Joel Greenblatt (Trades, Portfolio) is a legendary investor and the founder of Gotham Asset Management, an investment firm that reported $3.55 billion in 13F holdings as of the end of the fourth quarter of 2022. Greenblatt is most famous for creating the “Magic Formula," which is a systematic methodology that can be used to find and identify value stocks with growth potential based on their earnings yield and return on capital.
Investors should be aware that 13F reports do not provide a complete picture of a guru’s holdings. They include only a snapshot of long equity positions in U.S.-listed stocks and American depository receipts as of the quarter’s end. They do not include short positions, non-ADR international holdings or other types of securities. However, even this limited filing can provide valuable information.
In an April 2023 interview with Investors' Chronicle, Greenblatt discussed the current economic climate and his investment strategy for 2023. In this article, I have summarized the interview and provided some of my own commentary as well; let’s dive in.
Note: The parts of the post in which Joel Greenblatt (Trades, Portfolio) has said directly are in quotation marks. The rest of the post is a summary of the interview by the author.
Earnings yield strategy
Greenblatt generally aims to identify high-quality value stocks with growth potential. More specifically, he aims to make investments that would beat a risk-free rate of ~6%; this is his "hurdle rate." The risk-free rate generally refers to the 10-year Treasury bill rate, which is effectively “risk-free” as it is backed by the U.S. Central Bank.
Generally, this has hovered between a low of 0.62% in 2020 and 3.48% in March 2023. Therefore, by calibrating investments to a 6% rate, Greenblatt has a “margin of safety” embedded into his strategy. This aims to take into account the impact of various macroeconomic forces. If the 10-year T-bond rate ever got above 6%, Greenblatt stated he would use that figure exactly; for example, 7%, 8%, etc.
Taking a step back, when the risk-free rate was below 1% in 2020, investors chose to invest in more speculative assets. This was because if you can only earn 0.5% to 1%, then even a risky or more speculative stock with a 4% expected return looked enticing. This is based upon the phenomenon of T.I.N.A, or "there is no alternative," which was a common driver of the speculative investing of 2020.
Going back to the 6% rate, Greenblatt factors in this can assume at least a 6% earning yield, or the potential to achieve that measure or above long term. For example, if a stock has an earnings yield of 4%, but earnings are expected to double over two years, then this will be well above the 6% mark.
Simplifying things down, Greenblatt states “expected return” is a “quick and dirty” way to analyze investments. Your savings account may pay an interest rate of ~2%, while a private business may provide an expected return of 20%.
If you're investing in a house to rent out, you can compare options by also analyzing the yield. This is calculated as the rental income divided by the value of the property and then multiplied by 100. Therefore, higher rental income equals a higher yield, but also a lower house price equals a higher yield. For example, if a house pays $12,000 per year in rent, but costs ~$200,000 to buy its yield is ~6%, this is considered to be quite good in general. Of course, this is not taking into account void periods, maintenance costs, etc., but you get the idea. In relation to stocks, a cheaper stock price (with earnings held constant or growing) would equal a higher yield.
Greenblatt believes “yield” is a great way to look at the entire world of investing and compare “apples and oranges." The hard part with investing is predicting how those earnings will change over time - will they increase or decrease? This is the job of a “cold and calculating” independent thinker or analyst. After checking if an investment has a good chance of beating his risk-free rate, he compares this to alternatives.
What returns can we expect?
Choosing the right company, stock or investment can be challenging. Thus, constructing a portfolio of a basket of stocks or bets makes sense. The goal of this is to be “right on average."
Greenblatt revealed he does a rebalancing of his portfolio weighting towards the cheapest 20%. He bases this analysis on trailing free cash flows, relative to the price.
As of March 2023, Greenblatt’s investment portfolio was in the 94th percentile towards “cheap” relative to the entire U.S. stock market. From the current valuation level, Greenblatt revealed that historic data shows a 63% increase in stock prices (of the cheaper stocks) could be possible over the next two years, which is fantastic.
A similar analysis can also be done for the S&P 500. In this case, Greenblatt revealed that it the index is within the 27th percentile towards expensive, relative to the past 30 years. This means the two-year forward return potential is closer to 17%.
Will value investing return?
Greenblatt likes to say we have a “market of stocks, not a stock market." He is referring to the fact that individual stocks or companies present opportunities and thus should be analyzed on that basis. As mentioned prior, Greenblatt’s definition of value is “cash flow oriented,” not sales or book-oriented.
Greenblatt says the “rubber band” has stretched so far now towards value, that he believes a return of solid investment returns (for value stocks) looks likely over the next four years. This hasn’t been the case historically, as growth stocks have outperformed value in the five years prior to 2021.
Putting it more philosophically, “all investing is value investing," Greenblatt says, as growth is a part of the value of a company. Value investing basically involves trying to buy growth for cheaper than its true value.
Will technology stocks bounce back?
Greenblatt believes large technology stocks still have prospects and are “relatively cheap." An example he gives is Google's parent company Alphabet (GOOG, Financial)(GOOGL, Financial), which has seen its stock price correct down by 29% from its all-time high in December 2021. This was driven by a tepid advertising market, but also its core search business is facing challenges for the first time in over a decade due to the rapid rise of GPT-3 by OpenAI, which received a $10 billion investment from Google’s search engine rival Microsoft (MSFT, Financial).
It takes a contrarian to win
Most stocks only become “cheap" due to some bad news surrounding the company, as in the example of Alphabet. Greenblatt believes most investors tend to “over avoid” companies with issues, and that it takes a contrarian attitude to be successful.
By nature, everyone cannot be a contrarian, and the goal is to filter the real fundamental problems a business is facing from its short-term headwinds. Once identified, these type of investments can still be challenging to hold onto as it can take many years for business problems to be solved.
Being a contrarian should not be confused with investing in value traps. Value traps are stocks that have fallen in price but may still have fundamental issues or be difficult to understand. An example Greenblatt gives is banking stocks, which have of course sold off after the Silicon Valley Bank crisis. These types of businesses tend to have obscure balance sheets and thus can be difficult invest in.
Circle of competence
Similar to Warren Buffett (Trades, Portfolio), Greenblatt believes in identifying opportunities that are within his circle of competence. From that point, he looks for “one foot hurdles” and says you're always “turning over a lot of rocks” to find these opportunities. Investing isn’t easy and the market is emotional in the short term. It eventually gets things right, but nobody knows when that will be.
Final thoughts
Joel Greenblatt (Trades, Portfolio) is an incredible investor who has stuck with the value investing strategy over the years, despite a decade-prior rise in growth stocks. Now it looks as though Greenblatt’s strategy is favorable, and given his solid strategy of buying cash flows cheap, I believe his strategy will likely post strong returns in the long-term.
