The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.
NEW YORK (
) -- Psssst ... I've got a secret about investing your money: It's all about figuring out what things are really worth and then paying a lot less for them.
I don't know why I'm whispering. This secret is widely preached, but few seem to be able to actually practice it. One exception is Joel Greenblatt, the founder of Gotham Capital, an investment partnership that achieved 40% annualized returns for the 20 years after its founding in 1985.
Greenblatt is also an author of excellent books about investing -- the most recent is "The Big Secret for the Small Investor." It lays out a case that the average retail investor, with limited resources and time, can actually beat the investment performances of most Wall Street institutions, by following simple value-investing strategies and sticking with them through the ups and downs of the market over a long period of time (or by hiring a professional who can do it for them).
"The big secret is that the investment world has become more institutionalized and more short-term focused, and this trend can work to the advantage of the small investor as long as they know what they're doing and they stick with it," said Greenblatt, when I caught up with him recently.
The tenets of value investing and "buy and hold" strategies are not exactly revolutionary. They've been articulated many times before, starting with paragons of investing like the late Benjamin Graham and his protégé, Warren Buffett, the chief executive of
( BRKA). Greenblatt, who teaches investing at Columbia University, just happens to have a knack for laying out the complexities of stock investing in an accessible and entertaining style that is rarely found in financial writing.
Moreover, his proof for the validity of these claims is groundbreaking. Some readers may recall that
several months ago, I wrote about how the
shed nearly a fifth of its value between the year 2000 and the beginning of 2012, leading to widespread talk of a "Lost Decade" for U.S. stocks. However, on an equal-weighted basis, the S&P actually rose by about two-thirds over that time frame, putting a new shine on the market's performance.
See, the S&P 500 is cap-weighted, which means that companies with a larger market cap (or market value) comprise a larger part of the index than companies with a smaller market cap. So, if you buy an index fund that tracks the S&P 500, you'll own a lot more
(market cap: $499 billion) than you will
(market cap: $4 billion). Also, you'll own almost twice as much
(market cap: $385 billion) as you will
(market cap: $200 billion).
This cap-weighting is used in all the major stock indices, and the investment world accepts this as a matter of course. But value investors know that a company's market value is not a measure of its true value. It's only a reflection of the market's current perception of what that true value is, and this can vary wildly over time, as we have seen time and time again.
In fact, the S&P's cap-weighting system, which steers investors to buy more high-priced stocks and less low-priced stocks, is a direct contradiction to the tenets of value investing, where we strive to buy stocks at a low price and sell them at a high price.
Meanwhile, it feeds the very bad habits that lead most investors into trouble. That is, most people are lured into the stock market when stocks are going up, and they tend to buy stocks that are rocketing upward and are, therefore, expensive. Then, they run for the hills when stocks are crashing and they're cheap. This, it turns out, is exactly the opposite of what investors should be doing, but it's human nature, and most of us are only human.
Stock indexes, though, are not human, and Greenblatt demonstrates in his book that a value-weighted stock index will handily outperform a cap-weighted and an equal-weighted index over time.
What's a value-weighted index? It's a stock index that is weighted to reflect a combination of a company's cash-flow generation and its price, so that investors buying the index will buy more of a company that generates strong cash flow and trades at a lesser price, and less of a company that generates less cash flow and trades at a higher price.
According to a
Web site maintained by Greenblatt's firm, an index that is value-weighted using his formula returned 16.1% over the 20 years ending at the beginning of 2011. By comparison, the S&P 500 returned 9.1%. Most fund managers would love to be able to claim that performance, and most investors fell well short of both metrics.
Greenblatt predicted there would be a movement toward value-weighted indexes, and he made a variety of value-weighted index funds available commercially, but he told me recently that no such movement has really come to fruition.
"The Big Secret is still a secret," he said. Shhh -- don't tell anyone.
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At the time of publication, Worden and or his firm held positions in AAPL, BRK-B, XOM and GE.
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