Two numbers every investor should know
By
Deputy Editor
Tim Bennett Feb 05, 2010
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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, there’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 (long-term) assets. 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 £20m, working capital is £100m and
fixed assets total £200m, ROCE is (£20m/£300m) 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 £20m from the example above, and a firm has
100 million shares in issue trading at £3 each and £50m of debt at market
value, then Ebit/EV is £20m/(100m x £3 + £50m) 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.
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.
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