So Joel Greenblatt was just on CNBC and said some interesting things. I don’t intend to post every time someone I respect shows up on TV, but this appearance was especially interesting to me for a couple of reasons. One major reason is, of course, market valuation.
I don’t really care about the many folks that call for a crash or call the market overvalued and whatnot, as many of those people have no track record of turning their market views into long term profits. If you think about the guys that show up on TV as bears most of the time in the past ten or twenty years, most of them don’t have good long term track records.
But the other day, Seth Klarman was reported to have been pretty bearish saying that there is an impending asset price bubble (in his letter to investors). It’s true that he has been cautious since the 1980’s (and yet still manages to make a lot of money year after year), but still, his recent warning is not to be taken lightly.
On the other hand, Warren Buffett has said recently that the market remains in the “zone of reasonableness” or some such. He doesn’t feel that the market is particularly overvalued but not especially cheap.
And then of course there is the Robert Shiller P/E ratio (CAPE) that shows serious overvaluation.
What are we to make of all of this? I have posted in the past about market valuation, but since it seems to be such a hot topic again now, I thought Greenblatt’s input on this would be interesting. He is one of my favorite investor/authors so I do take what he says seriously.
Here is the link to his appearance: CNBC Greenblatt video
Anyway, this is what he said:
What he likes
Hewlett Packard (HPQ) and Apple (AAPL). They trade very low on measures of free cash flow with “huge return-on-capital businesses”. Most people don’t like them because they’re old and stodgy (referring to HPQ).
This is one of the parts that was really interesting to me. I always wondered why Greenblatt liked Apple. If you look at Greenblatt as the author of “You Can Be a Stock Market Genius“, it doesn’t make a whole lot of sense. The future of Apple is hard to predict; it doesn’t pass the five or ten year test of what the business will look like etc.
Greenblatt explained that when there is a business with a lot of change, where the technology changes, competition changes and you don’t even know what the company will be selling three or four years from now, he tells students to skip it and find something they can figure out.
But if you buy these businesses at such low valuations as a group, then you can do well. You don’t buy one Apple, you buy a basket of Apples. And when you buy a basket at such low valuations, it’s good. This bucket of technology stocks is cheap. He later mentions Microsoft (MSFT) as also one of the large, cheap tech stocks.
So now I understand that this is the author of “The Little Book That Beats the Market” talking. He doesn’t know or understand the future of Apple, but he is confident that a basket of tech stocks trading so cheaply will do well going forward. He has no view on the sort of things we talked about here regarding AAPL. I should have known that since every recommendation he has made on TV since the Little Book was published were basically magic formula stocks.
Large Caps Reasonable
Greenblatt said that looking back over the past several decades, the Russell 1000 index is trading at the 42nd percentile in terms of valuation; the index has been cheaper 58% of the time over the past several decades. So it is reasonable. His data shows that from here, the one year forward returns is somewhere between 7-12%. That’s not bad.
Small Caps Not
He said that the Russell 2000 index tells a “very different story”. That index is in the top 5 percentile of valuation, meaning it has been cheaper 95% of the time in the past several decades. The one year forward return from this level is a negative 3%.
Super-Large Caps Reasonable
He said that the top 20 names in the S&P 500 index, which is 30% of the index by weighting, are reasonably priced, even Google (GOOG).
What Do I think?
So this is all very interesting. You have some of the smartest investors saying all sorts of things about the market and not in agreement. Klarman said that on almost any metric, the market is “quite expensive”, and that a “skeptic would have to be blind not to see bubbles inflating…”
And yet we have Buffett pretty mellow about it all, still buying stocks and his underlings still buying and Greenblatt saying things are reasonable.
I personally don’t spend too much time on this stuff. I would rather spend time on bottom up and not worry too much about the top down.
For example, of all the posts I’ve made about investment ideas, the overall market doesn’t really make a difference to me. I wouldn’t say that JPM is attractive here only because the market p/e is 20x or some such. I like what I talk about here pretty much on an absolute basis. Of course, if the market was really overvalued at 30-40x p/e, then I would like my ideas more (at the current valuation), and if the market was trading at 7x p/e, then I would probably like the market more. But those are extremes on both ends.
I think the key is what Buffett said in the annual letter. If you own a business that you like that is a good business run by good people and is reasonably valued, why sell it just because some people think the overall market is overvalued? (Well, Buffett talks about macro factors, but I think the same applies to overall market valuation; why sell your business you like just because something else is overvalued?).
Identifying the market as overvalued and undervalued is fun stuff, but it is really hard to turn into long term profit. You can always guess one or two turns. You will always run into the guy that sold everything in August 1987 or early 2007. You may even run into folks that got out in August 1987 and then got back in in December 1987, or got out in 2007 and got back in in early 2009. But you really won’t find people who did that over several cycles.
In my previous life, I read just about every investment newsletter (of course courtesy of my employer), followed every guru and nobody calls the market continuously through cycles, even using rational, simple tools such as valuation.
Even recently, there is one prominent strategist that is a good read, but this strategist jumped in and bought gold just about at the top of the market. Another fund manager/economist who writes an interesting, well-written, convincing and widely-read newsletter has performed horribly over the long term. Yes, maybe the market is toppy so the fund looks the worst now (just as value investors look really bad at bear market lows), but I don’t think losing money is really acceptable for something that is not supposed to be a bear fund (it’s supposed to be hedged, which is not the same thing).
Klarman has been cautious for a very long time but still manages to make money, so that’s a bit different (and rare!).
I’ve talked about how Greenblatt and the Superinvestors of Graham and Doddsville made money over time (see here), not to mention Warren Buffett. These guys didn’t do it by getting in and out of the market based on market p/e, market cap to GDP, CAPE or anything else that I know of.
So What to Do?
So for stockpickers, just look at your stocks and if you like the business and where it is valued, who cares about the market?
What about folks invested in the S&P 500 index? Well, Greenblatt did say that the 20 largest names in the index are reasonably valued, so the index should be fine to own.
Even if Greenblatt didn’t say that, the stock market overall returned 10%/year or so historically, and that was only achieved by owning the index during good times, bad times, when they were cheap and when they were expensive. 10% was not achieved by getting in when they were cheap and sitting out the market when it was expensive.
If the market is expensive, the correct thing to do is not to sell out, but to adjust your expectations. Greenblatt did say something like that; if the market typically earns 8-10%/year and it’s a little overvalued now, then the returns will be a little lower, but still good.
I think the mistake is that when markets are overvalued, people think that it then must go down. So they take a short position or buy puts. Or they get out completely and wait to get back in cheaper.
Maybe the correct way to look at it is that when markets are higher we should expect lower returns going forward and that’s that. To assume that when markets are expensive, that we can sell out now and get back in cheaper later is a risky assumption, and one that hasn’t worked out over time (again, show me someone who has done that successfully over many cycles!).