Star Investor Joel Greenblatt Beats the Market Without Going Out on a Limb

JOEL GREENBLATT: Even top managers zig and zag wildly, and no one gets to stay with them because they have long periods of underperformance. So,

we’re trying to mitigate that. We’re trying to minimize that so that people can stay with us and collect the active premium that we’re trying to bring.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. We have an exclusive interview with great value investor and financial thought leader Joel Greenblatt this week.

He is living proof that active management can still work really well.

Greenblatt is Managing Principal and Co-Chief Investment Officer of Gotham Asset Management which he founded in 2009 and where he co-manages hedge funds and several hedge fund-like mutual funds utilizing long/short strategies. His early claim to investment fame was at his predecessor firm, Gotham Capital where he co-managed an extremely concentrated hedge fund with 34%

annualized returns over ten years, before he closed it to outside investors because he realized its volatility was too difficult for even sophisticated investors to handle.

His behavioral insight that the best investment strategy is one that both makes sense and that you can stick with led to the creation of the Gotham Index Plus fund in 2015.

Index Plus combines index investing tied to the S&P 500 with actively managed long/short strategies where the fund owns, goes long the S&P stocks selling at the biggest discount to Gotham’s estimate of their value, recently 262 of them, and sells short the companies

Gotham estimates are trading at the greatest premium, recently 236 names.

Rated 5-star by Morningstar, Gotham Index Plus has beaten the market and its sizable large cap blend category by wide margins since inception.

The proposition that active management still works can be made on a case-by-case basis in the highly competitive stock mutual fund business but it doesn’t hold up in general.

Morningstar’s latest Active/ Passive Barometer report found that just 38% of active U.S.

stock funds survived and outperformed their average passive peers in 2018, down from 46% in 2017. Active value funds saw the biggest decline, with only 26% beating the passive value competition. The longer term record is even worse. Only 24% of all

active funds topped their average passive rival over the 10-year period ending December 2018.

In Greenblatt’s opinion: the investment flows to passive will continue.

JOEL GREENBLATT: The reason that the wave to passive is really here to stay, whether there will be some little travels up or down over time, big picture, I gave a talk at Google a few years ago, and I started it this way. Even Warren Buffett says most people should

just index, and then I said, I agree with him and then I left. No, then I said but then again Warren Buffett doesn’t index and neither do I. How come? So, there’s a big dichotomy. If you don’t know what you’re doing, the safest thing to do is to index. Investing in stocks is really about valuing

businesses and try to buy them at a discount. If you can’t do that, your other alternative is to find a manager who has a good process and sticking with that. But I wrote a book a number of years ago, I think in 2011, called The Big Secret, and my line is always that it’s still a big secret because no one bought that book, but in it I talked about the best-performing mutual

fund for period 2000 to 2010, and that fund was up 18 percent a year, but the average investor in that fund ... oh, the market was flat during that decade, so up 18 percent a year was pretty good.

that fund ... oh, the market was flat during that decade, so up 18 percent a year was pretty good.

The average investor in that fund managed to lose 11 percent a year on a dollar-weighted basis by moving in and out at all the wrong times. After the market went up, after the market went up people piled in. After the fund outperformed, they piled in. After the market went down, they piled out, or after the fund underperformed, they piled out and turned that 18 percent annual

gain into an 11 percent dollar-weighted loss, and that’s just the way people are.

If you don’t know what the manager is doing, you look at past returns, but there have been plenty of studies showing the last one, three, five years don’t have much to do with the next one, three, five, and really what you’re supposed to do is look at process and finding a good manager and assessing that. Most people don’t have that skill set either.

I think the good news is that if most people just index, if you’re a stock picker and actually do the work, there’s less competition and I think that’ll be helpful as a stock picker long term, but the active management business will still continue to be threatened.

CONSUELO MACK: Even if investors understand what the managers doing, at least they’re investing in a fund and they think they do, but even if they understand that going in, they just can’t stand it when he underperforms or when a fund underperforms. So, it’s not even as if you don’t understand the manager in the process. It’s that psychologically right, from a behavioral finance point of view, you can’t take the pain. Is

that just the way it is? JOEL GREENBLATT: Sure.

CONSUELO MACK: With us. Understand the nature.

JOEL GREENBLATT: With everyone. I mean absolutely the other study I wrote up in the same book was about the best-performing institutional funds for the same decade. Looking at the top quartile managers, half of them, 47 percent spent at least three of those ten years, even though they ended up with the best ten-year record, they spent at least three of those years in the bottom decile.

