Gotham’s Joel Greenblatt: ‘There’s a big opportunity set out there’

You typically look for investments that can beat the risk-free rate of 6 per cent. For the past decade you were probably told that was too conservative, but this year there’s been a lot of renewed talk about how investors should factor in higher interest rates. How do you consider the concept of the margin of safety, both conceptually and in the current environment in particular? DJ

If you’re going to buy a stock, the first hurdle you want to pass is: over time, are you going to beat the risk-free rate of 6 per cent? That’s obviously a lot higher than the risk-free rate’s been for a long time, and as you suggest that’s one way to put in a margin of safety. That doesn’t mean a company has to have a 6 per cent earnings yield right now. If you think it’s growing, a 6 per cent earnings yield would be really good, so that’s a little over 16 times earnings. But even something that’s earning 4 per cent – if you think earnings are going to double in the next couple of years, then you’ll be over that 6 per cent rate we’re looking at. So it’s a good way to look at the world of investing, how to compare apples and oranges: what do I pay, what’s my yield.

Of course, there’s a good deal of guessing when you buy a business: what will that earnings yield be over time? Will it grow, will it shrink, how solid is it? Those are the questions that you ask as an investor. So it’s just a great way to frame the way you look at almost any investment.

That doesn’t mean necessarily that if you can beat a 6 per cent rate you should buy that business: it’s a world of alternatives. But that’s the first hurdle you want to beat.

 

You’ve said in the past that you yourself look at prospective earnings three to four years out in a ‘normal’ environment to try to work out how those earnings will grow. How difficult are you finding that task at the moment, given the debate about whether this is a normal cycle, post-financial crisis, post-pandemic. Does that make it harder to work out ‘normal’ earnings? DJ

It’s always hard to figure out what normal earnings will be, what part of the cycle we’re in, and what’s it going to look like in two to three years. One of the things we’re doing now is buying buckets of companies, trying to be right on average. In the US, we have a strategy that always tries to reweight the portfolio daily towards the cheapest 20 per cent of our universe, let’s say it’s the 1,400 largest stocks in the US. That’s based on trailing free cash flows, relative to what we’re paying. Then we can go back and say ‘where are we today’ for that cheapest 20 per cent, relative to the last 30 years.

When I looked this morning [14 March], we were in the 94th percentile towards cheap for the bucket that we could create today for that theoretical portfolio. That means there’s a lot of companies, that at least based on trailing earnings, that we could buy on very good free cash flow yields. The market’s only been cheaper for creating that bucket 6 per cent of the time over the past 30 years. Then you can say “what’s happened, from the [starting point] of the 94th percentile in the past”. The answer – though it doesn’t say what’s going to happen in the future – is +63 per cent over the following two years for that bucket.

We can do the same analysis for the S&P 500, and that’s quite a bit different. Still positive, but that’s in roughly the 27th percentile towards expensive. Two-year forward returns are closer to 17 per cent. That’s sub-normal returns for the last 30 years: not negative but not nearly the same opportunity set as the cheapest. That’s why it’s important to look at individual stocks.

That’s our definition of value investing, and giving a cash-flow-oriented view, there are some great opportunity sets. This type of investing has done fine, it hasn’t way outperformed the S&P over the last dozen years or so, but I feel the rubber band has stretched for this section of the market to such a degree that the next two to four years should give it a big advantage.

 

While not necessarily cheap in absolute terms, is it fair to say tech is another area you do see value in, in particular large-cap tech? DJ

There are tech companies that are still growing nicely that do have long-term prospects that get into the window of relatively cheap let’s say. The Googles of the world, on a relative basis, relatively to the quality of the business they might well be cheap – everyone knows they’re being challenged for the first time in a long time in search, but they have a great franchise.

People can see the free cash flow yield of at least some tech businesses get in the zone of buying. There are issues confronting any company that appears to be cheap and the job of an analyst is to look at that and say ‘is it too much?’. What people tend to do, systematically, is say “this obvious problem that someone has right ahead of them [means] I don’t want to buy that stock because I want to make money in the next year or two and I see this problem.” So what tends to happen is people tend to over-avoid those companies with the obvious, immediate problem, because they want to make money now. So there’s a lot of different ways to be a value investor. There’s a systematic bias, particularly for active managers, to make money now.

