Joel Greenblatt on How to Achieve a 40% Return a Year

So if you believe what Ben Graham said, that this horizontal line is fair value, and this wavy line around that horizontal line are stock prices, and you have a disciplined process to buy perhaps more than your fair share when they're below the line, and if so inclined, sell or short more than your fair share when they're above the line, the market is throwing us pitches all of the time.

So even Warren Buffett says the vast majority of people should index and I agree with him. So are there any questions or do I have any time? Then again, I get, well, I have time. So, uh, then again, you know, Warren Buffett doesn't index and neither do I. So I thought I'd tell you why, uh, and then maybe you'll have some more information to decide for yourself what makes sense for you.

In a sense, it shouldn't be that hard. I actually, I had a friend, uh, who's an orthopedic surgeon and is in charge of a group of orthopedic surgeons, and he asked me to speak to them at a dinner about the stock market.

I said, okay, these are smart, educated guys; they can understand this stuff. I spoke for about 35 minutes explaining how the stock market worked and everything else. Then, I started getting questions along the lines of, "Oil went down two dollars yesterday; what should I do?" or "The market was up two percent yesterday; what do I do about that?"

So my interpretation of those questions was I had just crashed and burned. Last year, uh, I was lucky enough to be asked to teach a 9th grade class—a bunch of kids mostly from Harlem—and I had just sort of crashed and burned with the orthopedic surgeons, and I didn't want to do that with the kids.

So I started to try to think of what could I do, uh, to explain the stock market a little bit better. I walked into class the first day, uh, and I handed out a bunch of three by five cards. I asked, uh, I brought in this jar of jelly beans right here, and I asked, uh, the students, uh, you know, passed around the jar of jelly beans, asked them to count the rows, do whatever they wanted to do, and write down their best guess for how many jelly beans were in the jar.

I collected the three by five cards, then I went around the room one by one to each one of the kids in the room, uh, and I said, "Listen, you can keep your guess; you can change your guess; that's up to you." I went one by one around the room, asked people how many, and wrote down the various guesses.

So it turned out the average of the guesses for the three by five cards was 1,771 jelly beans; there are 1,776 jelly beans in the jar. So that was pretty good. The guess when I went around the room, uh, that was 850 jelly beans.

I explained to them that the stock market's actually a second guess. Okay? Because everyone knows what they just read in the paper, what the guy next to them said, what they saw in the news, and are influenced by everything around them. And that was the second guess.

And that's the stock market—the cold, calculating guess. When they were counting rows and trying to figure out what was going on, that actually was the better guess. That's not the stock market, but that's where I see our opportunity.

You know, once a year in my class at Columbia, I, uh, at least for the last five or six years, somebody raises their hand and asks a question that goes something along the lines of, something like this: "Hey Joel, congratulations! You've been doing this for 35 years and you've had a nice record, but now there are more computers, there's more data, there's more ability to crunch numbers, and, kind of, isn't the party over for us? Isn't it just more hedge funds? There's just a lot more competition; isn't the party over for us?"

So my students are generally second-year MBAs; I'd say average age 27 or so. So I just answer it this way: I tell them, "Let's go back to when you learned how to read."

Uh, let's take a look at the most followed market in the world; that would be the United States. Let's take a look at the most followed stocks within the most followed market in the world; those would be the S&P 500 stocks. Let's take a look at what's happened since you learned how to read.

So I tell them, from 1997, uh, when they were 9 or 10, uh, to 2000, the S&P 500 doubled. From 2000 to 2002, it halved. From 2002 to 2007, it doubled. From 2007 to 2009, it halved. And from 2009 to today, it's roughly tripled, which is my way of, uh, telling them that people are still crazy.

That was just the last 17 years, uh, and I'm way understating the case because the S&P 500 is an average of 500 stocks. If you lift up the covers and look underneath what's going on, there's a huge dispersion of those 500 stocks between those at any particular time that are in favor and those that are out of favor.

And so there's a wild ride going on underneath the covers. If you look under the covers, the wild ride of those 500 stocks at any particular time, and that doubling and halving, doubling and halving, with the average of 500 stocks really smoothing the ride, so there should be an opportunity.

And if you understand what stocks are, and I, uh, guarantee my students first day of class—I make a guarantee every year—they walk in and I guarantee them this: If they do good valuation work of a company, I guarantee them the market will agree with them.

I just never tell them when; it could be a couple weeks, could be two or three years, but if they do good valuation work, the market will agree with them. Stocks are not pieces of paper that bounce up and down you put complicated ratios on like sharp ratios or certain ratios; stocks are ownership shares of businesses that you are valuing and, if so inclined, try to buy at a discount.

So if you believe what Ben Graham said, that this horizontal line is fair value and this wavy line around that horizontal line are stock prices, and you have a disciplined process to buy perhaps more than your fair share when they're below the line, and if so inclined, sell or short more than your fair share when they're above the line, the market is throwing us pitches all of the time.

The reason people don't outperform the market—there are behavioral problems, there are agency problems—but it's not because we're not getting those opportunities. I will show you briefly; let me tell you how we value stocks.

It's not very tough, and I think most of you will understand it. I think the best example that resonates, seems to resonate with most people, is thinking about buying a house.

And to keep the numbers simple, let's say that someone is asking a million dollars for the house they want to sell, and your job is to figure out whether that's a good deal or not.

So there's certain questions you would ask. First, one of the first questions I'd ask is, "Well, how much rent could I get for that thing?" Okay? So in other words, if I rented out that million dollar house, how much rent would I collect?

If I, uh, were going to collect 70, 80, 90 thousand dollars a year, seven, eight, nine percent yield on that house, that's one way I might go about valuing it. And what's the next question you would ask? I'm pretty sure I know what it would be.