CONSUELO MACK: Bottom decile.

JOEL GREENBLATT: Bottom ten percent. So, it’s very painful, but to beat the market you have to do something different than the market. The returns are going to zig and zag differently, and even if you’re a manager who can stick with your process, and that’s who ends up winning at the end, it’s very hard to get your clients to believe in you after you’ve had a couple bad years.

CONSUELO MACK: It’s also hard to keep your job unless you happen to be running your own shop.

JOEL GREENBLATT: There’s, as you mentioned, behavioral problems and there are really agency problems even if you’re a large endowment. I sat on a board of university endowments but think of the difficulty of the allocators of that endowment. While a university is effectively a perpetuity, there’s no pension that you have to pay out. There’s nobody retiring. It’s basically

a perpetuity. It should have the longest time horizon of anyone, but there is a gentleman or a woman who allocates to U.S. equity managers or private equity managers or bond managers or whatever it is, and they’re viewed over a three-year time horizon. It doesn’t mean they lose

their jobs, but they like to win. They like to beat their benchmark over that three-year period.

As I always say, no one really gets fired, but no one throws you a parade either if you haven’t beaten your benchmark. So, it was an agency problem even in the funds that should have the longest time horizon. So once again I view that as good news for stock pickers because if other people are impatient, and you can be, it’s really a great way

to make money. I read a great book this past summer. It’s called Astroball. It was really written by a Sports Illustrated ... It’s sort of a next-generation Moneyball book.

CONSUELO MACK: Michael Lewis.

JOEL GREENBLATT: But it talked about the Houston Astros and how in 2014 they were the worst team in baseball, and a Sports Illustrated writer wrote a story about them, thought it would be buried in the magazine, saying that I think seriously that the Astros were going to be the World Series champions in 2017.

CONSUELO MACK: Based on ...

JOEL GREENBLATT: On what they were doing. So, in 2014 actually to their credit, Sports Illustrated put on their cover, “Houston Astros 2017 World Series Champions,” and of course they won the World Series in 2017, going from the worst team to the best team, and what did they do?

They took a long-time horizon. So usually most teams are trying to win now, and they’re trying to get players and playing their best players right now and trying to get the best players right now, so they can win the most games.

But if your focus is only on doing really well three years from now, well, you’re going to start playing some of the players that you’re trying to develop, and you’re only going to try to get people who are still going to be with you three years from now. So, you make all your decisions based on the long term, and that really worked out for them, and I think it’s the same thing in investing.

Most people are judged over very short periods of time, and so that’s how many managers are.

You don’t want to pick stocks of companies that aren’t going to do well in the next few years, but sometimes those are the best prospects thereafter once they’ve gone through the tough period. That’s why you’re getting the bargain, and so if you’re actually focused on what’s going

period. That’s why you’re getting the bargain, and so if you’re actually focused on what’s going to happen three, four years from now, you’re kind of alone. It’s called time arbitrage. It’s

waiting for the market to agree with you. What happens in the short term could be very ugly.

Time horizons are actually shrinking. They’re not growing and so as much as I said unkind things about active management, the opportunity set is really quite nice for people who view stocks as ownership shares of businesses that they see the value and try to buy at a discount.

It sounds ridiculously simple, but it could be a nice world for stock pickers.

CONSUELO MACK: We’ve had a ten-year bull market, and we see all sorts of signs of corporate earnings are starting to slow down. The economy’s starting to slow down. We’ve got a global slowdown. Aren’t we possibly entering an era where the stock market is not going to do that well?

slowdown. Aren’t we possibly entering an era where the stock market is not going to do that well?

JOEL GREENBLATT: We’ve been valuing the stocks in the S&P 500, and we can do that based on the way that we value businesses based on varying measures of absolute wealth to value that we’ve always used, and we can go back to 1990 where we have good data.

Where do we stand today versus the last 28 years? Doing it that way right now based on our data, we sit in the 16th percentile towards expensive over the last 28 years. That

means the market has been cheaper 84 percent of the time and more expensive 16 percent of the time. This isn’t a prediction, but what we can do is go back in time and

the time. This isn’t a prediction, but what we can do is go back in time and say from the 16th percentile in the past, what’s happened over the next year or two?

CONSUELO MACK: What has happened?

