In this article we look at the strategy used by Joel Greenblatt, influential investor and managing principal and co-chief investment officer of Gotham Asset Management. There are many approaches to the selection and analysis of common stocks floating around the investment community, from simple value techniques to complex strategies combining a wide array of technical and fundamental factors. Many investors are initially drawn to intricate techniques, only to discover that basic, but sound, approaches often perform better and are easier to implement and understand.
With the The Little Book That Beats the Market and follow up The Little Book That Still Beats the Market, Greenblatt’s goal was to write books simple enough that his children could understand and use yet have them reflect the core values used by Greenblatt to manage his portfolio. The result is an easy-to-follow process that relies on two simple rules: Seek out companies with high return on invested capital (ROIC), and that can be purchased at a low price that provides a high pretax earnings yield. These two concepts—buying a good business at a bargain price—make up the “magic formula.”
Finding Good Companies
Greenblatt believes that a company with the ability to invest in its business and receive a strong return on that investment is usually a “good” company. He uses the example of a company that can spend $400,000 on a new store and earn $200,000 in the next year. The return on investment will be 50%. He compares this to another company that also spends $400,000 on a new store but makes only $10,000 in the next year. Its return on the investment is only 2.5%. He would expect you to pick the company with the higher expected return on investment.
Companies that can earn a high return on capital over time generally have a special advantage that keeps competition from destroying it. This could be name recognition, a new product that is hard to duplicate or even a unique business model.
Return On Capital
Greenblatt measures the strength of a business by examining its return on capital, which he defines as operating profit (EBIT or earnings before interest and taxes) divided by tangible investment capital (net working capital plus net fixed assets).
Return on capital, or return on invested capital, is similar to return on equity (the ratio of earnings to outstanding shares) and return on assets (the ratio of earnings to a firm’s assets), but Greenblatt makes a few changes. He calculates return on capital by dividing EBIT by tangible capital.
Greenblatt uses EBIT to calculate return on capital because his focus is on profitability from operations as it relates to the cost of the assets used to produce those profits.
Another difference is Greenblatt’s use of tangible capital in place of equity or assets. Debt levels and tax rates vary from company to company, which can cause distortions to earnings and muddy cash flows. Greenblatt believes tangible capital better captures the actual operating capital used.
The higher the return on capital, the better the investment, according to Greenblatt.
For our Greenblatt Magic Formula screen, we required a return on invested capital greater than 25%.
Identifying Cheap Stocks
To those familiar with the value investing style of Benjamin Graham, the point is fairly obvious: Buy stocks at a lower price than their actual value. This assumes you are able to somewhat accurately estimate a company’s actual value based on future earnings potential.
Greenblatt says that stock prices of a firm can experience “wild” swings even as the value of the company does not change, or changes very little. He views these price fluctuations as opportunities to buy low and sell high.
He follows Graham’s “margin of safety” philosophy to allow some room for estimation errors. Graham said that if you think 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.
Using EBIT Relative to Enterprise Value to Find Value
Greenblatt finds stocks selling at bargain prices by seeking out companies with high ratios of EBIT to enterprise value. Enterprise value is equal to the market value of equity (including preferred stock) plus interest-bearing debt minus excess cash.
A company’s enterprise value represents its economic value, which is the minimum value that would be paid to purchase the company outright. In keeping with value investment strategies, this is similar to book value. Greenblatt uses enterprise value instead of just the market value of equity because it takes into account both the market price of equity and the debt also used to generate earnings.
EBIT relative to enterprise value helps to measure the earnings potential of a stock versus its value. If the EBIT-to-enterprise-value ratio is greater than the risk-free rate (typically the 10-year U.S. government bond rate is used as a benchmark), Greenblatt believes you may have a good investment opportunity—and the higher the ratio, the better.
Stocks that passed the Magic Formula screen are domestic, exchange-listed stocks with a market capitalization of at least $50 million. Greenblatt also excludes financials and utilities because of their unique financial structures. The 30 companies with the highest level of EBIT relative to enterprise value made the screen.
Greenblatt wanted to write a book his children could read and learn from. The main point Greenblatt makes is that investors should buy good companies at bargain prices—businesses with high return on investment that are trading for less than they are worth.
Greenblatt recommends that you build your portfolio slowly over the course of the year by selecting five to seven stocks every two or three months until you have a portfolio of 20 to 30 stocks. When it is time to select some stocks, you would run the screen to get a fresh list. Because this simple approach relies on no additional research, it is important to hold a significant number of stocks to diversify your risk and allow the general principles of the approach to take hold. The Magic Formula approach is banking on smart money eventually realizing the value of the “good businesses” selected by the approach and driving up stock prices to reward the value investor.
Stocks Passing the Greenblatt Magic Formula Screen (Ranked by EBIT Relative to Enterprise Value)
The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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