 

What about some of those areas you find too difficult to analyse: what might those sectors be, and are there more or less at the moment than usual? DJ

I’ve generally been a generalist. When I was doing special situation investing, very concentrated portfolios, I really could be very patient because I only owned a few things at a time. I only tried to have a few good ideas a year, and I was always looking for those easy ones, as Buffett puts it those one-foot hurdles, not the ten-foot ones. Those don’t always come along, and even if they do you’re probably not going to recognise them, so you’re always turning over a lot of rocks to find the easy ones. I don’t think it’s easy, but there are times when certain things become easier or less easy. Given what’s going on now, [the answer might be] banks. You don’t really know what their loan book looks like specifically. You have hints, but it is a leveraged business, kind of a black box. That was coming to mind when you said “what’s in the ‘too hard’ pile?”. Often they are; sometimes they present opportunities and you can really see the franchises there, but they’re more rare.

 

Many investors gave up on the tenets of value investing over the past decade. Did you ever worry about what you were doing, or think ‘am I in trouble here, is this a new paradigm?’ DJ

Growth is part of value, and all investing is value investing: you’re valuing a business and trying to buy a business at a discount. I wrote a book, The Big Secret for the Small Investor – I always say it’s still a secret because no one bought that book, and by the way, the big secret was patience – I wrote about the fact that if you’d missed out on the Faangs, which were outperforming, maybe you wouldn’t beat certain averages – yet you were still able to beat the risk-free rate by taking low risk.

I started Gotham in 1985. My business partner Rob Goldstein joined me in 1989, we returned our outside capital at the end of 1994 but continued to run our portfolios, and 1998 was the first year we lost money. We were down 5 per cent, but the S&P was up 28 per cent that year, so not a good year to lose 5 per cent. In 1999 the market was up another 21 per cent; we were down 5 per cent again. In 2000, the market was down 9-10 per cent, we were up 115 per cent. We didn’t do anything different during those three years. The work we’d done in 1998 and 1999 finally got paid in 2000. What I was suggesting at the start, not that this is anything like the internet bubble, is that there’s a big dichotomy in the opportunity set out there. I don’t think it’s anyway near what it was in 1998-2000, but I think it rhymes and I think there are some nice opportunities out there.

 

When we at the IC use the magic formula screen, for the past few years many of the highest quality UK stocks it’s thrown up haven’t scored highly on the value score, and vice versa. Does this mean the screen effectively missed high-growth tech stocks [if it were applied to the US market over that period], or is this just a quirk of the UK market? DJ

The reason I wrote the book is that when we did the research on those original metrics, we didn’t spin the computer a thousand times, we just said ‘what’s a crude metric’ – I had originally done some work in college with friends on Ben Graham’s stockpicking, which was buying stocks below liquidation value, and we’d evolved fairly quickly into the way Buffett looks at the world, which is not just cheap, but if I can buy a good business cheap then even better. The idea behind the magic formula was to combine good and cheap, and we stuck our finger in the air and said 50/50. The very first test we did was 50/50. The results were phenomenal, so I wrote a book about it because I thought “what a good lesson”. Buying good and cheap, it wasn’t trying to find the optimal portfolio of all time. This was the very first test we ran.

We don’t use crude metrics or crude databases to pick stocks, but this tells you the not-trying-very-hard method, using some crude metrics, works really well – so what if we try a little bit? And that’s how we got into more diversified investing, and it’s been a fun journey trying to better that.

Something interesting to know is the way we calculate things. Thirty years ago, the returns on tangible capital for the S&P were about 20 per cent. Now they’re closer to 70 per cent. That’s very important, because if you want to grow your business 5 per cent, if you take 25 per cent of your earnings, invest it at 20 per cent you can grow 5 per cent by reinvesting in your business. If you’re earning 70 per cent returns on tangible capital, you only need 7 per cent of those earnings to reinvest at 70 per cent and grow 5 per cent. So really when you have an asset-light business, you get to keep 93 per cent of the dollar in earnings and still grow 5 per cent. Thirty years ago, you only got to keep 75 per cent. So all the metrics you use for earnings yield and everything else – when you have an asset-light business and can still grow at the same rate, your earnings are more than 20 per cent more valuable. So be very careful when you’re comparing historic numbers. The world has moved more asset-light. It’s the Apple and Googles of the world, and those are where the values are. It’s very interesting to see how that’s moved.

That portfolio I mentioned where we’re always weighting to the 20 per cent cheapest, when you look at the theoretical return since 2010 when we started, that’s actually beaten the S&P without buying Amazon (US:AMZN) and Apple (US: AAPL). There’s nothing wrong with what we’re doing over time and like I said it depends what your benchmarks are. There will be periods when there’s a few big companies or a theme that works well for a while, where if you don’t have that you’re going to trail an index. But if you’re consistently way outperforming the risk-free rate, if you’re getting very nice returns, you’re well compensated for the risk you’re taking, you’re also doing well. That really is a way that you can consistently follow something that makes sense, which is the most important thing for investors to keep in mind.

