Picking stocks like Joel Greenblatt

Many investors wouldn't recognize the name of Joel Greenblatt in India, but on Wall Street he has built a reputation for an excellent stock picker.  It is said that his hedge fund, Gotham Capital, earned an annualized return of 50%+ over ten years.  In fact after he had published his book, ‘You can be a stock market genius’, many hedge funds sprang up claiming to be following the approach Greenblatt’s book taught. It was on investing in special situations: take over, merger & acquisition etc.

Then, he wrote his second book called ‘The Little Book That Beats the Market’, focused on retail investors. Through it he has shared a simple quantitative methodology to pick stocks, which he calls ‘magic formula’.

Joel Greenblatt’s Magic Formula ranks firms on a combination of the following two ratios: First, a firm’s earnings before interest and taxes (EBIT) as a proportion of its Net Fixed Assets plus Net Working Capital; this ratio is akin to an adjusted return on capital employed (RoCE). Second, the firm’s EBIT as a proportion to its Enterprise Value; this ratio is akin to a firm’s earnings yield adjusted for capital structure.

“I was a member of the National Library in Singapore and came across Joel Greenblatt's book while teaching myself value investing,” says Madhu Gumballi, a software engineer who is also an active investor. His approach involved making two lists of stocks, one with earnings yield and the other with return on capital employed (RoCE) and then finally a third list that will add the rankings from the two list. “I used this formula during the initial days when I was learning investing, although now I focus more on qualitative aspects of a company rather than looking at quantitative aspects only,” says Gumballi.

But not everyone uses the entire formula as Greenblatt had explained. Sumedh Kadoo, Co-Founder, Craytheon Financial Services says, “The partners at Craytheon just use the second part to calculate the Return on Capital of Indian Companies, rank them based on the most profitable company to least profitable company.” He further adds, that from this list the top 30 companies with high ROC are studied further. “We then create a smaller list of companies whose business model we understand and buy the shares of those specific companies if the share price is undervalued or fairly valued,” says Kadoo.

Meanwhile, Tanushree Banerjee Co-head of Research at Equitymaster says, “We do not use ‘The Magic Formula’ in isolation. Instead, in our process of screening stocks for various recommendations, we screen stocks through various valuation metrics besides other fundamental ratios.” The companies are screened taking into account both earnings yield and return on capital, as suggested by Greenblatt. Bannerjee further says, “The only adjustment that we make is that we look at companies with market capitalisation in excess of Rs 250 crore.”

Ambit Capital has modified the screen. Gaurav Mehta, Vice-President, Institutional Equities, Ambit Capital says, “The difference between our and his (Joel Greenblatt’s) approach is that while he adjusts for cash and looks only at returns on invested capital, we look at returns on total capital including cash (similarly we include cash related income in the numerator). This helps us penalize firms that hoard cash because high cash balances lead to lower ROCEs.” The firms are ranked on both of these parameters individually and then they are added to arrive at a cumulative rank for each firm. Thus, firms which receive high scores have both good return ratios and inexpensive valuations.

Shedding additional light on the formula and the Indian scenario, Sankaran Naren, CIO, ICICI Prudential AMC says, “Unfortunately in India, there are a number of cyclical sectors. As cyclical commodity and financial sectors can be less invested through this model, we are finding certain constraints in using this methodology.” As the company base increases, over a period of time, just like the American market, Naren believes that the Indian market is likely to evolve to a situation where Greenblatt’s method will be applicable to a larger variety of companies. Having said that, the intrinsic theory behind Joel Greenblatt’s model appears to be very interesting even in India, in the non-cyclical sectors.

Although the strategy works over the long run, there are intermittent periods when it doesn’t. This is true for many value oriented strategies. Mehta explains this phenomenon, he says, “We believe ‘value’ works well when the macro environment is conducive. In challenging macro investors usually flock to safety even if it is expensive and valuations become secondary.” To the extent that macro revival looks likely, a value-oriented approach like the ‘magic formula’ may work especially well now.

