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The little book that beats the market

Joel Greenblatt is the founder of Gotham Capital, a private investment firm and also a professor at Columbia University Graduate School of Business. In 2005 he published a short book that has become famous among stock investors. Greenblatt wrote the book in such a way even his children could read and learn from and this little gem holds many useful insights for all of us.

His main point is that we should buy good companies at bargain prices. He says we should focus on businesses with high returns on investment and wait for the market to offer them to us at prices far less than they are worth. He even goes into some specific rules for how we should do this.

To those familiar with the investing style of Benjamin Graham this approach is fairly obvious. Buy stocks at a lower price than their actual value. This assumes you are able to somehow accurately estimate a company’s actual value, but Greenblatt makes this easier for us than we might at first think.

Stock prices can experience wild swings even though the company value does not change. It is these wild swings that give us the opportunity to buy low and sell high. If we determine a company is worth $70 and it is selling for $40, buy it. If you are wrong and the fair value is closer to $60 or even $50 you will still be purchasing the stock at a discount. It becomes riskier if we are buying this stock for $65. Patience and waiting for the big discounts are an investor’s best assets.

So how do we find good companies? That is where Greenblatt’s magic formula comes in. Greenblatt believes a good company can earn a high return on capital. For example, consider a company that can spend $200,000 on a new store and earn $100,000 the next year. This company is making a 50% return on its investment. Compare that to another company that spends $200,000 but only returns $10,000 next year. That return on investment would only be 5%. He wants you to pick the company with the higher expected return on investment.

The beautiful thing about Greenblatt’s magic formula is it is easy to calculate, and anyone can do it.

 

There are two parts to it.

  1. EBIT to Enterprise Value

To begin calculating how a company earns a return on its assets, Greenblatt calculates a ratio of a company’s EBIT (earnings before interest and taxes) to Enterprise Value. EBIT is readily available for most companies from many information sites or your broker site. For Enterprise Value, you could just use Market Capitalisation although Greenblatt believes Enterprise Value is more accurate.

Enterprise Value is calculated as the Market Capitalisation of the stock plus any interest-bearing debt minus excess cash. He uses this as a representation of what it would cost at a minimum to own the company outright. To do that you would need to buy all the shares (market capitalisation) and then pay back any debt to banks that might be owed (that’s the plus interest-bearing debt bit). But then you would own the company and so also own all the cash in the bank. You could give yourself that cash, so we could think of it as reducing the outright cost (the minus excess cash piece).

Again, these figures should be fairly easy to obtain from the company balance sheet or your broker. When you have this ratio for a bunch of companies you are interested in, you simply put them all in order and the highest ratio is assigned a 1 and the next highest a 2 etc all the way down to the last.

 

  1. Return on Capital

 

Return on Capital is similar to Return on Equity. Greenblatt calculates Return on Capital as EBIT divided by tangible capital. Tangible capital is defined as Cash on Hand + Accounts Receivable + Inventory – Accounts Payable. This might be a little harder to obtain but easy if you look at annual financial reports. Once you have these two figures you can create a ratio of EBIT / Tangible Capital and then do the same ranking procedure as we did in Step 1.

 

Implementing the Magic Formula

 

Now you have a ranking number for each of your companies for two calculations. The next step is simple. Add the two ranks together to get a combined rank then sort this from lowest to highest. In his book, Greenblatt purchased the top 30 stocks from his rank (he started with 3500) and held them for one year. Then did the exercise the following year and switched to those 30 stocks etc…

 

Performance

According to his book, Greenblatt tested this strategy for a 17 year period and earned an average annual return of 30.8%. We have not verified the accuracy of his test.

In his book Greenblatt dedicates an entire chapter to explaining the strategy is not a “magic bullet” that always works. Sticking with a strategy when it does not perform in the short term, even if it has a good long-term record can be difficult, Greenblatt says, but he believes you will be better off doing just that. The best news for those of us who think calculating these numbers once a year is too much work, is that Greenblatt runs a free website with the magic formula (www.magicformulainvesting.com ). After you register with the site you can use the screener to find the stocks for you!

We like Greenblatt’s work. The approach is simple and only needs to be performed once each year. Blindly buying and selling stocks is never a good idea. Developing disciplined buy, hold, sell strategies is a much better option and the past performance of this simple approach makes it a winner in our books.

 

This article was first published in the Australian Investors Association – Investor Update, September 2018.

Author: Matthew Jones: Managing Director, Capital 19 Global Investments.

Capital 19 are your local experts in Global Investing and specialise in new ideas and approaches to Australian investors.

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