Joel Greenblatt, an investor whose name may not be familiar to you, rose to prominence managing a hedge fund called Gotham Capital, which averaged 50% returns for a decade.
On top of being my all-time favorite investor, he’s also written many books. You can Be a Stock Market Genius is my favorite, but I’ve read them all and fully endorse them.
When teaching a Business School class at Columbia in 2005, Greenblatt invited his friend, Richard Pzena, to host a guest lecture.
A famous value investor, Pzena focuses on deep value investing and founded Pzena Investment Management, a firm with over $50 billion in assets under management.
Pzena’s lecture highlighted three key investing lessons which are critical to his process.
Investing Lesson #1: Reversion to the Mean
Markets project current trends long into the future. That’s why fast-growing businesses are often overvalued. At the same time, businesses that stop growing, for whatever reason, get sold off harshly. This happens to the greatest businesses.
In 2018, for example, Apple (AAPL) shares dropped over 35%. Why? Because the market was uncertain about Apple’s future growth. Suddenly, the market couldn’t project big growth numbers into the future anymore. It overreacted and punished Apple’s stock price.
And that type of overreaction creates opportunities for rational and patient investors. Stocks that grew extraordinarily fast will revert to their mean over time, resulting in less growth. Stocks that underperformed their potential will revert to their mean over time, resulting in more growth.
Investing Lesson #2: Ignore Catalysts
“Once you can see a catalyst, you are late.” – Richard Pzena
You can’t make money with information that everyone has. Let’s use the Apple example again. When Apple fell off their trend, you could’ve bought the business for 10x earnings.
But this opportunity was available because of the uncertainty. If you wait for the next earnings call, and earnings are on trend again, the price will quickly re-rate. Instead, evaluate the business right now. Would you buy Apple for 10x earnings even if growth slows down permanently?
Warren Buffett did. Eventually, Apple did get back on track – both the business and the stock price. While the stock is up many times since then, the upside wasn’t the crucial factor here. It was the limited downside that made the investment so attractive.
Investing Lesson #3: Temporary or Permanent
This way of investing relies on asking one question: Is the reason for the trend fall-off temporary or permanent? How do you answer that? Again, focus on the downside risk.
Every situation is different. Some are easier to evaluate than others. If it’s a complicated situation, you must assess the potential downside. Make the most conservative estimates possible and decide if you could still live with the estimated returns.
If you do, your downside is capped, and surprises can only happen on the upside.
I hope you enjoyed Richard Pzena’s learnings as much as I did. I want to finish with one additional point.
When learning from the greats like Joel Greenblatt and Richard Pzena, I think it’s important to utilize what resonates with you and discard what doesn’t.
For example, I think point #2 (Ignore Catalysts) may be smart for large-cap stocks. But I’ve learned that catalysts can be incredibly important for micro-cap stocks and small-cap spin-offs, my areas of focus.
As Bruce Lee said, “Absorb what is useful. Discard what is not. Add what is uniquely your own.”
What investing gurus do you follow? What bits of investing advice have you incorporated into your own personal investing approach?