Howard Marks & Joel Greenblatt on Value Investing

So I don't think the reason people don't beat the market is because the market is efficient or even close to efficient or not emotional. It's very emotional. Or that it can't be done. There's all kinds of institutional and agency reasons and tons of other reasons why they don't do it. But because prices are efficient, if you just pick up the paper or observe what's going on or listen to what I told my students since you know when they were 10 years old, it's pretty clear that people are still crazy and there's opportunity out there.

You wrote the book on special situations investing, enumerating a number of ways to make money from spin-offs, recaps, reorgs, bankruptcies, mergers, and the like. Given that you wrote the book and thus there were no books before you wrote yours, how did you figure out how to invest in this way? How did you figure out what was important and where you could and couldn't make money?

Well, you're right; that is a great question. Um, well, I actually started, uh, my first job was with, uh, they didn't call them hedge funds back then, but it was with a risk arbitrage firm. Risk arbitrage, otherwise known as merger arbitrage, involves buying a company after a merger deal is announced and hoping that it closes. Generally, the risk-reward in that business is, uh, well, if it— the merger closes, you make a dollar, and if it breaks, you lose 10 or 15 dollars. And that risk-reward wasn't that appealing to me.

Um, and so I started looking for other ways to do it. So I looked for mergers that had interesting securities. I, uh, you know, coming off, uh, you know, the way they were paying for the merger, I looked for, uh, extraordinary events happening within companies, whether recapitalizations or spin-offs or anything where I could get out of the business, where I could make a dollar and lose 10 or 15. And so I was just looking for things that were a little off the beaten path.

I really started learning when I was at Wharton, and at the time, uh, Wharton was really in the efficient market camp, the way they were teaching things, and it didn't resonate with me. In my junior year, I happened to read an article about a guy named Benjamin Graham, and as soon as I read that article, I said, “Ah, this makes sense to me.” I started reading everything that he wrote and started looking at the world really through a different lens. And that lens was not the first job I took, which was risk arbitrage; it was really looking for, uh, figuring out what something is worth and paying a lot less, leaving a large margin of safety.

And so these special situations gave me that opportunity. I opened up that book “You Can Be a Stock Market Genius”—one of the worst titles ever given [Laughter] to a book. It was supposed to be “Any Fool Can Be a Stock Market Genius,” and then my editor had the Motley Fools at the time, which was very popular, so he said, “Oh, you can't use the word fool.” And so my dad said, “How about, 'You Can Be a Stock Market Genius'?” And then in parentheses, “Even If You're Not Too Smart.” And so I giggled a little bit, and they only gave me a day to change the title, so I just went with it.

That wasn't a good choice, uh, but I opened the book with a story about my, uh, in-laws, uh, who spent, uh, they used to live in Connecticut for part of the year, and they would spend their time antiquing, uh, going to country auctions, going to tag sales, and they were looking for art and antiques that were undervalued. When they found a painting at a country auction or at a tag sale, um, the question they asked was, uh, if they saw a painting by an artist, and they had seen that, that artist had just gone for auction with a similar type painting, similar size, similar genre, whatever it was, and it had sold at auction recently at two or three times the price that they could buy it for, they would go buy it.

That's a lot different question than asking, uh, “Is this painter going to be the next Picasso?” That's a much harder challenge. So I opened the book saying special situation is a little like that. You know, you don't want to be so smart to know who's going to be the next Picasso; you sort of want to look a little off the beaten path because this is a little more obscure.

Uh, it's smaller market cap; it's something strange is going on, and the normal people who follow this aren't going to look at it because it's too complicated or you got to read a 400-page thing or, uh, you know, the piece being spun off, uh, is not really why people bought the original stock in the first place. It's for the small, not for the little small business that's being spun off. So these were discarded things. So it was my way of making the challenge easier, finding things that were selling well below their fair value.

It wasn't so much, um, you know, I finished that first chapter of "You Can Be a Stock Market Genius" with a story about the plumber who comes to your house and, uh, bangs on the pipe once and says, “That'll be 200.” You know, fixes your pipes and says, “That'll be 200.” And you say to the plumber, “What do you mean 200? You came here and banged on the pipe once!” He says, “Oh no, that's only five dollars. It's 195 dollars to know where to bang.”

So, so that's how I view special situation investing—just making the challenge easier. And so, uh, I'd rather be a little and not as smart and a little bit lazy but go for, you know, uh, Warren Buffett would call them, uh, one-foot hurdles. Why go around looking for ten-foot hurdles to jump over if you could find some one-foot ones? So I don't have to be all that smart to be good if I'm looking in the right places.

