This post is a summary of my learnings from Joel Greenblatt’s latest book – The Big Secret for the Small Investor. The book is a perfect guide for the novice/amateur investor to understand why money managers won’t work for her, or for the intermediate investor to refresh basic concepts. More advanced folks will probably benefit from just re-reading Joel’s previous book.

  • Investing approaches (4 ways) –
  1. Stock-pick / invest yourself. Fraught with danger because most people have no clue about –
    1. how much to invest
    2. which stocks to invest / how to construct a portfolio
    3. when to pull out
  2. Leave it to an investment professional or money manager –
    1. Only 30% of active fund managers beat indices like S&P 500 over long periods of time, and even those have years of huge underperformance (expected because they are doing something fundamentally different from the market).
    2. Picking good professional managers is harder than picking good stocks.
    3. Even if you’ve picked a really good manager, what is to say you will not move in and out of investing in them, (i.e.  when they underperform the market significantly for 2-3 years?). It is likely that you will not reap the full benefits of their performance.
  3. Invest in traditional index funds
    1. They have the Mr.Market fallacy that Graham coined – when stocks are overpriced, their market cap goes up and the index weighs them move. So you are moving in tandem with Mr.Market’s emotions and buying more of what is already well-priced or expensive and not buying much of the under-priced or bargain opportunities.
  4. Read this book and follow its approach.
    1. A new kind of index fund that is value-based – factors in how cheap the stock is (based on earnings yield) and how good the company/business is (based on return on capital invested by the company itself). 
  • The secret to successful investing is to figure out the value of something and then pay a lot less.
    • The concept of value – what it is and where it comes from.
    • The true value of a life comes from not a bad week or even a series of bad months, but everything that has been done and accomplished over a period of several years.
    • The value of a business similarly does not have much to do with what happens over a single month or year, but how much that business can earn over its lifetime.
  • Present value of a business  = Annual cash flow / (Discount rate –  Earnings growth rate)
    • Value of a business  = sum of all the earnings we expect to collect from that business over its lifetime, discounted back in value to today’s cash dollars.
    • Valuing a business is hard because small changes to the estimate earnings, growth rate of earnings or discount rate can lead to wildly different results.
    • As as result, the “expert” guesses on the value of a business are not very meaningful.
  • One could potentially eschew absolute valuation, and go for the following alternatives –
    1. Relative valuation – Just like you would do with a house, “how much did similar houses in the same neighborhood go for?”. The downside is obvious in the dot-com bubble – when everything in the sector is overpriced, this is not much help.
    2. Acquisition value – how much is this company worth to another company? With this approach, you have more than double your work – you not only need to understand two companies and business models well, you have to account for synergy, merger costs etc. Not very helpful.
    3. Liquidation value – Some businesses are worth more “dead than alive”. The downside is that this seldom works in practice – management will keep coming up with new ideas to turn around the business and run the company out of resources instead of liquidating.
    4. Sum-of-the-parts valuation – when a company has multiple different businesses. This is not a separate technique and involves combining multiple valuation techniques including the above 4 (absolute, relative, acquisition, liquidation),
  • TL;DR – Valuation, in even in its alternate forms is hard.
  • Proposal – eschew absolute valuation. Instead compare with what you could earn risk-free with your money first. (e.g. 6% annual return on 10-year govt. treasury bonds).
    • Even if prevalent interest rates are low, sticking to a lower bound of 6% is helpful as passing that test builds confidence in the investment.
    • If you have high confidence in your estimate that the earnings from the business will offer a significantly higher annual return than the risk-free rate over the long-term, you’ve cleared step one.
    • Next, find another business to compare with. If something is too hard to evaluate (i.e. earnings, growth rate, discount rate), skip that company and find one that’s easier to evaluate.
      • For example, the local cyber-cafe business offers better returns than the govt. treasury bonds, but the local arcade-machine business provides even better earnings yield with higher confidence.
    • The best course of action is to stick to a few companies where you have a deep understanding of the business, industry, and future prospects for earnings. (Most professional money managers cannot afford to do this, for various reasons explored later).
  • You can’t beat Tiger Woods at golf, but you can play a different game. You can’t beat most professional money managers on Wall St, but you can do things the way they won’t do or cannot do, to eke out good returns for yourself.
    1. Manage smaller amounts of money
    2. Go for smaller companies – companies below $1 bn don’t make sense for institutional investors with large sums of money to manage. They cannot hold more than 5-10% ownership stakes of most companies. Wall St. research analysts won’t cover many small companies, and the possibility of there being a bargain due to lack of information or mispricing is more.
