If you could pick just one metric to base your valuation on, what would it be?
If you are a traditional value investor, you might look at the price-book ratio. A growth investor may look at revenue or sales. Joel Greenblatt (Trades, Portfolio) prefers to look at cash flow. In an interview with Bloomberg, the co-chief investment officer of Gotham Capital explained how examining cash flow helps him avoid value traps. He also explained why focusing on cash means staying away from some of the more well-known glamour stocks.
Focusing on cash flow helps avoid value traps
âSo weâre really concentrating on companies that have seven, eight, nine percent free cash flow yields in a 3% interest rate environment. And while some of those may be priced cheaply because people are concerned about the future, we tend 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 âtraditional value.ââ
One of the main hurdles for value investors to avoid is value traps - companies that look cheaply priced based on some metric like price-book or price-earnings ratios, but are actually priced that way because there is something deeply wrong with the business. Cash doesnât lie - if a company is providing a good return on invested capital, then that is generally a very good sign it is doing well, and is a much better indicator than metrics that use earnings, which can be manipulated much more easily.
The worldâs worst investment strategy
Greenblatt had an interesting answer when asked about whether he would consider investing in some of the high-flying tech stocks, and if not, how cheap they would have to get for him to consider getting involved. His philosophy is that a company that does not make money is not something worth investing in:
âThe things that weâre short are generally trading at 50 times or 100 times earnings, or losing money. So within that group will often be certain types of FAANG stocks, if theyâre not earning a lot of money yet, and people are pricing it on 2024 earnings, and they have a lot of high hopes involved there⌠The bucket of companies that are trading at 50 times or 100 times pretax free cash flows, or losing money - historically, thatâs the worldâs worst investment strategy. There will be some winners within that group, and youâll actually know their names, because they won! But I call that the âtyranny of the anecdoteâ - itâs really the worldâs worst investment strategy as a group, but some of them will winâŚ
That doesnât mean that the FAANG stocks or some of the names youâre familiar with wonât do well, or they wonât meet the expectations that people think, itâs just that as a group, the growth group where people just pay up for expected growth over the next 5 years - I would expect that to come back to earth. I donât know [what the catalyst for that will be] I would just say that it always happens.â
This quote illustrates the divergence between value investing and growth investing, at least as practiced by those who look at speculative future growth. Sticking to a "cash first" strategy means you will probably miss out on the next Amazon AMZN, Facebook FB or Google GOOGLGOOG, but it will also mean you will miss out on the next Pets.com. Do not throw away what you have in an attempt to get what you donât need.
Disclosure: The author owns no stocks mentioned.
Read more here:
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- Warren Buffett Explains the M&A Boom
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