JIM GRANT: I'm Jim Grant. I'm the editor of Grant's Interest Rate Observer and what I do for a living is write. I will interview famous people but who are famous perhaps for reasons that the public is not fully aware of. I hope to elicit from them new thoughts, frank admissions of things that they had not previously admitted to, and I want to get them to laugh once or twice.
Well, hello, Real Vision. I am Jim Grant. With me today is Joel Greenblatt who is all of the following things. He is the last guy who hit 400, figuratively speaking, at finance a compounded money between 1985 and 2006 at the rate, mind you, at the annual rate of four-zero percent. That is not a typo. Joel is the author of many books, wonderful I have one which I have right here. I'll get into this in a moment.
He's a benefactor of public education in the city of New York. He's a teacher. He's all those things. With regard, Joel, to your investing, acumen and career, I want to ask you concerning the four mention record, astonishing record, which by the way, if you were a racehorse, they give you a blood test concerning about this record, why did you stop?
JOEL GREENBLATT: Well, I haven't stopped investing. The way you get to high compounded returns, a couple of ways. One is to be very concentrated, meaning just have a few of your favorite things. The other is to stay small. By mean concentrated, I mean six to eight names were traditionally 80 plus percent of our portfolio. I have a partner, Rob Goldstone, who joined me 1989 so he's a big part of that record as well.
The problem with owning six to eight names, at least for outside investors usually is that every two years or so, you wake up and lose 20% or 30% of your net worth in a matter of a few days. If you know what you own, now, sometimes that's because you made a mistake. Sometimes that's because the market doesn't like what you think, for a period of time, but it happens like clockwork. That's very uncomfortable for many investors to live through.
The other way to get high returns is to stay small. After five years in business, we returned half our outside capital, the capital after 10 years in business, we returned all our outside capital. The problem with compounding at high rates of return is you end up with a lot of money so you have to keep investing less.
JIM GRANT: That is a serious problem as many aspire to it. Well, so you have gone from a life as a hedge fund guy. In fact, Joel, now that I think of it, you are rather an old school fellow because you made your record in the world of hedge funds, which is a world that's now shrinking properly so many say, and you have come up through the ranks as a value investor, value now having fallen on difficult times and furthermore, you teach value investing and special situations investing in the MBA program at Columbia. MBA is now thought to be a vestigial degree, no sense getting one. Do you ever wake up in the morning and wonder why you're not with it?
JOEL GREENBLATT: Well, one answer, it's good I'm old. The other is really I can only do what I know how to do, but it really comes down to investing. I try to simplify it so I can understand it and stocks in particular, ownership shares of businesses. If I'm good at valuing businesses, that's what I do. Then when they're available at prices at a good discount to what I think they're worth, there's an opportunity.
People are people. That doesn't change so they're quite emotional at times and there'll always be opportunities for people who know how to value businesses. Even in the private market, we just saw what happened to WeWork, those are very smart people giving billions of dollars at a very high valuations and sometimes it doesn't work out so people are emotional.
JIM GRANT: Now, this speaks, WeWork speaks it seems to me to the strict form of the efficient markets hypothesis which holds basically that information well distributed is in the marketplace before you know it and this market absorbs it efficiently, of course, and diffuses it and prices accordingly and you can add nothing to the soup, because it comes premade. It's like a can of Campbell's. Yet in the case of WeWork, one day, it was valued they say at $48 billion, the next 15 minutes later, not 48 actually, eight. Are markets efficient?
JOEL GREENBLATT: That is a great question. I wouldn't probably be sitting here if I thought so. I actually learned that theory when I was in business school way back in the '70s. I had very learned professors trying to be convincing about that, but all I had to do was look in the newspaper and they used to have 52-week high and low lists. At one point during the year, a stock is worth $50 a share. Six months later, it was supposedly worth 100. Both prices were efficient, and nothing generally happened in the business.
What they were teaching me, didn't seem to make a lot of sense to me and so I think my whole career has been a rebellion against what I learned in the business school that stocks are efficient. I would say they're often efficient. I would say it's tough to know enough about a lot of businesses to outsmart the market. On the other hand, stocks are ownership shares of businesses. If you pick the ones that you're pretty good at valuing and our discipline swing it, as Buffett would say, you don't have to swing at every pitch, swing at one of 20 pitches, so you won at 50 pitches doesn't really matter and wait for your pitch.
There are always going to be opportunities because people don't change, people are very emotional and the math of it is pretty straightforward. The value of businesses, the discounted value of all the cash you're going to get over a period of time. You basically have to make two assumptions. One is, whatever earnings there are today or lack of earnings doesn't matter. You're trying to project what those earnings are going to be over the next 20 or 30 years, what the cash flow from that business will be over the next 20 to 30 years. You have to project a growth rate.
