Thread by @InvestmentTalkk

In 1981, Joel Greenblatt authored a paper on buying stocks selling below their liquidation value, and ran some backtests with impressive results.

It was called 'How the Small Investor Can Beat the Market'.

Here are a few takeaways from the paper.

1. Greenblatt refutes the EM hypothesis (an idea has persisted).

While the #s may differ today, institutions still neglect certain stocks; many of them too small/illiquid. For this reason, many investors believe there will always be unrecognised value in the market.

2. Greenblatt's paper sought to combine Graham's approximation of liquidation value (below) with the PE ratio. This process was intended only to be a “rough screening device” to sort out the likely prospects from the thousands available. He excluded firms with TTM losses.

3. He constructed four unique portfolios and compared their performance to that of the OTC and Value Line indexes across 18 four-month periods from 1972 to 1978.

4. An initial $100 investment across the OTC and Value Line indexes would return $88 and $79, respectively. After six years, portfolios 1 through 4 returned a range between $248 and $517.

5. The portfolio with the lowest value with respect to PE and LV was found to be the highest-performing vehicle.

Portfolios with floating PEs beat the indices, but underperformed those with fixed ratios.

6. Triple A yields ranged from 7% to 9% during the period, so we can assume that the PE value was considerably higher for portfolios 1 and 2.

7. Portfolio 1 had, collectively, the highest values for LV (≤ 1.0) and PE (5.5 to 7) and performed the worst. The study suggests that searching for profitable stocks that have an LV ≤ 0.85 and PE ≤ 5 is the most attractive fishing spot for stock pickers.

8. There are some limitations to the study, most of which I outline in the article linked at the bottom of the thread, but include;

• Reconciling returns
• Dividends & fees
• Sample period
• Sample size
• Market cap threshold
• Portfolio size

9. As one example, the avg # of stocks in the sample portfolios was ~15. Concentrated by some people’s standards, but then again this comes from the guy who said this in 2022:

10. Why Did It Work?

The selection criterion produces results based on the “large 2nd tier of stocks” that are forgotten and inefficiently valued by the market.

11. While there were no magic qualities associated with buying stocks trading below LV, the study sought to exploit stocks that were undervalued and protected by large asset values and strong balance sheets.

12. Investing history is a funny thing. The more years you peel back, the more likely you are to analyse a version of the world that is no longer applicable today. The further back you go, as Housel suggests, the more general your takeaways ought to be.

13. While Greenblatt's paper is unlikely to work as well today, the fact that a retail investor can exploit underexamined pockets of the market remains true, some 40 years later.

Here's the essay these highlights are from.

investmenttalk.substack.com/p/how-the-smal…