Can just two numbers make you wealthy? Joel Greenblatt, a bestselling investment writer and managing partner of Gotham Capital International, thinks so. A value investor, he follows in the footsteps of Benjamin Graham, the man credited with creating the approach in the 1920s. And Greenblatt’s track record is pretty good. Between 1984 and 1994, Gotham Capital made gross compounded returns of 50% (before fees), generating cumulative gross returns of 5,197% versus 154% for the S&P 500. So he knows about making money.
Value investing is about analysing firms from the bottom up, with the goal of buying above average firms at below average prices. Or, as Warren Buffett puts it, they must be “good as well as cheap”. Greenblatt focuses on just two ratios: return on capital employed (ROCE) and the earnings yield – and combines these into a single ranking. He sticks to firms with a market capitalisation of at least $1bn. They must also be easily traded, so they should have a minimum aggregate daily value traded of at least $250m over each of the last three months. After all, here’s no point in spotting a bargain if low trading volumes mean you can’t trade it. So what do his ratios measure and do they really work?
Return on capital employed (ROCE)
This measures the annual return made on the capital used by a firm to run its operations. There are several ways it can be calculated. Greenblatt favours earnings before interest and tax (operating profit, or Ebit) over net working capital and net fixed (longterm) assets (defined on page 53). He uses Ebit because, by ignoring interest or tax charges, it “levels the playing field across companies that have different levels of debt and are subject to different tax rates”. By taking working capital and fixed assets you get a view (based on accounting rules) of how much capital a business is using. So if Ebit is R20m, working capital is R100m and fixed assets total R200m, ROCE is (R20m/R300m) x 100%, or 6.7%. That could be compared to other investments, such as bank deposits or other firms in the same sector. But Greenblatt combines it with another ratio – the earnings yield.
Earnings yield
This can be simply the p/e ratio inverted. But Greenblatt prefers to use Ebit divided into a firm’s enterprise value (EV) instead. That’s partly because the p/e ratio uses only shareholders’ funds to value a firm, whereas Greenblatt prefers to include lenders’ contributions in the form of a firm’s debt. So if Ebit is the same R20m from the example above, and a firm has 100 million shares in issue trading at R3 each and R50m of debt at market value, then Ebit/EV is R20m/(100m x R3 + R50m) x 100%. That’s about 5.7%.
Once he has the ratios for each firm, Greenblatt combines them into one score to generate a ranking. The best scores reveal the shares of profitable companies that are undervalued by the market.
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Does it work?
Not always. 2008 was a tough year for value investors as stockmarkets plunged. But in the long run Greenblatt’s approach has turned in some impressive statistics. Back testing reveals that an investor who had tracked the newly launched Gotham Enhanced Value index (which follows his criteria) would have made an annualised return of 18.7% between 31 August 1999 and 13 August 2009 with dividends reinvested. That compares to –0.8% for the S&P 500 total return index.
The risks
There are three. Firstly, the past is not a reliable guide to the future. The next ten years may well not replicate the last ten. That said, Greenblatt’s value investing principles have their roots in an approach that has worked on and off since the 1920s. Secondly, the Greenblatt approach carries some risk. Volatility over the same ten-year period for his theoretical portfolio comes out at 23.3%, against 16.5% for the S&P 500 (in other words, the value of his portfolio had more ups and downs than the market did).
And thirdly, his stock-pickers leave out certain sectors, in particular financials (including insurers and property firms) and utilities. That’s because financials present their results differently to most other sectors and run on a different business model. Utilities suffer from a capital structure that is set around a regulated return. As such, uncovering deep value is much tougher as the ROCE is, to some extent, guaranteed by the state. So the Greenblatt formula doesn’t work for fans of banks and utilities, and it doesn’t fully diversify a portfolio.
What to buy
RBS is launching an exchange-traded fund to track the Gotham index. But we wouldn’t pile in until it has established a track record and proved it does what it says on the tin. So what stocks does the approach recommend buying now?
The three sectors that are currently top of the Gotham index weightings are unloved by many analysts: pharmaceuticals, defence and construction, and engineering. From those sectors we like the look of defence contractor Lockheed Martin (NYSE: LMT), on a forward p/e of ten and a price/earnings-growth ratio of just 0.9, despite beating recent results forecasts. Pharma group Pfizer (NYSE: PFE) trades on a forward p/e of 9.1 and a dividend yield of 4.4%. Like other pharma stocks it suffers from “what investors see as scanty new drug pipelines”, says Bloomberg’s John Dorfman. But we agree that, while being a cause for some derating, “they worry too much”. Lastly, there’s oil services firm Fluor Group (NYSE: FLR), on a forward p/e of 11. All three stocks have solid brands and good management teams, yet trade below the S&P 500’s forward p/e of 19 and historic average p/e of around 14.