    3. Concentrate on a smaller number of companies – ones that you have done intense analysis on, and are comfortable with the economics of. Most professional money managers are held to one or the other benchmark, and evaluated against those frequently, so they cannot concentrate in a few companies they believe for fear of significantly underperforming the benchmark. If that happens for just 2-3 years, they will lose significant clientele.
    4. Invest in special situations – spinoff transactions, mergers, acquisitions, These are cases where institutional investors won’t be as interested in, and there isn’t as much as research coverage (unlike IPOs, Wall St. firms don’t make money in these transactions). The author wrote a separate book called “You can be a stock market genius” covering these cases.
  • TL;DR – there are plenty of ways for investors willing to do some work to gain an edge. Most professional money managers don’t or can’t take advantage of them.
  • Where professional money managers fail –
    1. Fees for funds are some fraction (1-2%) of assets under management. Incentive to gather more assets is not good for investors.
    2. Most actively managed funds own 50-200 stocks in their portfolio. Valuation is hard, and by the time a fund gets to its 20th or 40th favorite pick, it is highly unlikely that that pick is both accurately valued and available at a good price.
    3. The way the system is set up (they can’t own more than 5-10% of a stock), the most practical route for them is to own a number of small positions in large market-cap companies.
    4. They cannot concentrate their portfolio on just their few best ideas. Being held against a benchmark they are regularly compared to, implies that they cannot risk a small # of bad stock picks having a negative influence on their portfolio. And hence the miss the upside of a small # of good stock picks having an outsized influence!
  • Even the best performing managers go through significantly long periods of significant underperformance.
  • The best performing stock mutual fund of 1999-2009 earned 18% annual returns. Yet there were investors in this fund who lost 11% annually – because they moved in and out at the wrong times.
  • Morningstar admits ranking funds based solely on low expenses would have done a more consistent job of predicting future good performance than their proprietary star rating system.
  • “I think I could make 50% a year on a million, no, I know I could. I guarantee that.” – Buffett in 1999.
  • Creating an index that doesn’t suffer from the built-in flaws of market-cap weighting i.e. an index that doesn’t systematically own more of the overpriced stocks, and less of the bargain ones.
    1. Equally weighted S&P 500 index – i.e every company is 0.2% of the index. This is flawed in that you will value an economically larger and more valuable sector less because it has fewer companies.
    2. An index weighted by attributes that reflect economic footprint (sales / earnings / book value) solves the problem with a. Fundamental economic footprint also tends to be correlated with market capitalization.
      • There’s proof that such indices can beat S&P and Russell by 1-2% per year before fees. Check out Powershares FTSE RAFI US 1000 (ticker:PRF) constructed by Rob Arnott at Research Affiliates.
      • The 1-1.5% advantage just comes from the benchmark (market-cap-weighted) being flawed, but that annual little edge translates to a 32% larger nest egg over 20 years.
    3. Let’s build a value-based index! The problem with market-cap-weighted indices is that they suffer from Mr.Market’s emotions (overpricing or underpricing something) rather than taking advantage of it. How can we correct that?
      • Start with the top 1000-1400 market cap stocks.
      • What is underpriced? A stock with a large trailing year’s earnings yield (i.e. 15% compared to overall market’s 8%). Even though the earnings were high, the market did not believe that they would be sustained, and the low stock price is a reflection of that. There’s a possibility Mr.Market punished this stock too much!
      • Ranking by last year’s earnings yield gets you a universe of cheap stocks.
      • Of these, which are good businesses, since Buffett talks about getting “good business at a bargain price”? Use trailing year’s returned-on-invested-capital as a proxy for this. A business that took in $100k in cap ex last year and generated $40k in earnings is better than one that took in the same cap ex but generated $5k in earnings.
      • With these two metrics, you can rank firms to build an index that will significantly outperform S&P-like indices over the long term.
  • TL;DR –
    1. Market-cap weighted indices are bad, but still beat most active money managers.
    2. Fundamentally weighted indices do a little better (1-2% annually) than market-cap weighted.
    3. Value-weighted indices can beat them all (and that’s not the big secret!).
  • Large part of investing success is not doing silly things that our psychology programs us to do – flight (run away / exit) when stocks turn down, or buy more when they go up and are overpriced. Sticking to value-based indices provides an automatic way of fighting that psychology.
    1. Along with that, do one more thing. Decide the allocation of stocks in your overall net-worth portfolio (for most people, this is between 40% and 80%) based on how much downturn and pain you can take without exiting.
    2. If you stick to say 60% of stocks in your portfolio, set an upper and lower bound as well – say 10% on each side. You cannot let stocks be more than 70% of your portfolio (if you are buying as prices jump up) or be less than 50% of your portfolio when (if you sell as they go down). Furthermore, you are only allowed one round-trip up and/or down per year.

KR Notes:

  1. PRF is the one big recommendation this book makes. The 6-page appendix at the end of the book lists other recommendations, but none are value-weighted in the way the author recommends. Surprisingly, references to Joel’s own funds are hard to find, either in the book or on the companion website
  2. I had the privilege of meeting Joel at Google for his talk , which is also nicely summarized here.