You know, Joel, I wrote a memo in, uh, January of '14 called “Getting Lucky,” and I told the story of a guy who was working on becoming a better poker player. So he's working on learning the odds of getting the cards you need, the odds that the hand you had would beat other hands, the tells that tell you whether the other side is bluffing or not. And he—his uncle said to him, “You're wasting your time trying to become a better poker player. Why don't you just find an easier game?”

And it sounds to me like what you did is look for what you thought were easy games.

Yeah, it's, uh, you know, the last story I told in the book that illustrates the same point is, uh, I tell a story that I lost a bet, and the loser had to take, uh, the winner to, uh, the best restaurant in New York at the time. It was Le Cirque; there was a chef there, Andre Saltner, which at the time was considered probably the world's greatest chef.

And so first I called up and they wouldn't give me a reservation. You know, I thought, I said, “I'll take any time, any day.” And they said, “Sorry.” I didn't understand that. And it turns out, you know, there's some 30-day period where they'll only book for 30 days, and they were all booked. So I kept calling back, finally got in, we get to the restaurant, and I wasn't really paying attention to who came over to take my order. But I, uh, pull out my manual and point to one of the appetizers and I said, innocently, “Is, I pointed to one and I said, 'Is this one any good?'”

So Andre Saltner turns to me and says, “No, it stinks.” So, uh, you know, the best chef in the world, I'm asking if, you know, this thing he just cooked is any good. So the point was, I think the point he was making was everything on the menu is good. This is the best restaurant in the world.

And so I try to shop in in the best places where almost everything, uh, is good and I just have to discern between a bunch of different good things.

So Joel, you mentioned buying things for a lot less than they're worth, and that provides the margin of safety. Would you say that those are the core, uh, elements in value investing? And do you want to enhance that definition, uh, any, or is that enough?

Um, well, and one other question: you mentioned that you didn't think it would be a great idea for your in-laws to try to find the next Picasso. Would you analogize that to growth investing?

Um, sometimes. I mean, uh, my definition of value investing is figure out what it's worth, pay a lot less. It has nothing to do with low price-to-book or low price-to-sales. And so that's how a lot of people like Russell or Morningstar would classify value investors, and so they probably wouldn't classify me as a value investor or a growth investor. They kind of don't know what to do with us. And, you know, as Buffett has said, you know, growth and value are tied at the hip. I mean, uh, part of what makes value is by investing in a business that can grow over time.

So they're not two different, uh, way they're classified by, let's say, Morningstar, Russell. Maybe there's much lower growth in value and and much higher growth in growth, and that they they make it that way, but I’m looking for good businesses that are cheap. You know, Ben Graham said, figure out what it's worth, pay a lot less, leave a large margin of safety, uh, between those two big—space between those two things.

Warren Buffett, his best student, made one little twist that made him one of the richest people in the world. Buffett simply said if I can buy a good business cheap, even better. Part of good is a business that can grow over time. And so, um, I slowly gravitated—not fast enough, I, you know, certainly in my first decade of investing—gravitated more towards the way that Warren Buffett invests. He's looking for good and cheap businesses, and growth is part of, uh, sometimes being good.

But at the beginning, Buffett wasn't so entranced with good businesses. He was famous for starting off with the cigar butt approach, where he wasn't looking for quality, he was just looking for cheapness. But then he too made a transition.

Yeah, I mean, my master's thesis at Wharton, or turned into that, uh, with, uh, my friend Rich Pizina and Bruce Newberg, was a paper we wrote that eventually got published in the Journal of Portfolio Management about buying cigar butts. You know, they were called net nets—buying stocks selling below their liquidation value—and showed that just buying, if you bought it cheap enough, you could make nice money. And and that's sort of the way Warren Buffett started.

But when you think about why we move towards quality, let's say you find a stock that's worth ten dollars and it's selling at six. It's pretty cheap. Uh, but if you're not controlling the business, uh, and it's not in a good business, your margin of safety may erode over time, meaning that ten dollars could turn to eight if you're not really controlling those assets.

And what you're really looking for businesses or what looks better to me anyway are businesses where that ten dollars might be growing to eleven or twelve, increasing your margin of safety. So, uh, I might take a lower margin of safety if I thought that was growing.

