Tuesday, March 18, 2014

Greenblatt on CNBC: Market Reasonably Valued

So Joel Greenblatt was just on CNBC and said some interesting things.  I don't intend to post every time someone I respect shows up on TV, but this appearance was especially interesting to me for a couple of reasons.  One major reason is, of course, market valuation.

I don't really care about the many folks that call for a crash or call the market overvalued and whatnot, as many of those people have no track record of turning their market views into long term profits.  If you think about the guys that show up on TV as bears most of the time in the past ten or twenty years, most of them don't have good long term track records.

But the other day, Seth Klarman was reported to have been pretty bearish saying that there is an impending asset price bubble (in his letter to investors).  It's true that he has been cautious since the 1980's (and yet still manages to make a lot of money year after year), but still, his recent warning is not to be taken lightly.

On the other hand, Warren Buffett has said recently that the market remains in the "zone of reasonableness" or some such.  He doesn't feel that the market is particularly overvalued but not especially cheap.

And then of course there is the Robert Shiller P/E ratio (CAPE) that shows serious overvaluation.

What are we to make of all of this?  I have posted in the past about market valuation, but since it seems to be such a hot topic again now, I thought Greenblatt's input on this would be interesting.  He is one of my favorite investor/authors so I do take what he says seriously.

Here is the link to his appearance:  CNBC Greenblatt video

Anyway, this is what he said:

What he likes
Hewlett Packard (HPQ) and Apple (AAPL).  They trade very low on measures of free cash flow with "huge return-on-capital businesses".  Most people don't like them because they're old and stodgy (referring to HPQ).

AAPL
This is one of the parts that was really interesting to me.  I always wondered why Greenblatt liked Apple.  If you look at Greenblatt as the author of "You Can Be a Stock Market Genius", it doesn't make a whole lot of sense.  The future of Apple is hard to predict; it doesn't pass the five or ten year test of what the business will look like etc.

Greenblatt explained that when there is a business with a lot of change, where the technology changes, competition changes and you don't even know what the company will be selling three or four years from now, he tells students to skip it and find something they can figure out.

But if you buy these businesses at such low valuations as a group, then you can do well.  You don't buy one Apple, you buy a basket of Apples.  And when you buy a basket at such low valuations, it's good.  This bucket of technology stocks is cheap.  He later mentions Microsoft (MSFT) as also one of the large, cheap tech stocks.

So now I understand that this is the author of "The Little Book That Beats the Market" talking.  He doesn't know or understand the future of Apple, but he is confident that a basket of tech stocks trading so cheaply will do well going forward.  He has no view on the sort of things we talked about here regarding AAPL.  I should have known that since every recommendation he has made on TV since the Little Book was published were basically magic formula stocks.

Large Caps Reasonable
Greenblatt said that looking back over the past several decades, the Russell 1000 index is trading at the 42nd percentile in terms of valuation; the index has been cheaper 58% of the time over the past several decades.   So it is reasonable.  His data shows that from here, the one year forward returns is somewhere between 7-12%.  That's not bad. 

Small Caps Not
He said that the Russell 2000 index tells a "very different story".  That index is in the top 5 percentile of valuation, meaning it has been cheaper 95% of the time in the past several decades.  The one year forward return from this level is a negative 3%. 

Super-Large Caps Reasonable
He said that the top 20 names in the S&P 500 index, which is 30% of the index by weighting, are reasonably priced, even Google (GOOG).

What Do I think?
So this is all very interesting.  You have some of the smartest investors saying all sorts of things about the market and not in agreement.  Klarman said that on almost any metric, the market is "quite expensive", and that a "skeptic would have to be blind not to see bubbles inflating..."

And yet we have Buffett pretty mellow about it all, still buying stocks and his underlings still buying and Greenblatt saying things are reasonable.

I personally don't spend too much time on this stuff.  I would rather spend time on bottom up and not worry too much about the top down.

