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Subject:  Value Lessons from Graham and Doddsville Date:  10/14/2012  5:59 PM
Author:  yodaorange Number:  406002 of 538822

Each Year, Columbia Business School students publish a lengthy newsletter entitled “Graham and Doddsville.” It was inspired by Graham and Dodd’s seminal book on value investing: Security Analysis [1] which was originally published in 1934. Graham and Dodd both taught at Columbia. The students published this year’s edition last week. [2] It weighs in at 32 pages and has several interesting interviews. One of the interviews is with well known value investor Joel Greenblatt. He is best known for writing The Little Book That Still Beats the Market (Little Books. Big Profits). [3]

There are several pertinent investment points in the lengthy interview. I have excerpted 4 of the points verbatim.

1. Joel: My definition of value in-vesting is figuring out what something is worth and paying a lot less for it. 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. When you put together a group of companies, that process can often happen a lot faster, on average. One argument I make in another one of my books (which few have read), called The Big Secret for the Small Investor, is that the world has become much more institutionalized over the years, even more than it was when I wrote You Can Be a Stock Market Genius, and that is a real advantage for longer-term investors. For institutional investors, you can track all money flows by one simple metric – which managers did well last year and which did poorly. Managers who did well last year attract all the money and managers who did poorly lose the money.

If you’re an active manager, you may have a long-term horizon but your clients probably don’t. 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.

2. Question: Do you see anything that could lengthen institutional investors’ time horizons, thereby reducing the “time arbitrage” from which many value investors’ profit?

Joel: No, not really. The reason is that there is an agency problem where the people who are allocating the capital are not making the investment decisions. I was talking to a gentleman at one of the top endowments, and he said, “I would like to tell you that we have a long-term horizon, be-cause we should. But I’ve been here 11 years, we’ve had three chief investment officers, and none of them left after a period of positive performance.”Jeremy Grantham spoke at a Graham and Dodd Breakfast several years ago and one of his lines that I thought was funny, and probably very, very accurate, was: “for the best institutional investors, their time horizon is 3.000000 years.” That is the horizon for the best. For many institutional investors, it’s even shorter. So I think that’s about all you can hope for as an investment manager.

3. In the original edition of The Little Book That Beats the Market, I grouped the “magic formula” stocks as I called them – or stocks which were systematically considered good and cheap – into deciles. Decile one was the best combination of good and cheap. Decile two was the second best, and the tenth decile was com-posed of companies that earn lousy returns on tangible capital, yet nevertheless were expensive. There was a big performance spread between decile one and decile ten when we did the study, and it worked in order as I mentioned earlier. Decile one beat two, two beat three, three beat four, all the way down through decile ten. Pretty much every student I’ve had, and hundreds of e-mails after the book was published, have said, “Joel, I have this great idea for you. Why don’t you buy decile one and short decile ten? You’ll take out the market risk and you’ll make 15% or 16% a year.” I did that experiment in the afterword of the revised addition of The Little Book, and the results showed that you couldn’t figure out a compounded rate of return because you lost all of your money. Somewhere around the first quarter of 2000, the shorts went up a lot and the longs went down such that the combined loss was so severe you went broke.

There were a couple things a bit unfair about that because we kept the portfolios for a year, and we didn’t readjust as we lost money. What I was trying to show at a high level was that if I wrote a book that had a formula and it worked every day and every month and every year, everyone would use it and it would stop working. So, the magic formula, like all value investing, can give you noisy returns over the short term, but that’s also why it continues to work.

The interview has several other important points and might be worth your time if you are interested in value investing. A necessary condition for successful value investing is being able to withstand several years of underperformance as Joel has outlined.



[1] Graham and Dodd book “Security Analysis” 8th edition

[2] Graham and Doddsville Fall 2012

[3] Joel Greenblatt book: “The Little Book That Still Beats the Market (Little Books. Big Profits)”
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