Joel Greenblatt, co-chief investment officer and managing principal at Gotham Asset Management, discusses how the hedge fund evaluates targeted equities as part of its investment strategy and why he likes ‘gushing’ cash-flow stocks.
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Why Gotham’s Greenblatt Likes ‘Gushing’ Cash-Flow Stocks
So we actually value all the businesses in the S&P 500 bottoms up and we have good data going back to 1990. So we can actually contextualize where do we stand today. According to the way we value our measures of absolute relative value that we use and we apply them consistently over the 28 years and right now we're in the 22nd percentile towards expensive over the last 28 years meaning the market's been cheaper 78 percent of the time more expensive 22 percent 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 what's happened over the next year. Chan and markets up 4 to 6 percent over the next year 10 to 12 over the next two. So subnormal meaning during that 28 year period market was up about 10 percent a year and were expensive or above average. So four to six is closer to what's happened in the past over the next year. The market has repriced from its peak P.
By about four four and a half times.
Do you see that as healthy. You know we don't really look at P/E we're really looking at cash flows and so we're pretty consistent about that. And so market's gotten somewhat cheaper I mean it was down maybe towards the end of September it was probably down about the 14th percentile. Now it's back at the 22nd so it's dropped but it's not cheap. But then again how what could happen from here in the 22nd percentile with expected returns of 4 to 6 percent. One way to get back and no guarantee that we get back to those expected returns of 10 percent or so. But one way you can get back there is if the market fell 18 or 20 percent tomorrow the expected returns going forward from there would get closer to 10 percent a year. But that doesn't have to happen because if the market just under earned meaning had some normal returns of 4 to 6 percent in each of the next three years then three years from now with a normal earnings trajectory we would also be back to a 10 percent expected return. So it's really not helpful for me to know what's going to happen in the next few months but it is helpful from an investment standpoint of you know what are the prospects for the market in general and and how exposed when you're if you're really taking portfolio exposure to the market. Where should you be.
Joel tech stocks and in particular the Fangs have led this recent sell off. How cheap would those stocks have to get to appeal to a value investor like you.
You know it's it's interesting the things that were short are generally trading at 50 or 100 times earnings or losing money. Those are your sort of choices of the things that we're going to be shorting. So within that group will often be certain types of Fang's stocks if they're not earning a lot of money yet and people are pricing it on 2024 earnings and they have a lot of high hopes in involved there. And we're not really opening we own hundreds of stocks on the long side and hundreds of stocks on the short side. So the bucket of companies that are trading at 50 or 100 times pre-tax free cash flows or losing money. Historically that's the world's worst investment strategy. There will be some winners within that group and you'll actually know their names because they've won. But I call that the tyranny of the anecdote OK. It's really the world's worst investment strategy as as a group but some of them will win and you'll know their names because they won. But as a group it's a bad investment strategy so we're really concentrating on companies that have 7 8 9 percent free cash flow yields and a 3 percent interest rate environment. And. While some of those may be priced cheaply because the people are a little concerned about the future even though they're earning lots of cash flow now 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. And so I think that brings up the point we don't really think of value was a low price book low price sales investing we were actually valuing.