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05/11/2011

Book Review: The Big Secret for the Small Investor


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The Big Secret for the Small InvestorJoel Greenblatt is a master of succinct and humorous writing about investment. He is also the founder and portfolio manager of hedge fund firm Gotham Capital and an adjunct professor at Columbia University’s Graduate School of Business, where he teaches courses in value investing. His latest work, the smart and simple The Big Secret for the Small Investor: A New Route to Long-Term Investment Success, would have saved me several years of research on the art of investing, had it been part of the CFA curriculum in the 1990s.

Greenblatt gives away the “big secret” early on. It has to do with Benjamin Graham’s concept of margin of safety: Figure out the value of something and then pay a lot less for it. He wants us to pay a lot less because it is often difficult to get the valuation part right. Greenblatt sums up the point this way: “What strategy would you use to beat Tiger Woods?… Just don’t play him in golf!”

At any point in time there may be only a handful of investment opportunities that offer a large margin of safety. Greenblatt explains the constraints faced by mammoth investors—those with hundreds of millions of dollars in assets—that do not allow them to concentrate their portfolios on those few great ideas. Large investors get to choose from among only the largest 1,000 or so firms, but several thousand companies have stocks that trade in the US alone. And, while large investors are accountable to investment committees or scrutinized by consultants, small investors are not. As the old adage says, a camel is a horse that was designed by a committee (or a consulting firm).

The Big Secret describes the techniques most professional investors use to value businesses. If there were no uncertainty, a business’s objective value would simply be the present value of a few decades of its known free cash flows discounted at a known interest rate. But the future is unknown, and a slight tweak in an assumption used in the present value calculation can lead to huge differences in value estimates. Small changes in guesses about sales, expenses, growth, or discount rates could mean the difference between investment success and failure. Thus, Greenblatt argues we should not spend too much time making precise guesses about the future because our present value calculations are rarely accurate. As Carveth Read wrote, “[I]t is a mistake to aim at an unattainable precision. It is better to be vaguely right than exactly wrong.”

Greenblatt also points out flaws in other valuation methods, such as estimates of relative value, acquisition value, liquidation value, and sum of the parts. While all valuation methods may be flawed, they are all we have, so it is best to use them conservatively. Then, we must be disciplined and wait patiently until the price of a business in the market is much lower than our conservative guess of its value. That margin of safety compensates for the likelihood that our guesses will be wrong.

Greenblatt also explains the risk-free minimum return we should accept and the reason investors who are not comfortable managing their own portfolios should avoid capital-weighted index funds, such as the S&P 500, and consider instead one of several new index alternatives⎯some of which he lists at www.valueweightedportfolios.com. Although Greenblatt stands to earn fees if we invest through his mutual funds or other accounts listed at his websites, the book is honestly written so that savvy investors can invest wisely without them. At the very least, the book is a good introduction to Greenblatt’s sound investment philosophy.

Greenblatt warns that it is difficult to be out of step with the rest of the market, but being different is necessary to make the big secret work. All investors tend to sell whenever everyone else sells and buy when everyone else buys, so they frequently buy high and sell low. As proof, he shows the performance of the best stock mutual fund of the last decade. That manager ran a concentrated portfolio of equities and generated annual returns of over 18% for ten years while the S&P 500 was flat. However, investors in that fund lost 11% on average over the same time period. How could that be? By constructing a portfolio that is vastly different from the major indexes, the manager had periods of underperformance. Investors in the fund tended to sell fund shares at the low after a period of underperformance, and buy at the high after a period of outperformance. Greenblatt suggests some rules-based investing techniques to help us avoid these behavioral pitfalls.

The Big Secret for the Small Investor should be read by small investors as well as mammoth professional managers; however, only the small investor can truly exploit its ideas. Large investors have camels, but how many small investors have the ability and willingness to saddle a thoroughbred?

–Ray Galkowski, CFA, is the Founder and Portfolio Manager of Princeton Absolute Returns, LLC and the PAR Value Fund, LP, a value-focused, long-short equity hedge fund.

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