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Joel Greenblatt: Don't make this investing mistake

Joel Greenblatt has built his career by picking stocks on the cheap.

As a hedge fund manager, his Gotham Asset Management earned annual average returns of about 50 percent in its first decade through 1995 — "before fees," he joked, sitting down for a CNBC Pro "Value Spark" interview .

Greenblatt's career has since progressed from hedge fund manager to professor to author — he's sold more than 400,000 copies of his 2005 treatise, "The Little Book That Beats the Market" — to manager of several mutual funds and a hedge fund once again.

Over the years, he has morphed from running his original, extremely concentrated hedge fund — which often had fewer than 10 holdings — to a broader approach of holding hundreds of long and short stock positions at a time.

(To watch the full in-depth interview with Greenblatt, click here . You must be a CNBC Pro subscriber.)

Greenblatt said the stock market overall today is "at about the 25th percentile, towards expensive, over the last 25 years. That means the market has been cheaper 75 percent of the time," and more expensive only a quarter of the time, he said.

That said, "in our long portfolio, we're able to buy ... cheaper than average over the last 25 years," said Greenblatt.

"There is a real dichotomy" between the richly valued broad market and the cheapness of many individual stocks, he said.

One way Greenblatt identifies cheap but worthy stocks in his "Little Book" is to overlay a company's return on invested capital against its earnings yield relative to its net worth. A basket of 30 or so stocks that scored well on both parts of this "magic formula" should be refreshed, he wrote, about once a year for optimal returns.

On the day of our interview, that screen, which is made freely available at Magicformulatinvesting.com, turned up such names as Apple, Cisco, Gamestop, Gilead, Fitbit and Viacom.

Other "Value Spark" Interviews:
Strategy session with billionaire investor Howard Marks
Value investing with Mario Gabelli
Tilson on value investing, shorting, Buffett

Of course, many of those companies have become cheap for good reason.

But, "I don't just own Apple," Greenblatt said, speaking hypothetically. "I own what I would say is a bucket of Apples. And I know my bucket's going to work out because companies that gush cash and earn high returns on capital, and have nice niches, they tend to work out very well."

"Stocks are not pieces of paper that bounce around," he said. "As far as we're concerned, they're ownership shares of businesses that we value and then try to buy at a discount. So that's value investing. Figure out what a business is worth, and pay a lot less."

The flip side of that is how expensive some companies are trading today.

"There are also a bunch of stocks that are way overvalued," Greenblatt said. "This is the most expensive short book you could short over the last 25 years."

"When you're paying 100 or 1,000 times earnings, or buying something that's losing money, these are hope stocks," he said.

"It doesn't mean Tesla won't work out," Greenblatt said. But, "if you bought a bucket of Teslas, really bad strategy ... history would say pretty much the worst thing you could do."

And when it comes to Gotham's own suite of mutual funds, some of which have had a rocky start relative to the S&P 500, Greenblatt is unwavering.

"In order to beat the market, you have to do something different than the market," he said, pointing to a study that showed nearly half of top-performing managers over a 10-year period spent at least three of those years in the bottom 10 percent of performance.

"We spend our time explaining to people who will hopefully understand what we're doing, to get sticky investors," Greenblatt said.

After all, he is among those who think the current shakeout of underperforming hedge funds –- and other types of actively managed funds — will be a lasting one.

"There are not many managers that justify those fees," he said.