JOEL GREENBLATT: Year four returns have averaged about four or five percent a year going forward and nine to 11 over the next two years. So not terrible, not negative, even though we’re above average in valuation. Market averaged about nine or ten percent returns during the 28 years we looked at, so certainly sub normal but not negative.

Of course, your opportunity set is not just what’s in front of you today but what might be in front of you nine or 12 months from now or even two years from now. So, should you be patient and hope for better opportunities? That one I can’t help you with. I can tell you for the Russell 2000 we’re in the fourth percentile. That’s stock number 1,000, one through 3,000 in market cap.

CONSUELO MACK: So, 96 percent of the time it’s been cheaper, in the Russell 2000.

JOEL GREENBLATT: Yes. Very, very expensive. Small cap stocks, the Russell 2000, super expensive in the fourth percentile. Only been more expensive four percent of the time over the last 28 years and cheaper 96 percent of the time. When it’s been here in the past, year four returns have been negative two to negative four percent.

CONSUELO MACK: Oh, interesting.

JOEL GREENBLATT: So, a totally different story, and like we do, we short stocks.

We don’t short the index. We short the most expensive stocks in that expensive index.

CONSUELO MACK: The Russell 2000.

JOEL GREENBLATT: So hopefully our opportunity set is pretty nice on the short side in small caps. They’ve been hurting us for a little while. Luckily, we’ve been making money on the long side,

caps. They’ve been hurting us for a little while. Luckily, we’ve been making money on the long side, but on the short side those have been hurting us for quite a while, but we’re shorting the most expensive stocks in a very expensive index. So, we think our opportunity set is really good there and much, much greater than in the large cap space.

So, when we go putting together a portfolio now, we’re finding the relative bargain’s more in the large cap space even though they’ve done quite well, and the most expensive stocks in the small cap space.

CONSUELO MACK: Value investing has underperformed momentum, underperformed growth more to the point.

So, is active management in value investing in big trouble?

JOEL GREENBLATT: Well, that’s a great question. Value outperformed the way Morningstar or Russell defined it for a long period of time up till 2006, and then since 2006, the last 12 years, growth has outperformed by five percent to beat the market by five percent. So,

people often ask, is value investing dead? I answer it this way. Yes, no, maybe. I don't care.

The reason is because it really depends how you define value. The type of value that’s used when Russell or Morningstar define it really has to do with low price to book, low price sales stocks,

and those are factors that have correlated with cheap stocks in the past, but our definition of value is different. We value businesses. That’s what stocks are, ownership shares of businesses.

They’re not pieces of paper that bounce around that we put fancy ratios on. They’re actually

ownership shares of businesses, and so we value businesses and try to buy them at a discount.

That’s our definition of value investing. Both Russell and Morningstar put us in blend, meaning we’re not low-price book, low price sales investors. As Warren Buffett has often said, value and growth are tied at the hip. Growth is part of valuation. So, if we were private equity investors which is the way we going to buy the whole business, that’s the way we value businesses, like we’re going to own the whole thing. They don’t buy whole businesses,

private equity firms, based on low price book, low price sales.

They’re looking at cash flows, and that’s what we’re looking at. What are the cash flows? How

much are they going to grow? This is how we’re going to value the business. That’s

what we do. So, it doesn’t make sense that if you’re good at valuing businesses and then can buy it at a discount that that should ever go out of favor.

So if you believe what Ben Graham said, you know Warren Buffett’s teacher, that this horizontal line is fair value and this wavy line around that horizontal line are stock prices, and you have a disciplined strategy to buy more than your fair share of companies when they’re below the line, and if you’re so inclined to sell or sell short more than your fair share when they’re above

the line, the fair value line, the market’s throwing us pitches all the time. You just

have to be cold and disciplined to be able to take advantage of them, and that’s really hard.

CONSUELO MACK: You’re still getting the pitches even when the markets are valued at kind of near historic highs.

JOEL GREENBLATT: We go in cycles, and we’ve had a good run. That’s true,

but we always have shakeouts, just the nature of the beast. People get very emotional, and if you’re patient, that was just the last 20 years. A lot of doubling and halving, doubling and halving, so I think the world won’t change. The reason for that really is simply you can throw all the computers you want into this. People are people, and people don’t change,

and so that’s really what we have going for us. CONSUELO MACK: One of the reasons you created the Gotham Plus Index fund was because people just couldn’t take the variation in the returns, anything that deviated tremendously from what was happening in the market, and the Gotham Index Plus fund has knocked the lights out,

so congratulations on that. Why has the performance been so good?

