When it comes to investing legends, I think Joel Greenblatt (Trades, Portfolio) is often overlooked. When managing his investment firm, Gotham Capital, Greenblatt presided over an annualized return of 40% from 1985 to 2006.
These impressive returns have continued. Today he runs the Gotham Index Plus Fund, which according to a recent article in Business Insider, has outperformed 99% of its peers over the past three years. In an industry that is struggling to attract capital and outperform as index funds swallow investors' cash, Greenblatt stands out.
The Magic Formula approach
Greenblatt's whole investment strategy is built around his Magic Formula, a plan for finding cheap, high-quality stocks. When he finds companies that meet his criteria, he buys and holds in a concentrated portfolio.
Earlier this year, at the Robinhood Conference, Greenblatt gave some more detail on his strategy and how he is investing in the current market environment, particularly, his thoughts on the current level of the market and what it means for investors for the next few years.
Speaking to Bloomberg after the conference, Greenblatt said:
"So we actually value all the businesses in the S&P 500 bottom up and we have good data going back to 1990. So, we can actually contextualize where we stand today. According to our measures of absolute and relative value, we apply them consistently over the 28 years, and right now we're in the 22nd percentile towards expensive over the last 28 years. The market has been cheaper 78% of the time and more expensive 22% of the time. Now this isn't a projection, but we can go back in time and look from this valuation percentile in the past to what's happened over the next year or 10. Markets tend to go up 4% to 6% over the next year and 10% to 12% over the next two."
This is an interesting perspective from the master of fundamental value analysis. It seems he is saying that while the market might look expensive today, investors may still have the opportunity to make money over the next two years based on historical precedents.
Focus on cash flow
So, in this environment, what kind of companies are Greenblatt and his team buying?
He wet on to explain that Gotham is buying companies that "have 7%, 8%, 9% free cash flow yields." Greenblatt likes these businesses because while they might look cheap today, "They're earning lots of cash flow."
He opined, "We try to stick to companies that are gushing free cash flow huge returns on capital meaning they deploy their capital well. That avoids some of the value traps from traditional value."
Here is some more detail on Greenblatt's investment strategy in the current market:
"We're actually valuing businesses based on cash flows like a private equity investor would. If you're trying to figure out what a company is worth, and buy it for less at a bigger discount, that will never go out of favor. Even if value, as defined by Russell or Morningstar, which is low price book low/ low price sales investing, that may or may not stay in fashion. It may be out of favor sometimes or in favor. It may not even outperform the market going forward...There are early indications in recent weeks that maybe there's a shift. That may be the premium investors have given to growth stocks is coming off."
Over the past few years, value investing has underperformed growth investing, but it seems that Greenblatt has been able to buck the trend by investing in cash flows and not the traditional low price-book model some value investors favor. The results speak for themselves.
Cash is king in business, and while traditional value investing might have fallen out of favor with investors around the world, cash flows remain fundamental to business success.
Disclosure: The author owns no share mentioned.
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