In a wide-ranging interview with the Columbia Business School’s Graham & Doddsville newsletter, hedge fund guru Joel Greenblatt says the stock market is in the “87th percentile towards cheap” right now, and discusses a myriad of aspects of his investment approach.
Greenblatt says that, using the market-cap-weighted free cash flow yield of the Russell 1000 as a gauge for cheapness, the market has been cheaper only 13% of the time over the past 23 years. When the market has been that cheap over those 23 years, the forward return for the Russell has been about 17% over the next year, and about twice that after two years. “That’s not to say that the market’s prospects are better or worse going forward — they’re probably a little below average for the forward period and therefore you could say that perhaps you won’t do quite as well as would be implied by historical returns,” he adds. “But, even in the 50th percentile, you would expect to make 8% or 9% based on the history of the last twenty-something years, so I would just say that if I had a choice between being more long or more short, I’d be more long. It’s a very attractive time to invest in the market, despite the run-ups that we’ve seen in the last year.”
Greenblatt also talks about value investing, portfolio size, and a variety of other issues. “My definition of value investing is figuring out what something is worth and paying a lot less for it,” he explains. “I make a guarantee the first day of class every year that if you’re good at valuing companies, the market will agree with you. I just don’t guarantee when. It could be a couple weeks or it could be two or three years. And the corollary is simply that, in the vast majority of cases, two or three years is enough time for the market to recognize the value that you see, if you’ve done good valuation work.”
He also says that the investing world has become more institutionalized in recent years, which actually helps the little guy. “If you’re an active manager, you may have a long-term horizon but your clients probably don’t,” he says. “So, most managers feel that they need to make money over the short term. Therefore, professionals systematically avoid companies that are perhaps not going to do as well in the short term. In some ways, there’s actually more opportunity in those areas now than ever before due to the greater institutionalization of the market.”
The institutionalization of the market, the emotional nature of investors, and “the fact that there are still lots of nooks and crannies out there that even successful hedge funds can’t pursue” mean that Greenblatt is “not concerned about the size of the existing opportunity set.”