Greenblatt inspired screen focuses on stocks with low return on capital

Joel Greenblatt, managing partner of Gotham Capital, defines value investing as determining how much a stock is worth and then buying it at a much lower price. He advocates that accuracy in assessing values will pay off after purchasing undervalued stocks but he cannot say when. Gains can materialize in weeks or in years. Greenblatt, however, thinks that in most cases it takes two or three years to determine whether a stock was value properly.

Two of the main inputs of Greenblatt’s magic formula outlined in his book The Little Book That Beats The Market are return on capital employed (ROCE) and enterprise value (EV) over earnings before interest, taxes, depreciation and amortization (EBITDA). Greenblatt takes the companies with the highest ROCE calculated using EBIT instead of final net earnings to reduce accounting driven biases. He also uses EV to account for value a buyer will pay for the company; that is he includes debt and preferred shares and subtracts cash. He chooses companies with low EV/EBITDA as he seeks companies that will earn enough to pay their value as soon as possible.

Morgan Stanley analysts led by Matthew Garman used low ROCE, which flags companies that do not invest capital as well relative to the universe, and high EV/EBITDA to identify expensive companies. They identified 50 names, three of them rated underweight by Morgan Stanley. The three underweight stocks are Mediaset Espana Com (SM:TL5), Pearson (GR:PES), and Norwegian Air Shuttle (NO:NAS). The analysts also back-tested the strategy to get an idea of its performance during various market cycles. Since 1990, the short strategy has enhanced the long/short portfolio’s return in 18 out of 23 years. The test suggests that the screen identifies underperformers when markets gain or lose.

Morgan Stanley Value Tenets

Morgan Stanley Performance

Source: Morgan Stanley, Worldscope, IBES and MSCI

Morgan Stanley: Reverse intelligent investor screen flags expensive equities

This screen was inspired by Benjamin Graham’s “margin of safety” approach. Graham advocated buying a stock below its true value, leaving a margin of safety to leave room for errors in valuation analysis. The margin of safety is also designed to help long term investors navigate market downturns. His approach in his book, The Intelligent Investor, focuses on paying attention to both making profits and minimizing losses. It points out that market swings should not drive investment decisions, and that investors need to focus on dividends and company performance.

Morgan Stanley analysts reversed the following screening criteria from The Intelligent Investor:

  1. Earnings per share (EPS) growth of 33% or more in the past ten years
  2. No negative EPS in the past ten years
  3. Price/Earnings ratio (P/E) 3 year average is at a 20% discount to market multiple
  4. P/E and Price to Book (P/B) ratios are at 20% discount to market multiple

The sell idea screen generated 50 names, with Corio NV (OTCMKTS:CRIOF) (FRA:CL6) and CGG SA (EPA:CGG) (NYSE:CGG) rated underweight by Morgan Stanley (NYSE:MS). Morgan Stanley analysts calculated gains that would have been obtained if the reverse intelligent investor screen was applied to past years. Data shows that screen did underperform the MSCI Europe, suggesting effectiveness in capturing underperformers.

Morgan Stanley Investor Stocks

Source: Morgan Stanley, Worldscope, IBES and MSCI