- Joel Greenblatt, the managing principal and cochief investment officer at Gotham Funds, thinks investors should think about buying stocks in the same manner they would buy a house.
- Greenblatt has crushed markets for decades, and is currently trouncing 96% of his competitors.
- His strategy adds a unique twist to the time-honored strategies of legendary investors Warren Buffett and Ben Graham.
- Greenblatt defines the term “value investing” differently than most, and eschews a strict adherence to popular metrics such as price-to-book and price-to-sales ratios.
- Click here for more BI Prime stories.
It only takes a few minutes of chatting with legendary hedge fund manager Joel Greenblatt — the managing principal and cochief investment officer at Gotham Funds — to understand how much of an influence the likes of Warren Buffett and Benjamin Graham have had on his investment career.
It all started when Greenblatt stumbled upon an article in Forbes magazine delineating Benjamin Graham’s stock-picking formula when he was studying to become a lawyer.
“I was immediately smitten,” he said in an exclusive interview with Business Insider. “I thought everything that I read in the article made sense to me — a formula to pick stocks sounded really good to me as well.”
He continued: “From there I just started reading everything that Ben Graham wrote and eventually got to Buffett.”
The confluence of Buffett and Graham’s timeless, value-centered investment principles immediately resonated with Greenblatt. And in time, they’d serve as the foundation of his own similar strategy — one that’s been trouncing markets for decades, and more recently, crushing 96% of competitors.
The amalgamation that Greenblatt acquired is: buy it good (Buffett), and buy it cheap (Graham). However, Greenblatt differentiates himself by shorting companies with nose-bleed valuations as well. In this conversation, the focus will be on his buy criteria.
Greenblatt’s strategy is simple in theory, but without the right emotional or valuation skillset (something he puts an emphasis on), difficult in practice. It revolves around figuring out what a business is worth, paying a lot less than that valuation, and leaving a wide margin of safety.
He provided the following analogy to demonstrate his thinking:
“You’re buying a house. They’re asking $1,000,000 for it. Your job needs to be to figure out whether that’s a good deal. One thing you might think to yourself is ‘if I rented out that house — net of my expenses — how much would I be earning every year?'” he said. “If I can get $70,000 or $80,000 — in a 2% interest rate environment — on a $1,000,000 house, that might look pretty attractive and might help me justify the million-dollar purchase price.”
Redefining value investing
Greenblatt defines value investing differently than most. His eyes aren’t fixated on buying businesses with low price-to-book ratios or low price-to-sales ratios like most traditional value investors. His attention is on the cash flows he expects to receive from the business — and that’s made explicitly clear in his example.
The $70,000 or $80,000 that Greenblatt refers to above is analogous to a company’s cash flow. A crucial indicator that many investors look towards in order to forecast earnings growth (or lack thereof). In this case, Greenblatt’s house would be earning 5% to 6% above the risk-free rate of return (2%) based on the provided metrics.
The next step in Greenblatt’s investment strategy is comparison.
“Then you’d probably ask some other logical questions like: ‘What are the other houses on the block going for? And the block next door? And the town next door? How relatively cheap is this house relative to other similar houses?'” he said. “And we do that too.”
The same holds true for stocks.
“When we look at companies, we ask questions like: ‘How cheap is this company relative to similar companies? How cheap is this business to all companies? How cheap is this business relative to historical prices?'” he said. “We use our measures of absolutely cheap on a free-cash-flow basis and relatively cheap, and all these different ways to zero-in on fair value.”
Juxtaposing the business under consideration to comparable businesses, different businesses, and the overall market gives Greenblatt a better sense of whether or not its stock is — you guessed it — a good value.
That last bit is crucial to understanding Greenblatt’s methodology and thinking. He views stocks as ownership shares of businesses, not a flashing ticker symbol.
“No private equity firm who’s valuing a business to buy the whole business looks at whether it’s low price-to-book,” he concluded. “They’re looking at the cash flows they’re going to receive from the business, and that’s the way we look at valuing businesses as well.”
Leave a Reply
Leave a Reply
This site uses Akismet to reduce spam. Learn how your comment data is processed.