JOEL GREENBLATT: I think we’ve done well because we’re doing what we said we’re going to do. Number one, Gotham Index Plus was made not to have too much underperformance on any annual period below the S&P 500. Why? Because most people use the S&P 500 as their benchmark to whether you beat the market or not.

Most people can’t take the pain when you underperform by a lot, so we structured the fund so that we could take advantage of our stock picking, but we try to mitigate the periods of underperformance by making compromises basically. So, what the fund really is, is you give us a dollar. We’ll go invest in the

basically. So, what the fund really is, is you give us a dollar. We’ll go invest in the S&P 500 and put a dollar into the S&P 500, the underlying stocks, and then we’ll go out and buy 90 cents more of our favorite S&P stocks, and we’ll short 90 cents of our least favorite.

CONSUELO MACK: Where’s the compromise there?

JOEL GREENBLATT: The compromise is in the 90-90 long-short overlay. So, in other words, we buy the 90 cents of the cheapest stocks. We short the 90 cents of the most expensive stocks.

CONSUELO MACK: By your valuations.

JOEL GREENBLATT: By our valuations subject to certain constraints, number one, that 90-90 we keep at zero beta because we’re already long a dollar in the S&P 500. Second,

we don’t want small stocks to drive returns.

So, let’s say we really like a company, but it’s only 0.01 percent of the S&P 500. If we really like it, we’ll buy more of it, and even five or eight times more of it than what’s in the S&P, but that’s only 0.05 or 0.08. Those stocks aren’t really going to drive the returns and, therefore, won’t drive tracking error to the S&P 500, and the third thing we do is we match fundamentals.

So, in other words, when we’re short companies, usually the ones we don’t like are the ones trading 50, 100, 200 times pretax free cash flows. Why are they trading so high? It’s

because they’re not earning tons of cash flow yet, but people think in 2025 it’s going to be great.

So, there are other fundamentals about that business that look good, like sales are growing really fast and other fundamentals are doing well. So, we actually balance fundamentals, so you’ll see on the 90 cents that we’re buying as the cheapest, our sales growth in that 90 cents is just as good as the sales growth in our shorts. So, in other words, we’re making compromises. We’re balanced, buying the cheapest we can find, shorting the most expensive.

making compromises. We’re balanced, buying the cheapest we can find, shorting the most expensive.

We hope that the 90-90 long-short overlay adds to the return of the S&P 500 but without too much pain for the investor. I wrote an essay about this, and I said the strategy that’s best for you is not only one that makes sense but one you can stick with.

CONSUELO MACK: You can stick with.

JOEL GREENBLATT: So, I told you about the history of how even top managers zig and zag wildly, and no one gets to stay with them because they have long periods of underperformance. So,

we’re trying to mitigate that. We’re trying to minimize that so that people can stay with us and collect the active premium that we’re trying to bring. So, it’s really a way to navigate what’s going on in the world where you’re taking human nature into account.

CONSUELO MACK: What do you do in a situation like Boeing where they have kind of an unexpected crisis with the 737 MAX? What do you do in a fund like the Gotham Index Plus fund?

JOEL GREENBLATT: Well, that’s a great question. Bad things happen from time to time. Unexpected bad things happen.

CONSUELO MACK: I assume you were long Boeing? I don't know.

JOEL GREENBLATT: Well, we were long Boeing but pretty much in line with the market. So,

it wasn’t a stock that we had over-weighted, so we lost in line with the market, so on a relative basis it didn’t hurt us, but that can hurt us in any particular stock even if we liked it. If there was unexpectedly bad news that is a one-time nature like what happened with Boeing,

it. If there was unexpectedly bad news that is a one-time nature like what happened with Boeing, over the short term we could get hurt. In that particular name we didn’t relative to the market anyway, but certainly when bad things happen. That’s why we own hundreds of stocks on the long side and hundreds of stocks on the short side. We have a combination of lucky

things happening for us and then bad luck. And hopefully they come out in the wash.

CONSUELO MACK: You don’t expect index funds to blow up in investors’ faces.

JOEL GREENBLATT: Well, they could lose money like I said. The S&P

500’s in the 16 percent percentile. It could fall 200 percent tomorrow CONSUELO MACK: But they’re market cap weighted, so you’re owning the biggest market cap and, therefore, those are the ... think about the FANGs. Isn’t that dangerous for the average investor?

JOEL GREENBLATT: Well, stocks are expensive but still expecting positive returns. Even

the S&P 500 is weighted. So, stock investing is dangerous.

