How to pick WINNING stocks

Value investing works like clockwork, but your clock has to be really slow.

Joel Greenblatt is a professor at Columbia Business School and the author of You Can Be a Stock Market Genius and The Little Book That Beats the Market. He is also the chief investment officer and managing principal of Gotham Asset Management, the successor to Gotham Capital, an investment firm he founded in 1985. Here he speaks to Morningstar's Anthony Dasaro on value investing.

You've been a successful value investor. If the secret of value investing is out, and everyone knows that it works, can we expect value investing to work in the future or will it be arbitraged away?

The secret to value investing is patience, and that's generally in short supply now. The reason it doesn't get arbitraged away is that in typical arbitrage, the usual explanation is that you buy gold in New York and simultaneously sell it in London for $1 more. And what tends to happen in typical arbitrage, there are professionals out there who see those price difference, and so they'll keep buying gold in New York and selling it in London until the prices converge.

That happens so fast that individual investors certainly can't take advantage of it, a few very quick institutional investors can.

But if I told you as a value investor that you could buy gold in New York today and sometime in the next two or three years, it's likely you'll be able to sell it for a profit, but you may lose 40 per cent while you are waiting around for that to happen, it's much harder to find someone to arbitrage that away.

Time horizons are actually shrinking over the last 20-30 years even. So, things are actually getting better for value investors, not worse. The world is becoming more institutionalised, there is more access to performance information, it's much easier to trade. So, patience is in short supply, and it really makes it much nicer for patient value investors.

If value investing worked every day and every month and every year, of course, it would get arbitraged away, but it doesn't. It works over time, and it's quite irregular. But it does still work like clockwork; your clock has to be really slow.

What I promise my students at Columbia the first day of class is that, if they do good valuation work, I guarantee them the market will agree with them. I just don't tell them when. It could be a couple of weeks, could be two or three years.

How do you avoid investing in stocks where the numbers may disagree with the story behind the stock?

We're very tough on cash flows. Benjamin Graham said, buy cheap. Figure out what something's worth and pay a lot less. And Warren Buffett, Graham's most famous student, made one little twist that made him one of the richest people in the world. He said, if I can buy a good business cheap, even better.

So, the stocks that we tend to like earn very high returns on tangible capital, and the stocks that we tend to short are high-priced, but they also don't invest their money very well in their own business.

I wrote, The Little Book. And the example I gave in that book of cheap, was companies that earned high returns on tangible capital. So, in its simplest form, I talked about when you build a store, you have to buy the land, build the store, set up the display, stock it with inventory, and all that cost you $400,000. If that store earns $200,000 year, that's a 50 per cent return on tangible capital; that's really nice. If you can open new stores and earn 50 per cent a year, there are not many places in the world you can reinvest your money that way.

Then, in the book, I used an example, and I called that Just Broccoli. That's another store. It just sells broccoli. Unfortunately, you still have to buy the land, build the store, set up the display, stock it with inventory, and all that still costs you $400,000, it's just that selling broccoli in your store is not a very good idea. So, maybe it somehow earns $10,000 a year, that's a 2.5 per cent return on tangible capital.

So, we tend to like those companies that are not only cheap on various metrics of absolute relative value that we use to value them, but they also earn very high returns on capital.

In our mutual funds, that we run like hedge funds, are long/short funds. Our longs tend to have right now the returns on tangible capital on average of over 50 per cent, even though the stocks are very cheap. And our shorts earned almost 40 per cent lower returns on tangible capital, and they're very expensive. So, certainly we own cheap and good, and with short, expensive and not nearly as good.