I recently watched a video of Joel Greenblatt with Morningstar. Most of the video discusses the index approach to investing using a value weight (as opposed to equal weight or market weight, which most indexes use).
I’m not that interested in indexing, although for individuals that want completely passive exposure to stocks, value weighting certainly makes much more sense to me than market weighting (because market weighting systematically buys more of a stock as it goes up, thus forcing you to buy more of a stock as it becomes more overvalued, and less of a stock as it becomes undervalued… equal weighting makes these errors random, and value weighting essentially reverses the errors, thus allowing you to own more of a stock as it becomes cheaper, and less of it as it becomes more expensive).
Anyhow, it’s an interesting concept that Greenblatt has been discussing for a few years and it is the topic of a book he recently wrote called the The Big Secret for the Small Investor.
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It’s a good book, but indexing is not what we do here, so it’s less interesting to me than his previous work on bottom up stock picking.
Cheap is Good, Cheap and Good is Better
But in this short interview, he made some interesting remarks on specific metrics he wants… first, he recapped the same basic things he likes to look for in stocks. Greenblatt likes stocks that are “cheap and good” as he often puts it. This means he likes stocks that are cheap relative to earnings in the Ben Graham tradition, but he strives to own stocks that are not just cheap, but also good.
The “good” part comes from what Warren Buffett talked about in his shareholder letter in 1992… basically he wanted businesses that could invest large amounts of incremental capital at very high rates of return. Good businesses earn high returns on capital, great businesses can reinvest large amounts of capital at similarly high rates. Greenblatt uses historical financial statements as a guidepost for identifying businesses that could potentially meet this critiera.
So Greenblatt attempts to combine Graham and Buffett… he wants stocks cheap (low price to earnings) and good (high returns on capital).
The Importance of Return on Capital
Now, for some inside baseball stuff… To determine valuation, Greenblatt doesn’t use P/E, but rather EV/EBIT, which is a better measure that removes the effect of leverage and tax rates which makes for easier apples to apples comparisons across capital structures and across time. For quality, he uses return on capital.
I might do a more detailed post on return on capital at some point, as it seems each investor calculates it slightly differently.
Return on Capital is a general concept that is extremely important for investors to understand. Some investors prefer to buy cheap assets (Graham bargains, net-nets, etc…), but even in these businesses, return on capital is important to understand as it will impact your margin of safety, i.e. the window of time you have to sell those cheap assets before their intrinsic value begins to decline over time (as inevitably occurs with poor earning assets). Cheap assets and special situation investments can work out wonderfully over time, and they can be very simple investments, but ideally we’d prefer owning businesses that produce high returns on assets at those same cheap prices. That’s what Greenblatt endeavors to do with his magic formula. He wants to have his cake and eat it too…
This broad measure is usually referred to as “return on capital”, “return on capital employed”, “return on invested capital”, among other terms, and they can have slightly varying definitions, but the main objective—regardless of how it’s labeled or the nuances involved in calculating it—is to determine how good a business is at using its capital to generate earnings.
As investors (part business owners), we are interested to know—among other things—these basic things when it comes to Return on Capital:
- How much capital has the business invested?
- What kind of rates of return has it historically earned on that investment?
- How much capital will it need to invest going forward (or better yet, how much can it invest going forward?) and what can we expect to earn on that future investment?
The first two things we can determine by looking at the financial statements. The invested capital is listed on the balance sheet. The third thing is really what we want to find out (how much money can we earn going forward, and what kind of capital will we need to invest to achieve those earnings?). Ideally, we want a business that can produce high returns on capital and can also invest large amounts of additional capital at similar rates of return in the future. There are methods to approximate returns on the incremental capital that a business employs, which we can discuss a different time, but we’ll discuss Greenblatt’s method now…
Greenblatt’s Definition of Return on Capital
Greenblatt defines “capital employed” as net working capital plus net fixed assets (PP&E) less excess cash. In other words, he uses total assets less non-interest bearing current liabilities (a more common calculation), but then he subtracts goodwill and intangibles as well as excess cash.
His objective is to determine the tangible capital that a business needs to operate. A business needs to lay out money to stock shelves with inventory, equipment to produce goods, buildings to house employees and products, etc… but it doesn’t have to lay out money for goodwill, intangibles, or accounts payable (which are essentially an interest free short term loan reducing the amount of required capital). Also, the excess cash is not needed to operate the business either, so that gets subtracted from the total assets as well.
He also uses EBIT in the numerator as opposed to net income, which allows for a better apples to apples comparison of earning power as it allows us to compare earnings across capital structures and across time (varying tax rates).
So the two main components of value that he uses for his “magic formula” are:
- Valuation: EV/EBIT
- Return on Capital: EBIT/(Net Working Capital + Net PPE – Excess Cash)
To use an oversimplified example, think of it like this… if you buy a duplex for $100,000 in cash, and it gives you $6,000 per year in net operating income (rent less all expenses before taxes), your duplex provides you with a 6% return on invested capital. Since there is no debt, your return on equity (ROE) is also 6%.
Return on capital accounts for the total capital that your business uses, whether it’s equity (all cash) or equity and debt (cash plus a mortgage). In this example, if you used $20,000 of cash for a downpayment (equity) and took out an $80,000 mortgage at 5% interest (debt), then your Return on Equity changes, but your Return on Capital is still 6%. In this case, you now have a $4,000 interest payment each year, which gets subtracted from the $6,000 net operating income, leaving you with $2,000 pretax income, meaning that your pretax ROE is 10% ($2,000 pretax earnings divided by $20,000 equity). In this case, using debt increased your return on equity, but the business itself (the duplex) didn’t become better. The duplex is the same duplex, and the monthly rent checks didn’t change. The capital structure changed, but the earning power of the duplex didn’t change.
Greenblatt was interested in determining and comparing the raw earning power of each business, and so he didn’t want results skewed due to the effects of leverage and tax rates, which is why he preferred to use pretax operating earnings, or more specifically–Earnings before Interest and Taxes (EBIT).
I introduce these terms here to provide a brief backdrop, but here is what I found interesting in the video. Greenblatt said he prefers companies that produce 50% or better returns on capital, and most of the stocks he owns are businesses that produce 50% returns on capital or better.
He points out that he specifically looks for businesses with these types of returns on capital. I have a few more thoughts on this topic, which I’ll post in a “part 2” in a day or two, as this post is getting lengthy. I also will provide a link to the video (couldn’t find it in my bookmarks at the moment), as well as a link to one of Buffett’s letters where he did a general study of these types of high quality businesses in the 1980’s.