When you invest in stocks, the market could fall for any reasons that we don’t know 20, 30, 40 percent in a year. It doesn’t matter whether you’re in an index, whether you’re in an active fund. They’ll all pretty much go down together. So that can always happen, and if you’re not prepared for that, then you will be surprised. That’s why people decide,

you know what, I can’t put all my money into stocks. Maybe I can live with 60 percent net long or 70 percent net long because I can take a 25 percent drop, but I can’t take a 40 percent drop.

People always don’t guess very well what they’ll be able to take before it happens either, so it’s better to be a little conservative there. But if you’re truly a long-term investor, you should be mostly long.

there. But if you’re truly a long-term investor, you should be mostly long.

Warren Buffett has his wife being 90 percent net long the index and ten percent in cash.

CONSUELO MACK: When he dies. JOEL GREENBLATT: When he dies and thinks she’ll do well, and I’m sort of the same mind for two reasons. One, I think he’s right and, two, it’s Warren Buffett, so he’s usually right. CONSUELO MACK: Morningstar says that the Gotham Index Plus Fund’s fees are too high, and they have your fees at better than three percent. What’s your response to that criticism?

JOEL GREENBLATT: Sure. Well, the way they account for fees at the moment isn’t doing it the way that we would look at it. Our management fee is only one percent. We cap

our other expenses at 0.15 percent, so that adds up to 1.15 percent. What Morningstar has included because it’s included in our SEC filings is that when we short a stock, we owe dividends to the owner of that stock, but it excludes the dividends that we earn on the stocks that we’re long.

CONSUELO MACK: So, for the record, 1.15 percent (Laughs) is the fee that you think is the accurate fee for the Gotham Index Plus fund.

JOEL GREENBLATT: Thanks for asking the question, by the way.

CONSUELO MACK: (Laughs) You’re welcome. One investment for a long-term diversified portfolio. The last time you were on over a year ago it was the Vanguard Value ETF, VTV. So Vanguard Value ETF?

JOEL GREENBLATT: I would stick with that I think, despite the fact that that type of value investing has not worked for quite a long time. When you analyze the portfolio and the stocks that they’re in, I think investors are getting a relative bargain to the S&P today, and it’s had a long period of underperformance, that type of value, and so I think it’s a good long-term play.

CONSUELO MACK: A piece of advice for individual investors. Given the fact that we’ve had this ten-year bull market – stock prices are pretty expensive – do you have any advice for individual investors on kind of how to navigate maybe the next ten years?

JOEL GREENBLATT: Well, I wrote in my book, The Big Secret, and I’m telling you the answer now because, like I said, it’s still a secret; no one read it. But what I said was look at your risk tolerance. If you think that if the market falls 40 percent you can only handle about

tolerance. If you think that if the market falls 40 percent you can only handle about 25 percent loss of your portfolio, maybe you're better off only being 60 or 70 percent long the market. Once you decide that, when you get bullish I’ll let you add ten percent to that.

market. Once you decide that, when you get bullish I’ll let you add ten percent to that.

When you get bearish, I’ll let you subtract ten percent from that exposure, not that you’ll be right. You’ll be wrong, but I’m trying to limit how much you mess up your portfolio within a narrow range.

CONSUELO MACK: Joel Greenblatt, always a pleasure to have you on WEALTHTRACK. Thank you so much for giving us your time.

JOEL GREENBLATT: Thanks so much. CONSUELO MACK: At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point is: Invest with funds and firms that are committed to patient investing. In this short-term oriented world where even

perpetual investors like endowments are under pressure to fire funds that underperform for 3 years and hire funds that outperform for 3 years, most portfolio managers and their firms don’t have the patience, ability or desire to stick with a long-term investment strategy.

Remember all of the funds that weren’t invested in the dot com craze that lost most of their investors? Great investors such as Jean-Marie Eveillard at First Eagle and Steven Romick at FPA Crescent were among them but their firms backed their investment approach and discipline which ultimately paid off big time.

A firm’s culture, independence and dedication to investment excellence makes a huge difference to investment returns. Those independent managers are the ones we seek out to interview on WEALTHTRACK.

investment returns. Those independent managers are the ones we seek out to interview on WEALTHTRACK.

Meanwhile we encourage you to continue connecting with us on Facebook, Twitter and our YouTube channel.

Thank you for watching. Have a great weekend and make the week ahead a profitable and a productive one.