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Stepan Lavrouk
Stepan Lavrouk
Articles (627) 

Joel Greenblatt: Think About Buying a Business Like Buying a House

Thinking about earnings like rent may help to streamline your thinking

October 27, 2020 | About:

Joel Greenblatt (Trades, Portfolio) is the managing principal and co-chief investment officer of Gotham Asset Management, a New-York based hedge fund. Greenblatt employs a value investing philosophy that is based around looking for special situations like bankruptcies and spinoffs. In a speech to the CFA Society of New York, Greenblatt discussed the way in which he likes to value businesses.

How much cash can I get?

Greenblatt's investment philosophy revolves around doing deep and diligent valuation research on businesses, and looking for situations where assets are undervalued. This doesn't mean that he only buys "cigar butts" - cheap businesses on their last legs - or that he only buys cyclically undervalued companies. He likes to think of himself as a value investor in the broadest sense, which sometimes means that he will buy stocks that he thinks have great growth potential.

With that being said, while any of us would want to own companies that can demonstrate strong, robust growth forever, the reality is that most companies eventually run out of steam. Of course, there will often be a number of such businesses. The problem is that in a positive market environment, investors usually overestimate how many of these great companies exist. Therefore, the best place to look for value is in underpriced cash flows. Greenblatt summed up this approach::

"Our definition of value is pretty straightforward. Let's say you're thinking about buying a house and they're asking a million dollars for it and your job is to figure out whether or not it's a good deal. So you ask certain questions that will help you figure that out. One thing is 'if I rented out this house, how much would I get, net of my expenses?' If you could get seventy or eighty thousand dollars a year net of your expenses, in a 2% interest rate environment, that might justify you paying a million dollars for that house. You'd also probably look at what the other houses on the block cost - 'How relatively cheap is this compared with my other choices?'"

In the same way as our hypothetical real estate investor, Greenblatt likes to look at what the likely future earnings of a company might be in the future. The "business as real estate" analogy is one that Berkshire Hathaway's (NYSE:BRK.A)(NYSE:BRK.B) Warren Buffett (Trades, Portfolio) has often used, comparing companies to farmland. He argues that, if you owned a piece of land, you wouldn't rush to get a pricing quotation on it every single day.

This seems like a silly thing to do - yet that is exactly what investors are conditioned to do by putting out daily price updates on their portfolios. There is nothing really inherently different between a publicly traded company and a piece of real estate - ultimately, both are assets that generate (hopefully) some amount of free cash flow. Reminding yourself of this fact will help to focus your thinking on the long term and block out the day-to-day fluctuations in the market.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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