For example, of all the posts I've made about investment ideas, the overall market doesn't really make a difference to me.  I wouldn't say that JPM is attractive here only because the market p/e is 20x or some such.  I like what I talk about here pretty much on an absolute basis.  Of course, if the market was really overvalued at 30-40x p/e, then I would like my ideas more (at the current valuation), and if the market was trading at 7x p/e, then I would probably like the market more.   But those are extremes on both ends.

I think the key is what Buffett said in the annual letter.  If you own a business that you like that is a good business run by good people and is reasonably valued, why sell it just because some people think the overall market is overvalued?  (Well, Buffett talks about macro factors, but I think the same applies to overall market valuation; why sell your business you like just because something else is overvalued?).

Identifying the market as overvalued and undervalued is fun stuff, but it is really hard to turn into long term profit.  You can always guess one or two turns.  You will always run into the guy that sold everything in August 1987 or early 2007.  You may even run into folks that got out in August 1987 and then got back in in December 1987, or got out in 2007 and got back in in early 2009.  But you really won't find people who did that over several cycles.

In my previous life, I read just about every investment newsletter (of course courtesy of my employer), followed every guru and nobody calls the market continuously through cycles, even using rational, simple tools such as valuation.

Even recently, there is one prominent strategist that is a good read, but this strategist jumped in and bought gold just about at the top of the market.  Another fund manager/economist who writes an interesting, well-written, convincing and widely-read newsletter has performed horribly over the long term.  Yes, maybe the market is toppy so the fund looks the worst now (just as value investors look really bad at bear market lows), but I don't think losing money is really acceptable for something that is not supposed to be a bear fund (it's supposed to be hedged, which is not the same thing).

Klarman has been cautious for a very long time but still manages to make money, so that's a bit different (and rare!).

I've talked about how Greenblatt and the Superinvestors of Graham and Doddsville made money over time (see here), not to mention Warren Buffett.  These guys didn't do it by getting in and out of the market based on market p/e, market cap to GDP, CAPE or anything else that I know of.

So What to Do?
So for stockpickers, just look at your stocks and if you like the business and where it is valued, who cares about the market?

What about folks invested in the S&P 500 index?  Well, Greenblatt did say that the 20 largest names in the index are reasonably valued, so the index should be fine to own.

Even if Greenblatt didn't say that, the stock market overall returned 10%/year or so historically, and that was only achieved by owning the index during good times, bad times, when they were cheap and when they were expensive.  10% was not achieved by getting in when they were cheap and sitting out the market when it was expensive.

If the market is expensive, the correct thing to do is not to sell out, but to adjust your expectations.  Greenblatt did say something like that; if the market typically earns 8-10%/year and it's a little overvalued now, then the returns will be a little lower, but still good.

I think the mistake is that when markets are overvalued, people think that it then must go down.   So they take a short position or buy puts.   Or they get out completely and wait to get back in cheaper.

Maybe the correct way to look at it is that when markets are higher we should expect lower returns going forward and that's that.  To assume that when markets are expensive, that we can sell out now and get back in cheaper later is a risky assumption, and one that hasn't worked out over time (again, show me someone who has done that successfully over many cycles!).





18 comments:

  1. Thank you for your blog, you do outstanding work and I look forward to your posts.

    I am the King of Doom & Gloom, I read it all, from Seeking Alpha to Zero Hedge (way too much Zero Hedge) and it has not served me well at all.

    I have an advisor that I truly respect, but I am terrified to give him a large sum of money, because I know I am the kiss of death and the second I get in the market, that will be a decades long top even if he is buying value stocks.

    I totally agree with what you say but remain totally paralyzed.

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  2. Great post, as usual. Greenblatt is one of my favorite investors also. The Genius book is in my top 4 or 5 investing books I've read. One interesting (somewhat useless) fact about Greenblatt... I think in the Santangel interview he did a few years ago (which is excellent and discusses his and his partner Rob Goldstein's long term returns--which, as you know, were absolutely astounding). In the interview, he actually mentions he liquidated a large portion of his portfolio prior to October 87 simply because he got spooked at all of the debt (and the crazy PE deals that were taking place). And he calls that the only accurate marking timing call of his career--and he admits that it was pure luck.

