Joel Greenblatt, who ran Gotham Capital and averaged an annual return of +40% for two decades, shared some insights during an interview about how hard it is not only to pick a good manager, but also to stick with him. Even with Joel’s performance his investors would find it really hard to stick with him, and he felt it was easier to manage his own money after a while.
Joel started the interview saying that even Warren Buffett says most people should stick with index funds, and he agrees with him. But Buffett doesn’t index himself and neither does he – how come? The answer: If you don’t know what you’re doing, the safest thing to do is index. By periodically investing in index funds, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.
If you on the other hand are a know-something investor, Buffett suggests that you should focus on your best ideas.
According to Joel Greenblatt stocks aren’t pieces of paper that bounce around that you put fancy ratios on. Stocks are pieces of ownership in a business, that we try to value and buy at a discount. Investing in stocks is really about valuing businesses and try to buy them at a discount. In doing so, the best strategy, says Greenblatt, is the one that makes sense and that you can stick with.
If you can’t value businesses on your own then you have an alternative to find a manager with a good investing process and sticking with that. The problem is that sticking with a good manager is really hard to do. Human nature tends to work so that we pile in and pile out at all the wrong times. For example the best performing mutual fund in the U.S. in the period of 2000 to 2010 managed to gain an average annualized return of 18 percent. The market was flat in that period so that was pretty good. But the average investor managed to lose 11 percent a year by moving in and out at all the wrong times. After the market went up they piled in, and after the market dropped they piled out. And after the fund outperformed they piled in, after the fund under-performed they piled out. They thereby turned an average gain of 18 percent into an average loss of 11 percent. The example shows that it’s really hard to handle volatility for an investor, and to stick with a good manager even if he has a good process.
Another study Greenblatt did turned out that about half of the managers in the top quartile performing institutional funds over a ten year period spent at least three years in the bottom performing decile. How many do you think would stick with them?
The problem is that people tend to look at the returns of the last few years to determine whether they should start following the manager’s fund. But according to Greenblatt the last 3-5 years don’t determine the outcome of the following years. What you need to do is look at the manager’s investment process instead.
Most fund managers don’t want to pick stocks that look like they won’t make a good return over the next three years. But that’s where the opportunities are according to Greenblatt; that’s why you’re getting the stocks at a discount.
If you’re a stock picker you should focus on time arbitrage; buy undervalued stocks by doing good valuation work, and wait for the market to agree with you.