 

When an investor looks at return on capital [for the magic formula], they’re typically looking at Ebit or something like that. Given the way that companies often try to manipulate stated profits, is there value to using cash flow to replace Ebit as an alternative? DJ

The numbers that are usually manipulated are some kind of adjusted Ebit, adjusted Ebitda, so that’s where companies get into trouble, to say “if we didn’t have any expenses, we’d have earned this”, or similar. But we have a big research team. We start at reported numbers and then look at [for instance] if a company takes a write-off, they didn’t take that loss in that quarter, they didn’t lose all that money, it was spent over a period of years, so [we look at] what did they really earn going backwards and things of that nature. That’s the type of analysis we do to decide what is real cashflow, what periods do these expenses belong in, do they do serial write-offs every time something goes wrong. Those are the judgement calls that an analyst does.

I think the magic formula is being used correctly when it’s being used for two purposes. One is to buy a large bucket of companies and try to be right on average. The other is to create a list of things that might be cheap, then take a look, a deeper dive on each one.

 

In the UK large-cap market there’s often quite a large crossover between value investing and income stocks, the big dividend payers. How do you think about such stocks, if at all? DJ

We look at total return; we look at a company generating cash flow – are they doing smart things with it? If they’re reinvesting it well, I don’t need a dividend, if they have a lot of prospects, I don’t need a dividend. If they don’t have a lot of prospects, or the business is asset-light, they don’t need the money, I’m happy to get it. I’m agnostic. I will look at how the company allocates its capital.

You can do it by share buybacks – when you buy back your stock, if the company thinks the stock is trading below the obvious value of the business, it might be a good idea to buy it back. If the stock is richly valued, maybe it’s better to give a dividend and not to overpay.

 

There’s been a lot of angst about the UK market in recent weeks – companies moving to the US, the talk of a longer-term discount on UK shares. As a value investor, albeit one largely concentrated on the US, do you see opportunities in the UK market? DJ

It’s not typically what we look at. I don’t know the answer, but what you’re describing is a potential special situation where, if people are avoiding the UK market for some reason that would tend to perhaps give more opportunities over time. The market will eventually get it right, so if just being listed in the UK, it doesn’t make the company that is listed there worth less. You really have to look at where their revenues and earnings are coming from, and value it that way. So if what you’re describing is true, I would use that as an opportunity.

 

In the UK we’ve had a couple of big spin-offs lately – GSK (GSK) spinning off Haleon and Melrose Industries (MRO) soon to spin off Dowlais. In the past you’ve been quite interested in the spin-off as a concept, and as a structure that can offer some value to investors. Do you still subscribe to that philosophy? DJ

My first book was called You Can Be A Stock Market Genius and 40-50 per cent of it was about spin-offs. One of the great things that happens in a spin-off is that the highest and best buyer can come in for each business and buy it. The other thing is companies don’t typically cut their empire in half, or a third, or get rid of assets that they control. They’re usually conglomerating. When you’re separating, you’re doing something usually selfless for yourself and to help shareholders. It’s a nice indicator: why would you do it other than you think that shareholders will end up better off, or the businesses will operate better, or you’ll be able to incentivise management better?

There’s a million reasons why spin-offs make sense and why value is created usually in a transaction. The opportunity is always there because these are two companies that have never traded by themselves, no one has looked at them by themselves, but the shareholder of the combined company is probably getting one of the companies they didn’t want, and they’re generally now selling. So there’s an opportunity there too: there’s supply. When companies are going public, there’s a big roadshow, people are telling everyone how great the business is. That’s not happening in spin-offs either. You’re getting a new company that is not hyped.

They could be overpriced too, because they’re not followed well. I would just say it’s a fertile ground to look for opportunity.

Sometimes there are hidden gems buried in a conglomerate. One company’s making money, one’s losing money, but people just tend to put a multiple on the net. There aren’t very many Warren Buffetts. Sure, conglomerates can be great, if they have someone at the top that is really good at this. It’s more the exception than the rule, but certainly Warren Buffett has been one of the greatest capital allocators of all time. If I were teaching someone about investing, [I’d say] read everything you can about Warren Buffett, and the fact he’s been willing to share his wisdom over the years: what a great role model, and what a great way to learn.