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Making money just like magic?

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This is already post #10 (so week 10) and it feels like I just started The Snowball Effect! Writing and recording knowledge, resources and experiences has been a very rewarding experience so far – which I hope you’re also enjoying! Don’t hesitate to let me know what you would like to hear more about and I’ll also try to bring in some new stuff in the coming few weeks. Stay tuned!

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I rarely get sick but this week was one of these rare times. Nothing major but a serious flu (no gym for 3 days!), so while I was browsing I stumbled across a recommendation for a book, “The Little Book That Beats the Market” by Joel Greenblatt published in 2006 and decided to get it. Although I should have been more aware of this book as Greenblatt teaches at Columbia Business School, I had never really been attracted to it (maybe because of its simplistic title…) The book is very short and easy to read and although my brain power and efficiency were seriously impaired by a low level of energy, sneezing, several naps and just feeling sick in general, I was still able to finish the book in one day. It’s short and sweet mainly because the concept presented in the book is quite simple. When investing, people often don’t know where to start and how to select a few companies to look at. This book offers a great way to get started.

In “The Little Book That Beats the Market” Greenblatt presents what he calls a magic formula to select stocks and tells us exactly what to do with these stocks once identified. In summary, here is what he recommends (thanks to Wikipedia for this summary):

1-      Establish a minimum market capitalization (usually greater than US$50 million)

2-      Exclude utility and financial companies (their financials are just too different)

3-      Exclude foreign companies (i.e. non-US companies, ADRs)

4-      Determine company’s earnings yield = EBIT/Enterprise Value

5-      Determine company’s return on capital = EBIT/(net fixed assets + working capital)

6-      Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentage)

7-      Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over 12 months

8-      Re-balance your portfolio once per year, selling losers one week before the year-mark and winners one week after the year-mark (for tax reasons)

9-      Continue over the long-term (5-10+ years)

The basic idea above is based on a two-factor selection process – earnings yield and return on capital. Basically, what it tells us is find cheap stocks where the management/company has been able to reinvest profits at high rates of return – a real compounding machine! Applying that formula to 30 stocks for the period from 1988 to 2004 (17 years), Greenblatt was able to beat the S&P 500 96% of the time with an annual return of 30.8% as compared to 12.4% for the S&P 500. Quite impressive! In 2010, Greenblatt published an updated version of his book, this time titled as “The Little Book That Still Beats the Market” and for the period from 1988 to 2009 the overall CAGR went down to 23.8%. Still impressive compared to 9.55% for the S&P500. Using the magic formula and investing US$10,000 at the beginning of 1988, you would have been a millionaire by the end of 2009 – not bad.

But, it seems too good to be true… As I had my doubts, I did a bit more research and found out that I wasn’t the only one doubting these results. I found several websites and blogs who actually did all the hard work and back-tested the magic formula. Overall, the results are quite consistent. Some came quite close to the actual returns obtained by Greenblatt and some came out with somewhat lower results. However, overall the magic formula does seem to beat the market average by a significant margin.

As an international investor, one element that I noticed instantly when going through the book is the fact that foreign companies are excluded from the selected dataset (Step 3 above). However, in Greenblatt’s case, this is due to the fact that some companies might not provide the same level of information than US-based companies and he wished to compare a more uniform set of data. That being said, the two selection factors chosen by the author are so fundamental to any company that I wouldn’t be worried to use them for foreign companies or foreign markets that you know well.

So, under which conditions might this formula not work? In Greenblatt’s book, he double and triple checks his formula under different circumstances. One of the selection criteria he plays with is the size (by market cap) of the data set used (Step 1 above). The result is that the bigger the market cap threshold, the lower the returns, while still beating the index. One can assume that if you were to manage as much money as a firm such as Berkshire Hathaway, it could become quite challenging to use the magic formula to beat the S&P 500. However, as there are a very limited number of people who should be concerned about that factor, it shouldn’t be an issue. Also, Greenblatt’s argues that, if you are good at investing and know what you’re doing, you could select a portfolio of 8-10 stocks and achieve outstanding results. On the other hand, the risk is that (as always) if you venture too far from your comfort zone, you might end up with less than interesting results with a portfolio way too concentrated for your abilities or dedication. Another factor which might affect the superiority of the magic formula is time. Over time and in the long term, it can be difficult to predict how the market and investors will act and certain elements might impact the successful application of the magic formula. For example, if a large proportion of investors start applying the magic formula then its advantage will suffer. However, it doesn’t seem to be the case so far. One of the reasons I can think of is that, first you have to be patient to apply this formula successfully. You can’t expect outstanding results within 3 months and as many investors are focused on very short term objectives, this might not suit a lot of them. Second, if you are a large investment house, using such a simple formula to select stocks might be difficult to justify to the clients to which you are charging big bucks.

Now that we’ve considered possible shortcomings, the next question is, as an intelligent investor, how can you use the magic formula and modify its application to get the highest possible results without necessarily applying it blindly to a set of data? After all, Greenblatt’s firm, Gotham Asset Management produced average returns of 40% from 1985 to 2006(!) Which means that they must had done something differently. So what can you do? There are two angles you might want to consider here. The first one is to select the markets you are comfortable with, apply the magic formula to source ideas and then drill down in your analysis of the selected companies to make sure you understand the target companies and can appraise how these firms are likely to perform in the future. That means going really in-depth while making good use of your checklist and conducting your own valuation of the companies to insure a decent margin of safety (see previous posts on the subject) and to make sure you understand not only quantitative factors, but also qualitative factors. The other angle is to work backward. Find a potential investment target and see how it compares in terms of earnings yield and return on capital. These two factors are very fundamental and should definitely have an important place in your analysis. In any case, you should focus on relatively “cheap” companies. Unless you have billions of dollars under management, you have access to a very large universe of potential investments and you should take advantage of this, instead of only going for the large, well-covered, highly (or even fairly) valued stocks. If you can find a cheap company, with a high return on capital (ROC) and a sustainable moat to protect this high ROC, your chances of success look quite promising!

To conclude, let’s have a more in-depth look at how to calculate return on capital and earnings yield.

Return on Capital (ROC)

EBIT/(Net Working Capital + Net Fixed Assets)

ROC is a profitability measure to find out how profitably the company is using its capital. Net capital is calculated in order to figure out how much capital is actually needed to conduct the company’s business.

EBIT: Pre-tax operating earnings

Net Working Capital = Current Assets – Current Liabilities

Current Assets: Should exclude cash not needed to conduct the business

Current Liabilities: Should exclude short-term interest-bearing debt

Net Fixed Assets = Fixed Assets – Fixed Liabilities

Fixed Assets: Should exclude intangible assets, specifically goodwill

Earnings Yield

EBIT/Enterprise Value

Greenblatt argues that by using Earnings Yield instead of the more common PE ratio, you are less dependent on the leverage level of the company which can easily fluctuate over time.

EBIT: Pre-tax operating earnings

Enterprise Value: Market value of equity (incl. preferred equity) + Net interest-bearing deb



Embedded images: Do I really need to explain?

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