    But overall, his record from 1985-2005 is absolutely incredible... and came from sticking with a small group of 5-8 cheap stocks/special situations at most times. I think in the Columbia class he mentioned he was down 5% in 1999, which must have been difficult considering the roaring market... but he kept on owning what he felt was cheap, and in 2000 he was up 100%+, even as the overall market was down 9%.

    That's the other interesting thing. Years like 2008 are so rare (where everything goes down). Even in bad bear markets of 20-30% declines, it is still possible to do quite well even on an absolute basis if you run a strategy like Greenblatt's first one (concentrated value). Lots of value guys did quite well in the 2000-2002 market.

    Greenblatt is interesting... I saw the CNBC clip today and I really respect his work on the Magic Formula, but I've always been so surprised that he left an investment strategy that was so incredibly successful. And when you look at the magic formula portfolios and you see how many stocks it owns, I can't help but think that it will be so difficult for that type of strategy to beat the market by more than say 3-4% per year (which still would be great for a mutual fund, but a far cry from what Greenblatt is capable of). The backtests tell a different story, but for some reason, in actual practice, these types of fairly diversified quantitative strategies just don't seem to work nearly as well in real life as they do in backtests.

    Something I've always wondered about... but Greenblatt is great, and his original case studies are outstanding ones to review.

    Thanks for the post, and great thoughts as usual Brooklyn.

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    1. I invested a decent chunk of my 401k into the Formula Focused fund when it got started. Since then it's beaten the market by a pretty good margin (by more than 10% last year). This year however, he closed it down and my assets got moved to Gotham Enhanced Return by default. It's basically magic formula with long-short. I wonder if he did this because he sees opportunities on the short side become more attractive. Does he believe the market being fully valued, a hedge strategy makes more sense? Or is it because the hedged strategy can earn him much higher fees (though he doesn't strike me as being this kind of a guy)?

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    2. Hi, That's interesting about Greenblatt's 1987 call. Greenblatt reminds me of Benjamin Graham a little bit. I think Greenblatt moved away from his old style as a form of semi-retirement. He did well and made enough money and maybe he just wanted to move on from active value investing. And he had a curious mind which drove him to do the magic formula stuff; he was convinced there must be a better way to invest for non-pro's. All of this stuff (including the Big Secret) is driven by his curiosity; not so much trying to make more money... He said he wrote the Genius book with non-professionals in mind, but realized after it was published that it was over their heads. I think that's what drove him to the Little Book and magic formula.

      As for Formula focused fund, I don't follow it so didn't know it was shut down. I agree Greenblatt doesn't seem like a guy that would do things to increase fees. I have no idea how the business side of that works. Maybe they didn't have enough AUM in the focused fund? I have no idea.

      I was also surprised that he came out with a long/short version of this after all he has said about shorting (often said it's not a good idea and said that if you did long/short with the magic formula the performance would have been really volatile).

      But again, this was probably driven by demand (he was probably asked for a l/s option after the crisis so often) and also his own curiousity to figure out if he can come up with something.

      So I don't know.

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    3. The l/s fund was about 1/4 size of the focused fund, which was around $500m.

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    4. Hmmm... I have no idea, then, why they would do that.

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    5. Hi John:

      I did well in 2000-2002. In fact, it was not hard for a value investor to do well, as it was a 2 tier market - some things were incredibly cheap. Now it seems that the market is much more tightly clustered.

      As value investors, of course, we look at each business to see if we can get the expected return with some degree of confidence

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  3. For some reason, I'm "betting" on a repatriation holiday some time soon. Not betting but think of it as a catalyst or stabilizer for the near term (more capital investment, dividends, and buybacks).

    I don't even know how to think about the cash levels that the big companies have, whether it distorts positively or negatively.

