Distinguished Speaker Series: Joel Greenblatt, Gotham Asset Management

Joel Greenblatt, the legendary author, Columbia B-school professor and hedge fund manager, presented his thoughts and methodology on investing to CFA Society Chicago and local investment community on Wednesday, December 5, 2018.

The title of his presentation compared value investing to the New York Jets, i.e. unpopular and out of favor. Per Greenblatt, where we stand today on a valuation basis relative to the past 25 years is that about 25% of the S&P 500 could be considered “undervalued” versus just 7% of the Russell 2000, if we assume the S&P 500 earns its long-run average forward return of 7%. Greenblatt also thought that the S&P 500 could earn a below-average 3%-5% return for the next few years.

In a statement that was likely no surprise to anyone in attendance, Greenblatt noted that “Growth” has outperformed the market the last 5 years. Greenblatt defined for attendees what the parameters were for a value investor (with all of these definitions supported by the Russell and Morningstar definitions:

  • Low price-to-book
  • Low price-to-sales
  • Low cash-flow valuation

What Greenblatt admonishes his students to aspire to, “Do good valuation work, and the market will likely agree with it”. Greenblatt noted he just wasn’t sure when the market would agree, but in theory at some point it will.

Greenblatt put up the chart that showed the classical individual stock return versus company valuation, and to no surprise to anyone, the overvalued stocks typically had the lowest forward returns relative to the lowest valuation. He also used the examples of two lectures he gave to a group of NY doctors who only asked what he thought the market would do over the next few years, versus the Harlem high school jelly bean test, and asking the kids to guess as to the number of jelly beans in the jar. Joel Greenblatt used the story to lead listeners to the conclusion that the kids in Harlem were closer to the right answer in terms of the accurate number of jelly beans in the jar, when doing their own homework versus listening to “word-of-mouth” guesses by the class.

It was clear that Greenblatt was more impressed by the analytical rigor of the Harlem high school class than the group of doctors, but he also used the story to illustrate the power of impression and what is heard by the retail investor and how emotion and psychology play important roles in investing. Greenblatt also talked about one of first books, i.e. The Big Secret for the Small Investor and the two most important points from the book:

  • 41% of the investment managers with the best 10-year track records also spent at least 3 of those years in the bottom decile of performance rankings.
  • The “Big Secret” is really just patience. Find an investment strategy that you are comfortable with and stay with it.

Greenblatt noted that the press’s preoccupation with Tesla is the “tyranny of the anecdote” contrasting that with deep value investing strategies and how they work over long periods of time.

The Q&A session noted that – not surprisingly – Greenblatt finds more opportunities in the smaller-cap universe despite the valuation comments from above. The valuation metrics aren’t “weighted” in that price-to-sales isn’t weighted more heavily than price-to-book although from his side comments and what were more impromptu thoughts by Joel, price-to-cash-flow and cash-flow health was rather significant.

Greenblatt did note that with “international” investing, the Professor’s fund trades long-only since with international there are trading costs, different forms of regulation, liquidity and other notable differences between US and Non-US investing.

 

*If you missed the event the webcast of the full presentation is still available to watch on the CFA Society Chicago website.

Vault Series: John Wightkin, CFA, TradeInformatics

On November 8, 2018, John Wightkin, CFA, a senior trade consultant at TradeInformatics, spoke at the Vault Series of the CFA Society Chicago about how the process of examining trading costs can help preserve portfolio alpha.

According  to John, “trading costs can represent close to half of active returns” and the process of analyzing and examining trading costs can help claw back those costs that preserve alpha. The dispersion of average trading costs can be between 3 and 48 basis points per the presentation. The process John outlined to combat these high costs has three basic steps:

  1.  Alpha profiling, which is the analysis of the firm’s linkage and relationship between the portfolio manager, trader, broker and analyst. The “alpha profile” tries to identify the unique DNA of portfolio ideas and then link the process to return preservation and implementation.
  2. Return preservation, which means looking across different participation rates and liquidity buckets for opportunities which might not be apparent. The participation rate refers to identifying active vs passive relative to market flow and the liquidity buckets are determining what order size is relative to average daily volume.
  3. Implementation is the last step to be considered and ought to be low-cost and transparent. The client firm will learn how to take control of trade execution on a specific platform to prevent information leakage, but also use the platform as a way to receive information about market flow and trade reception.

A case study was provided where TradeInformatics examined a hedge fund with 30 traders but no central trading desk. When the trades were working in the desk’s favor, there was an average of 12 minutes between trades, but when trades were working against the desk, or positions were losing, the average time between trades lengthened to 40 minutes. The conclusion drawn was that actual returns were 5.9% lower than “expected return” based on the actual trading patterns.

Using a healthy lifestyle analogy, TradeInformatics concluded that to reduce trading costs, the trading desks should “lose weight and eat a balanced diet” which translates into slowing their trading down and doing it more consistently over both sides of the market, i.e. whether the trades are winning or losing.

Summary / conclusion: The takeaway from John Wightmkin’s slide presentation was to slow down and be more consistent with a firm’s trading practices. The time differential between winning and losing trades was antithetical to the traditional practice within investing of “cutting your losses and letting your winners run”. Trade Informatics often found that the opposite was the case.

Trade Informatics can provide more discipline around the trading / execution process, for which the goal is to ultimately lower trading costs and preserve portfolio alpha.