Investors always want to know the answer to the same question -- is today's stock market cheap or expensive?
And according to one of the greatest investors of this generation, the answer is both!
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It just depends on what kind of stocks you are looking at.
Let me explain...
Today There Is A Huge Disparity Between Growth And Value
From 1985 through 2006 Joel Greenblatt managed a hedge fund called Gotham Capital. His annualized rate of return over that period was 40 percent.
That is correct, forty percent annualized for two decades.
Greenblatt's track record isn't just good. It's epic.
That is why I'm always interested in what he has to say.
Greenblatt's investing style that generated those outrageous returns is actually very simple.
He owns stocks that are cheap, and shorts those that are expensive. There is nothing more complicated to it than that.
Over time that is a recipe for success. His returns prove that.
Based on what Greenblatt said in his most recent mid-year communication to investors, it is clear that he licking his chops at the opportunity that is in front of him right now.
The market today is ripe for his particular brand of investing.
Right now, Greenblatt believes that there is a huge disparity between the valuations of growth and value stocks.
Greenblatt thinks that growth stocks are currently extremely expensive, and that value stocks are extremely cheap.
Here were his exact words describing the market today:
"The valuation gap between value and growth has become very stretched. Although we can’t predict exactly when, we believe it will inevitably snap back in a very big way; meanwhile we stick to our systematic valuation process."
"In the periods following 1999 and 2007, valuations normalized leading to long periods of outperformance for our investment style."
With the largest growth stocks being dominant components (in terms of size) of the S&P 500, it means that the market overall is richly priced today. Greenblatt pegs the S&P 500 as being in the 17th percentile today in terms of price.
That means that 83 percent of the time the S&P 500 has been cheaper than it is today.
This is important for investors today to realize. The market that we are presented with today is expensive, which means that index funds are expensive too.
But as Greenblatt notes, this market also brings with it opportunity. While growth stocks are very expensive, value stocks aren't...
What You Shouldn't Own Today, And What You Should
I love Greenblatt's investing style.
He is a value investor, but he isn't interested in owning poor quality companies just because they are cheap on a price-to-book or price-to-sales basis.
Instead, Greenblatt wants to own companies that are inexpensively priced relative to the cash flows that the business generates.
He buys growth at a discounted price.
What you aren't going to find Greenblatt owning are any of the following companies -- which trade at absurd prices relative to the cash flow that they generate:
Amazon (Nasdaq: AMZN) – Trades at 27 times operating cash flow
Facebook (Nasdaq: FB) – Trades at 26 times operating cash flow
Tesla (Nasdaq: TSLA) – Earns negative operating cash flow
Netflix (Nasdaq: NFLX) – Earns negative operating cash flow
Greenblatt doesn't avoid companies like this because of problems with their businesses. He avoids them because the market values them at incredibly expensive prices.
All of those richly valued companies already have massive amounts of future growth priced into them. To somehow outperform the expectations that the market has already priced in will be virtually impossible.
Any misstep will be devastating to share prices, which is why we as investors should avoid these companies too.
Greenblatt instead owns growing companies that earn a high return on capital and are priced inexpensively relative to the cash flow that they generate.
Here are some examples of the larger positions I found in Greenblatt's portfolio:
Gilead Sciences (Nasdaq: GILD) – 10.5 times operating cash flow
Apple (Nasdaq: AAPL) – 13 times operating cash flow
Cisco (Nasdaq: CSCO) – 11.6 times operating cash
CVS Health (NYSE: CVS) – 7.2 times operating cash flow
These are businesses that generate a lot of cash flow and today Greenblatt doesn't have to pay a very rich price for that cash flow.
You will notice that the valuations of these companies are roughly 1/3rd the price of the expensive growth stocks that I listed.
Greenblatt's approach combines the best of value and growth by buying cheap stocks with room to grow.
Given the wide disparity between value and growth stocks today, investors really do need to pay extra attention to valuations -- not just to make sure that we avoid the risk presented by really expensive stocks, but also to capitalize on the opportunity available in those that are undervalued.
This article originally appeared on Daily Reckoning.