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  4. It seems Klarman's consistent success rests is his deep discount approach or the size of his margin of safety which gives him some protection in market down drafts. For us mere mortals that don't have his resources, maybe just holding more cash vs. sophisticated hedging (Watsa) is the answer. I really don't like putting cash to work if I don't feel comfortable with valuation levels as I see them. I know that during the 2008-09 period, I was pretty much fully invested and although I didn't sell anything, I wish I had cash to deploy at depressed equity and bond price levels. Anyway, thanks for your pertinent topics and thoughtful analysis.

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    1. I was actually not that invested in 2007/2008 because it seemed like everything was expensive. It feels like things in general were more expensive then that it is now even though the averages tell a different story. I think there was less dispersion in 2007; everything was expensive at the same time, but there weren't as many TSLA, NFLX-type things. This is another reason why I don't like those market averages (1999/2000 was the same; market average p/e's looked ridiculous but many stocks were actually cheap).

      Now the averages look more expensive, but you have banks at BPS and other financials at less than book (AIG etc.) and many businesses (like Greenblatt says) at reasonable levels.

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  5. I'd like the point out that Klarman did point out both the bear and bull case for equities in his 2013 letter. Although he does give a cautious warning to investors and policy makers, it seems like Buffett, Klarman, Greenblatt, Marks are within the same range in terms of market valuation. Buffett says "more or less fairly priced," Klarman says “Price-earnings ratios, while elevated, are not in the stratosphere,” Greenblatt says "reasonable," and Marks says, "I think most asset classes are priced fully - in many cases on the high side of fair."

    I don't disagree with your main point that investors should continue buying good businesses at fair prices. I enjoy reading your posts, please keep it up!

    Klarman via ValueWalk:

    Seth Klarman noted that those “born bullish,” those who “never met a stock market they didn’t like” and those with “a consistently short memory,” might look to the positives and ignore the negatives. “Price-earnings ratios, while elevated, are not in the stratosphere,” he wrote, stating the bull case. “Deficits are shrinking at the federal and state levels. The consumer balance sheet is on the mend. U.S. housing is recovering, and in some markets, prices have surpassed the prior peak. The nation is on the road to energy independence. With bonds yielding so little, equities appear to be the only game in town. The Fed will continue to hold interest rates extremely low, leaving investors no choice but to buy stocks it doesn’t matter that the S&P has almost tripled from its spring 2009 lows, or that the Fed has begun to taper purchases and interest rates have spiked. Indeed, the stock rally on December’s taper announcement is, for this contingent, confirmation of the strength of this bull market. The picture is unmistakably favorable. QE has worked. If the economy or markets should backslide, the Fed undoubtedly stands ready to once again ride to the rescue. The Bernanke/Yellen put is intact. For now, there are no bubbles, either in sight or over the horizon.”

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    1. Thank you for the clarification!

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  6. Greenblatt mentioned at the Columbia conference that an equal-weighted Russell 1000 is in the 77th percentile towards expensive. He said the mega-caps are relatively cheap, but the median stock is expensive.

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    1. Thanks or the update. When was this? Median stocks being expensive makes sense if the Russell 2000 is expensive.

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    2. He said this in February 2014. He meant the median stock in the Russell 1000, not the Russell 2000. Basically mega-caps are cheap and everything else is expensive.

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    3. Thanks. That makes sense as it would be the valuation of the stock 500 stocks down, so like the smallest stock in the S&P 500 or something like that.

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  7. Thanks for another great post. After reading your posts, I decided I needed to read the Outsiders. Really changed my perspective on what to look for, though I'm still sorting out how to think about valuing these modern-day compounders like Jarden, Post, Colfax, etc. This post was particularly helpful because I have a lot of cash on the sidelines at the moment, and have been wrestling with exactly this topic of knowing the market's overheated and that tapering will only hurt investment returns. At the same time, as you point out, lower returns don't mean negative returns. So thank you for a well-written article.

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  8. Hey, just wanted to make sure that you know Greenblatt is doing a half hour interview this Friday on Consuelo Mack Wealthtrack. Should be a treat.

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