Uh, what are the other houses on the block going for, in the block next door, in the town next door? How does this compare? How relatively cheap is this relative to all my current choices?

So that's what we do. We look at how relatively cheap is this business relative to other similar businesses, relative to a whole universe of choices that I have. We do that. We also go back in history, look at how this company or this house has traditionally been valued versus other ones in the neighborhood or versus other communities, and how is it being valued now?

So measures of absolute relative value—absolutely cheap, you know, on a rental basis, absolutely cheap, or relatively cheap on all different kinds of measures that makes sense to you now.

You wouldn't use any of these measures all by themselves. If you just use relative cheapness, uh, if some of you remember the internet bubble and you bought the cheapest internet stock, that wasn't cheap; it was just cheap relative to all the other crazy priced stocks at the time.

But we use our measures of absolute and relative values, checks and balances against each other, try to zero in on fair value. So when you do this, uh, I just want to show you a simple chart.

Uh, this is actually a study we did of our evaluation methodology, very, very similar to the way I just said we value a house. This is how we looked at the 2,000 largest companies in the U.S. over a 20-year period; this was 1992-2012.

We ranked them on a daily basis from one to two thousand based on their discount to our assessment of value using these metrics. The x-axis here, you probably can't see it, uh, is just a valuation percentile. All this means is if you're in the bottom left-hand corner and you're in the first percentile, you're the 20 companies at any particular time out of those 2,000 that measured cheapest according to our measures of absolute relative value.

Uh, go to the 99th percentile, uh, you would be the 20 companies that measure most expensive out of those 2,000. The y-axis is the year forward return on average during those 20 years.

What this chart simply says is on average, stocks that fell in our first percentile, the cheapest 20, uh, averaged a one-year forward return during those 20 years of 38 percent. Stocks that ranked in our second percentile averaged a one-year forward return of about 37 percent.

And then we dropped down to this best fit line, which we always say we don't mind missing when we're making extra money. And then as we measure something more expensive, the year forward return drops.

If you were sitting in my class at Columbia and I said, "Hey, does anyone see a long-short strategy 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 these guys up here in the upper left-hand corner and short these guys in the bottom right-hand corner," if you didn't say that, I'd probably throw you out of class because it's very straightforward; that's what you should do.

And by the way, that's what we do. The important thing to understand is that stocks are ownership shares of businesses.

Okay, now, uh, by the way, that beautiful chart I showed you with the 90 fit, you know, why doesn't everyone do this? Uh, well, unfortunately, it doesn't look like that when you're living through that. That's an average over 20 years. If I showed you a snippet of three or four years, uh, it would be nice; it might be 0.55, 0.6, something like that, but, uh, it's not going to be very cooperative, right?

If what we did worked every day and every month and every year, everyone would do it; it would stop working. But, but it, uh, it doesn't, unfortunately.

But the reason that we stick to what we're doing even when it's not working is that chart, meaning the way we value companies, our measures of absolute and relative value, approximate how the market values them over time.

If we were, for instance, momentum investors, okay? And I will tell you that, uh, for those of you who know what that means, uh, momentum has been studied across the globe over the last 30, 40 years. In the U.S., it's worked pretty much everywhere—uh, not all the time, but on average it's worked very well over 30, 40 years, and not just in this country.

But here's the problem: What if it didn't work over the next two or three years? It could be, uh, that we just have to be patient. You know, it works over time, and it's cyclical, and so it's out of favor, and we just have to stick to our guns because it's something that's worked.

Or it could be if it didn't work in the next two or three years that the explanation is, "Hey, it's 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 with all the data and the ability to crunch numbers, and computers, and studies that have come out, it's a crowded trade; it's degraded; it's not as good as it used to be. And if that's what happened over the next two or three years, I would know the answer to that question.

I didn't know which one it was; should I just be patient, or has the trade degraded? But if you view stocks as ownership shares of businesses that you value and try to buy at a discount, and that doesn't work for a couple of years, I'm not going to change what I'm doing.

I'm not going to buy the bottom, uh, right-hand corner, you know, buy all the money losers and the companies that don't earn anything or trading at 100 times free cash flow. I'm not going to buy those even if it works in one particular year and then sell the ones that are cheap relative to everything, get me high rents and everything else.

I'm not, I'm not going to change my strategy, uh, and I believe that, uh, stocks will eventually—not right now, but eventually—uh, people will get it right, and I may have to be patient. That's really what I have to do.

What that chart tells me is I'm on the right track, meaning that's sort of our true north, and we just have to be patient to get there.

Uh, the reason that these simple metrics don't get arbitraged away is the example I, uh, usually use for arbitrage is, uh, oh, you see gold in New York at twelve hundred dollars, and it's selling at London simultaneously at 1,201.

Well, an arbitrage sitting on a trading desk someplace will see that and buy up gold in New York at twelve hundred and push the price up a little bit; he'll simultaneously sell gold in London at 1,201 and push the price down, and they'll convert someone somewhere in the middle; it'll happen so fast on a trading desk that you don't really even get to see that.

But what if I told you you could buy gold in New York today at twelve hundred, and sometime in the next two or three years you're gonna make money, but you could lose twenty percent of your money while you're waiting?

There's no guy sitting on a desk anywhere that really can do that; and frankly, uh, time horizons are getting shorter. Uh, it used to be when I was, uh, younger I used to get quarterly statements, and most people would throw them in the garbage.

Now you can check your stock price 30 times a minute on the internet; maybe some of you do. Uh, and time horizons are shrinking and we're just playing time arbitrage, we're being patient, buying cheap good businesses and waiting for the market to recognize the value we see.