But there's, there's more—buying things cheap works. I mean, cheap alone works; I have nothing against it. It's just that you have to get out of it. So Buffett, who runs 100 billion or some number like that, it's not easy to go spend five billion and then go sell it to some other guy who's going to, you know, pay you more than the five billion; it's too big. So when he was—and he said as recently as, uh, you know, around year 2000, he said, “Well, if you give me a million dollars, I can make 50 a year on that. There's plenty of opportunities.”

Your opportunity set shrinks as the businesses become larger. If you can invest in anything, you know, if you don't have a lot of money, you can invest in thousands and thousands of businesses. Buffett is now looking at the top 300 businesses in size because, uh, the smaller ones aren't—they won't move the needle.

So there's a lot you can do in special situations. One thing a lot of my students asked me, uh, you know, and it happens every year now probably for the last five or six years, and they— and, uh, the question they asked me at some point in the semester is that, you know, when you were younger—because you're really old—they leave that part out, but you're really old, and when you were younger, things were easier. It goes unsaid. Well, I just said it.

But anyway, uh, things were easier. There was less competition; there were less hedge funds; there were less computers; there were less smart guys going into this business. I mean, when I got into it, I was telling Howard before, the market hadn't gone up in 13 years by the time I got to Wall Street. So it wasn't a place that really was attracting lots of people.

So they said it used to be easier for you, but you know it must be harder for, you know, “Hey, you stupidly wrote a book about this, and there's a lot of people doing this now.” Not just because of that, obviously. Um, you know, it's harder for us. You know, you got the easy stuff. And so my response is this: People who are very good, especially in a special situation, I have two responses.

One is, uh, people who are good at special situation investing really looking off the beaten path, uh, for liquidations or recapitalizations or spin-offs or any of those things—many of them are liquidity constrained. You know, Warren Buffett started making a lot of money doing those things, but he grew too big. And so I asked, I tell them that, “Listen, you know what happens to people who get very good at analyzing businesses in this area? What happens to them is they make a lot of money and they get too big to stay in this area.”

So there's always a new group of people who can come in and look at some of those smaller situations because the guys who are really good at it get too big to, to really take advantage of some of the smaller or more obscure situations. And so there's always room for new people to come in that area.

And then on a larger scale, uh, you know, because people still teach efficient markets and they'll say, “Hey, you know, active investing doesn't work,” and even Warren Buffett's saying, “Go buy some ETFs” or, you know, indexes and everything else. And what I'll say is, uh, that for most people that's true because they don't know how to value businesses.

But I will give you a counter, and this is what I tell my students, and most of my students are around 27ish or something like that, so I said, I tell them all, “Let's go back to when you were roughly 10 years old where you might start noticing some of this thing, and let's go look at the most followed market in the world.” And that would be the United States, and let's go look at the most followed stocks in the most followed world in the most followed market in the world, and that would be the S&P 500 stocks, to a large extent.

Let's take a look at what happened since you were 10 years old. Take a look at the S&P 500 from 1996 to 2000; it doubled. From 2000 to 2002, it halved. From 2002 to 2007, it doubled. From 2007 to 2009, it halved. From 2009 till today, it's basically tripled. That's my way of saying people are still crazy, and that's really an unfair thing to say because this S&P 500 is an average of 500 stocks.

There's huge dispersion going on within that average between stocks that are in favor that people love emotionally and stocks that people hate. So it's really much worse than what I just described—there's huge dichotomy between things people like and people don't, things that are in favor and out of favor. Within that, that is all this noise is going on within that average; that average is smoothing things.

So if you believe what Ben Graham said is, you know, here's fair value, and here's what the market prices are—it's like a wave around fair value. And if you have a disciplined way to value companies and buy more than your fair share when they're down here and sell some, maybe if you're shorting, when—and you're very disciplined, I mean, uh, I make two guarantees to my students on the first day of class.

First guarantee is this: If they do good valuation work, I guarantee them the market will agree with them. I just don't tell them when—could be a couple weeks, could be two or three years. But I tell them the market will agree with them, and the—and the corollary to that is this, and it's very powerful. I tell them in 90% of the cases for an individual stock, two or three years is enough time for the market to recognize the value they see if they've done good work.

When you put together a group of companies, that actually on average is actually happening quite a bit faster. So, um, you know, both those are very powerful. It just says good work will be rewarded. So I don't think the reason people don't beat the market is because the market is efficient or even close to efficient or not emotional. It's very emotional.

Or that it can't be done. There's all kinds of institutional and agency reasons and tons of other reasons why they don't do it. But because prices are efficient, if you just pick up the paper or observe what's going on or listen to what I told my students since you know when they were 10 years old, it's pretty clear that people are still crazy, and there's opportunity out there.