Then you have to use a discount rate that is appropriate to discount how much risk you're taking to your guests. If you make slight changes in those numbers, you discount at 6%, set it 8% or it grows at 4% instead of 3%, the value of a business could double or half depending on just very small changes in those assumptions. When people are optimistic, they tend to make optimistic assumptions and when they're pessimistic, they tend to make pessimistic assumptions and stocks could be all over the place. It doesn't make sense to me that over the long term, the market will always be right.
JIM GRANT: Markets are just as efficient and just as dispassionate as the people who operate in them.
JOEL GREENBLATT: Yes. I guess what you're saying is they're not particularly efficient. I get this question from my MBA students. I've gotten the same question at one point during the semester, every year sometime towards the end of semester for the last seven or eight years. Question goes some something like this. We know active managers haven't won over a long period of time. We know that if you buy an index fund, you can do quite well. Congratulations, Professor Greenblatt, on a great career, but isn't the party over for us?
My students are second year MBA, so roughly 27 or 28 years old. I just tell them, hey, why don't we go back to when you guys learned how to read, go back a couple of decades, 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 just take a look at what's happened since you guys learned how to read. I say from 1997 to 2000--
JIM GRANT: It can be that young?
JOEL GREENBLATT: Well, actually from 1996 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 more than tripled, which is my way of explaining to them that people are still crazy and it's way understating the case, because the S&P 500 is an average of 500 names. If you actually lift up the covers and look at the dispersion going on, amongst those 500 names between which are in favor at any particular time, in which are out of favor for whatever reasons.
You believe what Ben Graham said that look, this horizontal line is fair value, this wavy line around fair value are stock prices, and if you have a disciplined strategy to buy more than your fair share 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 market's throwing us pitches all the time. Of course, there are agency problems, there are behavioral problems, there are reasons why people really can't execute this, but it's not because we're not getting enough pitches.
JIM GRANT: At one of your books, I guess it was a second edition. You said I wish I had emphasized this more in the first edition. You said that beating the market is not the same as making money.
JOEL GREENBLATT: Well, if the market's down 14, you're down 32, I would just say you're not the happiest guy in the world so you might not be able to avoid that. That might be a good performance but there is a difference. When prices are high, beating the market, buying the cheapest stocks might not be good enough.
Right now, we take a look at bottoms up something called the Russell 2000, which is stock number 1001 in market cap through 3000, so small cap stocks. If we value those stocks, just with some common metrics on valuation over the last 30 years, right now, we're in the first percentile for that index versus those last 30 years, meaning the Russell 2000 have been cheaper 99% of the time over the last 30 years and more expensive 1% of the time, and it's not a projection but we can go back in time and see what's happened from the first percentile.
JIM GRANT: Anything good, Joel?
JOEL GREENBLATT: Not good. No, you're right on that markets, but not terrible. Market's been down an average of 3% to 5% from here over the next year. The S&P 500 is actually a little cheaper, it's in the 14th percentile. Been cheaper 86% of the time, more expensive 14% of the time and that in the past, from the 14th percentile, it's been up 3% to 5%.
JIM GRANT: This is an equity centered view of the world. Of course, that's what you do for a living. In the world of bonds, there has been nothing like this in 3000 years or so of recorded interest rate history, I'm talking about the phenomenon in Japan and parts of Europe of negative nominal interest rates, meaning that the borrower gets paid for the privilege of taking your money. Now, that is something new under the sun. In finance mainly, nothing is new under the sun that's new. How do you factor this new thing of zero percent yields or less into your valuation of equities?
JOEL GREENBLATT: That is a great question that I don't have an answer to. Luckily, my job is to look at all the choices if I'm looking at US equities. What we generally do is rank them in order according to our assessment of cheapness, so we buy the cheapest ones, and we tend to short the most expensive ones, so there's always a--
JIM GRANT: The biggest in the world outside to your purview?
JOEL GREENBLATT: Well, what I would say is, in my books, I've suggested that when the risk free rate is below 6%, which has been for quite a while-- pardon me?
JIM GRANT: Positive six?
JOEL GREENBLATT: Positive six. Yeah, I should point that out. Now, I never thought I would have to but yeah, so if the risk free rates below 6%, I tend to use 6% as the risk free rate. In other words, I'll look at the yield I could get from owning and earning asset. It's not that I can't buy something that only has a 5% cash flow yield on the price that I'm paying. As long as I think that 5%'s going to grow over time, that could be a flat 6% over a long period of time.
