During Greenblatt’s hedge fund days, he held a concentrated portfolio of undervalued stocks and special situations. He goes into detail on special situation investing in his book You Can Be a Stock Market Genius.
Special situations aren’t unique to Greenblatt. Buffett relied on it back in his partnership days. Peter Lynch did too. Klarman does, along with others. Buffett referred to it as workouts and here’s why he relied on it:
“Workouts” – These are the securities with a timetable. They arise from corporate activity – sell-outs, mergers, reorganizations, spin-offs, etc. In this category we are not talking about rumors or “inside information” pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in the paper. The risk pertains not primarily to general market behavior (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialize. Such killjoys could include anti-trust or other negative government action, stockholder disapproval, withholding of tax rulings, etc… However, the predictability coupled with a short holding period produces quite decent annual rates of return. This category produces more steady absolute profits from year to year than generals do. In years of market decline, it piles up a big edge for us; during bull markets, it is a drag on performance.
It’s the timetable and what Klarman calls “mindless selling”, which creates mispricing, that makes these so attractive.
With spinoffs, for example, existing shareholders receive shares of the newly spun-off company and they don’t always want to own it. So they sell, at any price, creating mispriced opportunities for Greenblatt, Klarman, and others who put in the work to find it.
Greenblatt gets into that in his book. And his results were astounding — 50% returns before fees over ten years. But that was with 6 to 8 stocks making up 80+% of the portfolio.
It’s not for everyone.
He explained how he dealt with such a concentrated portfolio (that goes back to Graham) in a great exchange on the MiB podcast that is useful whether you own 8 stocks or 8 index funds:
GREENBLATT: Right, well Warren Buffett has a good response to that as well. You know he says listen let’s say you sold out your business and you got $1 million and you’re living in town and you want to figure out something smart to do with it. So you analyze all the businesses in town and let’s say there’s hundreds of business and you stick to — if you find businesses where the managements really good, the prospects for the business are good, it’s run well, they treat shareholders well, and you divide your million dollars between eight businesses that you’ve researched well in town, no one would think that’s imprudent, they’d actually think that was pretty prudent.
But when you get to call them stocks and you get stock quotes daily on these pieces of paper that bounce around, people put numbers on it and volatility and all these other things where really it’s not that meaningful, you know from one sense if you’re investing in businesses and you did a lot of research and invested in eight different businesses with the proceeds of your sale, people would think you’re a pretty prudent guy.
All of a sudden if you invested in stocks and did the same type of work, people think you’re insane, and it’s just an interesting analogy that I always think of when people make fun of me that I was that concentrated.
RITHOLTZ: You know the flip side of that is imagine if we got prints minute by minute for the valuation of our homes, people would lose their mind, they wouldn’t be able to manage it. So that understanding —
GREENBLATT: Well, imagine if you had a theory of buying homes, I’m going to buy the ones that went up the most last three months or six months. I mean it’s a really good analogy. I usually use the house analogy when people asked me how do we go about valuing stocks and people understand completely when they’re buying a house, there are certain things you would do and we don’t do any different than owning a business.
That only covers part of it.
Successful strategies work because they take advantage of human nature. Misbehavior creates opportunities. With a concentrated portfolio, there is less room for error. So for the strategy to work – really any strategy to work — you have to be better behaved than the average investor. It won’t work without it. The secret to all of it…here’s Greenblatt again:
GREENBLATT: I would say probably the secret to being successful is patience. The big secret that no one bought and I might as will tell everyone is really just having a longer time horizon than most people and understanding what you’re doing, meaning you’re buying businesses, and if you’re good at valuing them, I actually make a promise to my students first day class every year, I promise them if they do good valuation work, the market will agree with them.
I just never tell them when. It could be a couple of weeks, it could be two or three years, but if they do good work, the market will agree with them and to keep that in mind to continue to do good work and have patience.
So if you can step back and take a longer time horizon, that is the big secret that I could share and the sooner you learn that and the sooner I learned that, the better off that they and I will be.
Buffett Partnership Letter – Jan. 1964
MiB: Joel Greenblatt Transcript
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