Thursday, September 29, 2011

Joel Greenblatt on Stocks

From this CNBC interview with Joel Greenblatt:

"It's a very scary time to invest, and that's when you get your best bargains," he told CNBC Tuesday.

Greenblatt, known for his "magic formula" investing approach, places emphasis on buying companies with a high free cash flow yield and high return on tangible capital.

Basically, a decent quality business that is cheap.

Greenblatt uses free cash flow yield* to measure whether a company is cheap and uses return on tangible capital as the measure of choice to indicate higher quality.

In the interview, Greenblatt acknowledged his formula isn't perfect and doesn't always work (nothing always works, of course). So it's far from comprehensive. Clearly, other factors must also be considered (threats to the sustainability of the company's economic moat among other things), some of them intangible, but high free cash flow yield in combination with high return on tangible capital is not a bad place to start.

I think it is a very useful way of looking at things.

Using this approach Greenblatt says the stocks he now likes include:

Gamestop (GME)
American Eagle (AEO)
Best Buy (BBY)
Microsoft (MSFT)
Wells Fargo (WFC)
Hewlett-Packard (HPQ)

More from Greenblatt on CNBC:

What they have in common is "each one of those companies is hated brutally by most people."

In the interview he added that at HP's current multiple "you're going to get your money back in the next 4-5 years and own the company for free at these kind of prices."

I happen to think HP's earnings and free cash flow will probably be less than $ 5/share but what he is saying is still chiefly valid.

Once something sells at or near 5x free cash flow (a 20% free cash flow yield) very little has to go right. Well, that is true as long as management doesn't do the equivalent of throwing the cash into a furnace (consistently overpaying for acquisitions, buying back the stock when expensive etc.) and there is not a serious threat to the economic moat.

In other words, just believing that a business is stagnating or even shrinking a bit isn't compatible with a 5x multiple. The economic situation of a business has to be much worse to justify a multiple that low.

Consider a durable high return on capital business bought at a 20% free cash flow yield that happens to shrink a bit over the next five years. I know I can still live with those kinds of returns as a co-owner. I mean, a 20% return getting reduced to something like 15% is not exactly a disaster as long as it stabilizes at a somewhat lower level of profitability**.

There is often an obsession with growth that can be misplaced. A low price combined with durability trumps growth.

At very low prices a little growth is not a necessity but a bonus if it happens.
(It's worth noting that extremely high growth sometimes attracts fresh capital and competition that can adversely change the economics of a business down the road.)

The story of a very low multiple stock will rarely sound like a great one (so usually not a great subject at a cocktail party) but that doesn't matter. You can't spend a story. What does matter is whether the future stream of cash flows provides satisfactory returns considering the risks.

The key thing will always be that the stream of cash flows remains durable, even if a bit variable, and is either returned to shareholders or put to high return use by management.

Adam

Long position in WFC established at lower than recent prices in addition to much smaller long positions in MSFT and HPQ.

* Use earnings yield (inverse price to earnings) as a measure instead is often sufficient but free cash flow is more economically reliable and helps in avoiding lower quality earnings via accounting gimmickry. It's easier to dress up the income statement than the statement of cash flows.
** At an extremely low valuation the business doesn't even need to stabilize. Berkshire's Blue Chip Stamps is an example that comes to mind.
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