I'm not going to price things just to use positive yields because I don't know how to calculate negative yield but let's say you had a 1% positive yield. If you start paying 100 times earnings for a lot of businesses, you can get into real trouble. At worst, I'm being very conservative in the way I look at things and if I can't be, my theoretical 6% risk free rate, I pass until I can find something that can beat that.
JIM GRANT: A dear friend of mine from yesteryear, Michel David-Weill, who was the head of Lazard Freres in New York, very aristocratic Frenchman and the late Alex Porter and I for seven years had a value fund in Japan, long only, and we bought shares of businesses valued at merely paid pieces of paper, Joel, we bought shares of businesses at prices of less than net current assets, they're the old time net nets and they were cheap in 1998. They were cheap five years later, and they were cheap 10 years later and we went to see Jen and Michel was an investor of ours, went to CM after, particularly long and vexing period hundred performance.
He said, with a Gothic shrug, he said, sometimes you have a bad decade, which words I treasure. I suppose one shouldn't actually fall back in them too often but value has had, shall we say, a dry patch. I wonder if this dry spell might not be the result of the aforementioned ground hugging interest rates, you may discount businesses at 6% as a stroke of caution and conservatism. Others perhaps are valuing using a discount rate much lower, which allows the distribution of semi free money with which to fund venture capital startups which disrupt the world and which perhaps, have made established legacy businesses much more vulnerable to serious business problems. Could this be what's wrong with value investing?
JOEL GREENBLATT: I don't think, to be honest, there's anything wrong with value investing, but I have to define my terms. Value Investing to me is not buying stocks that are low price book, low price sales, but the way it's defined by Russell or Morningstar, it's defined as stocks having those types of attributes. If I were a private equity investor buying a whole business, I'd be looking at cash flows. Nope, private equity firm's going to go buy a business because it's selling at a low price to book value.
JIM GRANT: They want really high value, that's what I do with these days.
JOEL GREENBLATT: It is but the private equity investor I'd invest in is someone who's really looking at cash flows and the successful ones over time are the ones that are actually looking at cash flows. If we define value investing as figure out what something's worth and paying a lot less by definition, it will never go out. We're cash flow oriented because that's where we think drive values.
The reason for instance, momentum has worked for the last 30, 40 years, not just in this country, but on average, but across the globe with one or two exceptions. Why won't we do momentum investing? The reason for that really is that, let's say it didn't work for the next two years. It could be that it's just cyclically out of favor, it works over the long time, we just need to be patient and it will work, or it could be that there's plenty of data in research papers and computers and ability to crunch numbers and the trade now, and it's not so hard to figure out a stock used to be down here and now, it's up here and it's got good momentum and the trade's become crowded, it's degraded and that's why it doesn't work over the next two years.
Two years from now, I wouldn't know the answer to that question. Is it just cyclically out of favor momentum or has the trade become crowded and degraded? If we're looking at cash flows and valuing businesses just like we value a house, they're asking a million dollars for a house, we ask a few simple questions to whether it's a good deal or not, one might be as well, if I could rent it out net of my expenses for 70 or $80,000 a year, that might help justify the million dollar price that I'm paying.
Now, the question I'd probably ask is, what are the other houses on the block going for, in the block next door, in the town next door? We do that, too, with businesses. We say, how cheap is this relative to similar businesses? How cheap is this relative to all businesses? How cheap is this versus how it's been priced over history versus other businesses. We use our measures of absolute relative value to try to zero in on fair value.
On average, that seems to work pretty well. That's how most people would value in earning asset. That's what we do. It's possible that that analysis doesn't work over the next two years, but I'm not going to stop doing what we're doing because it's the difference between causation and correlation. Momentum has correlated with good returns in the past. Low price book, low price sales for many years correlated with getting probably more than your fair share companies that are out of favor, because if a company is selling close to the historic cost of its assets, people aren't paying much of a premium for the actual underlying business, so a pretty good indication that it's out of favor.
If you buy a bucket of companies that have those type of metrics, you're probably going to end up with more than your fair share of companies that are undervalued. That's once again, also a correlation. What we look at is causation, and that's valuing businesses and the way we value businesses is looking at the cash flows.
JIM GRANT: Tell us, tell the viewers and me about life with five or six concentrated positions all those years. I wanted to invite you to reminisce about some of the ones that really worked, the fabulous ones and then some of the ones that perhaps moved into your sleeping pattern and kept you up at night. Can you give us some examples of what worked and what didn't work?
JOEL GREENBLATT: Sure, one of the ones I wrote up in You Can be a Stock Market Genius was a stock called Marriott which people know back in the early '90s. Marriott was really into businesses. One was the hotel management business and one was the owning hotels, building hotels, selling them to someone else, and then taking back a management contract for their hotel management business. The building hotels business was a capital intensive business with okay returns, but it was really a way