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Jun 4, 2009

How the Small Investor Can Beat the Market

With value investors, Ive always looked up to Joel Greenblatt. His book You Can Be a Stock Market Genius was actually my very first investing book. Since then Ive tried to read everything I could about him, from transcripts of interviews he gave on television, and his course material from Columbia.

I stumbled across a really interesting paper, penned by Greenblatt and noted value investor Richard Pzena published in the 1981 Summer issue of the Journal of Portfolio Management. Their paper is titled How the Small Investor Can Beat the Market.

I think that sometimes as value investors we spend too much time trying to emulate our idols, rather than take advantage of the opportunities that are available to us because of our small size. Greenblatt and Pzenas article affirms the idea that small investors do have an advantage, mainly in the area of net-nets where most securities are small, under followed, and often mispriced. The authors say:

Wall Street research houses limit their coverage to fewer than 500 actively traded issues (Merrill Lynch being the exeption with approximately 1100 stocks closely studied). Meanwhile, the NYSE trades 2000 stocks, the Amex trades 1000 companies, and the OTC market trades another 7000 issues that are required to provide relatively full disclosure to the SEC. Under these circumstances, the individual may in fact be able to locate unrecognized values in the nearly 9000-stock second tier not closely followed by experts.

Now this was written about 28 years ago, so maybe research has changed. Still, certain companies will always be under followed or receive scarce research coverage. Ive always noticed that there indeed are bargains in the net-nets area. Finding liquidations for example (often the result of a net-net where management realizes their operations are doomed) requires a little extra leg work on the part of the investor. Some enterprising online communities have sprung up that are dedicated to uncovering these bargains. The extra work required to find such bargains makes them less likely to be uncovered by the rest of the investing universe, allowing you, the small investor, to take advantage.

So Greenblatt and Pzena (G&P from now on) set out a methodology for what they define as Grahams rough calculation of liqudiation value:

Curent assets (cash, accounts receivable, inventory, etc.).

less

Current Liabilities (short term debt, accounts parable, etc.),

less

Long Term Liabilities (long term debt, capitalized leases, etc.),

Preferred Stock (claim on corporate assets before common stock),

Number of shares outstanding,

equals

Liquidating Value Per Share.

G&P didnt just test this method during a bull market. They say:

we selected 15 segments of 4 months each over a six-year period in which the over-the-counter (NASDAQ) averages halved and then doubled. (Approximately 60% of our selected stocks were traded in the OTC market.) The period under study ran from April 1972 to April 1978; it included the great market plunge of 1974 and the subsequent strong recovery. The obvious advantage of such a volatile period is that we were able to observe the performance of our selected stocks during extreme market conditions.

G&P look at three factors when designing their portfolio test.

1. Price to liquidation value

2. Price to earnings ratio

3. Dividend yield.

The authors included in the simulations that a security would be sold after a 100% gain or after 2 years, whichever came first.

Here are the portfolios:

Portfolio 1

Price / liquduation value:

Note the differences in performance that come with the adjustments in the portfolios screen factors. The best performing portfolio is #4, which contained not only a requirement that the securities be below liquidation value but also that they trade at a low price to earnings level. This resulted in a wide margin of outperformance for portfolio 4 compared to the others. This helps us see that not all net-nets are alike, and that employing the usual methods of sound stock investing in the net-net area will enhance results. Usually, the universe of net-nets is pretty limited, which I believe helps in making it possibly for investors to deeply examine. Plus, since many of these companies are tiny, the small investor may have more luck getting in contact with management than they would with large companies such as GE.

Over the same period, the Value Line index had a return of -0.3% and the OTC index had a +1.3% return. The liquidation value portfolios had huge levels of outperformance versus the respective indexes. G&P give a few reasons for why this might be: 1. large institutional investors can usually only invest in the top 1000 to 1500 high-capitalization stocks. 2. There are less research dollars in the area of such small stocks, resulting in a second tier of stocks that are unrecognized and thus may be inefficiently valued by the market.

G&P end with a comment on the future:

Unless the structure and focus of the securities industry changes dramatically towards more coverage of secondary issues,a route made unlikely by basic economic realities, the individual may not have to worry about the prospect of a completely efficient second tier. On the other hand, in the more computerized future, it is likely that bargain stocks will become harder to find and will provide lower excess returns than the bargain stocks currently available. Even under these circumstances, the small investor should retain a significant advantage over the large institutional equity funds.

As Ben Graham noted in his classic, The Intelligent Investor, It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone after deducted all prior claims, and counting as zero the fixed and other assets the results should be quite satisfactory. Apparently, in todays world of efficient markets, investors can still profit from Ben Grahams advice.

Whats really quite interesting is that much of this remains relevant today. The economics of the business right now prohibit many funds from stalking net-nets. Even though now its easier to find net-nets on screens, the universe is sufficiently large enough to satisfy the appetites of smaller investors and continue to provide opportunities that most larger players are unable to touch. In Greenblatts other book, he provides examples like spinoffs and other special situations which are not securities selling below liquidation but are undervalued and untouched by other market players because of institutional constraints. This is what I believe he is getting at when he says that a small investor should retain a significant advantage over the large institutional equity funds.

Some readers may be skeptical of this 30 year old advice. But remember that Graham was able to thrive with net nets 50 years before that. More recently, James Montier the strategist at Societe Generale penned a piece in September that said if an investor invested in a basket of net-nets over a 20 year period, their average annual return would be around 35%. My guess is that net-nets will always remain an area for small investors to profit from, as long as we actually start looking there and embrace the advantages that come with being a small investor.