or earnings weighted ETFs from WisdomTree that try to lessen the overweighting that overvalued companies can sometimes get in index land.
As Greenblatt said near the end of his presentation, “The key to value investing is that it doesn’t always work.” His systematic approach did better than the market in 54% of the years they checked (data went back 23 years, I believe), so it’s not an easy win, and it’s not easy for people to stick with it particularly when “junk” stocks (high priced stocks, momentum darlings, etc.) are outperforming. As long as people give up on it when times are tough or when sexy stocks rule, value investing for the long haul will work out fine.
More to come soon — I’ll be sharing a stock that I found very interesting with the Irregulars in a note this evening, and I’m sure tomorrow will bring yet more ideas to the fore.