Building portfolio

The way to construct a portfolio is to buy the top few stocks on the magic formula rank. Meanwhile, Mehta believes, that the quality of earnings and corporate governance are key to alpha generation in India. Hence, he says, “It is therefore important to weed out ‘value traps’ i.e. firms with suspect corporate governance or accounting from the output of any screen such as the magic formula.”

Investors need to do a good amount of due diligence even after coming across a list of stocks based on the Magic Formula. Studying the sustainability of the business, the management quality etc. are absolutely essential.

Where as Gumbali points out that portfolio allocation can be very subjective and depends on the individual's level of understanding of the company/sector and their risk profile. “In my case the portfolio has evolved from diversified to concentrated,” he says. The magic formula suggests looking at the top 20 stocks, but Gumbali recommends to use this 20 as a pool and pick 10 (looking at qualitative aspects) out of them and allocate equally. “Also after the end of a year, I would not sell my winners and retain them as long as the fundamentals remain good and there are no industry headwinds,” say he.

Deciphering Joel Greenblatt’s approach

Bannerjee says, “Greenblatt’s formula tried to merge Graham’s preference for cheap stocks and Buffett’s preference for good quality companies. That is the reason he suggests ranking the companies with the best possible combination of earnings yield and return on capital.”

After identifying the stocks for the portfolio, he even suggests the way to maintain the portfolio in order to maximize returns. But if one goes through the examples he has used, one thing that is clear is that the formula works only when applied in a disciplined manner over a long term.

Advice for investors

Bannejee opines that investors should take into account few other key long term fundamental parameters like profitability, debt to equity, etc. besides the earnings yield and return on capital. Having done that, investors should assess whether the top stocks in the screener have the business moat and management strength to find place in their portfolio. “Importantly, as Greenblatt suggests, as and when the stocks in the portfolio get expensive, investors should also consider booking profits,” she adds.

As an individual investor, Gumbali says, “I like the simplicity of the formula but as you put more years in your investing life you have to look beyond them. Never the less this is very useful for beginners.”

Excluding the financial, commodity and cyclical companies, even in a country like India, it would be useful to follow Joel Greenblatt’s model believes Naren of ICICI Pru AMC.

Using the magic formula is a bit tedious since an investors is expected to buy 15 - 20 companies and then rebalance the portfolio every year. Mehta says, “We at Craytheon follow a different approach. Buy good profitable companies and hold them for a long time. I think this strategy makes sense for other Indian investors too. My suggestion for investors would be to use the same strategy as ours.  Use the second part of the formula to find out the most profitable companies in the Indian market and then invest in them when the market crashes or the company's share price falls due to some temporary bad news. Once you buy the shares hold them for long term.”

Elements:

1.       ‘Magic Multiple’ of Benjamin Graham vs ‘Magic formula’ of Joel Greenblatt (sketch of Graham & Blatt)

Benjamin Graham’s Magic Multiple is the multiple of a stock’s P/E and its P/BV. Graham has put an upper limit to the output of this ratio - 22.5. This he derived using a maximum P/E of 15 times, and maximum P/BV of 1.5 times - the highest multiples he was ready to pay for stocks.

As Tanushree Banerjee Co-head of Research at Equity Master says, “The fact that Joel Greenblatt's Magic Formula ranks stocks based on the earnings yield, which when loosely defined is earnings per share / price (Greenblatt used EBIT/Enterprise Value) shows that it aims to restrict the multiple investors should be paying like in the case of Graham’s Magic Multiple.”

2.       Steps for Magic Formula (Methodology)

Method 1:

1. ROE/ROA/RoCE – Higher the better, rank them in descending order
2. PE – Lower the better, rank them in ascending order

Method 2:

1. EBIT/(Networking Capital +Net Fixed Assets) – Higher the better, rank them in descending order
2. EBIT/(Market Value of Equity + Net Interest-Bearing Debt) – Lower the better, rank them in ascending order

Common

1. Remove all banks and financial services companies
2. Remove all companies with market-cap of less than 500 crore
3. The cumulative rank put together. The top 10 stocks with ranks less 1000 could be bought. 

Returns when Money Today Team tested the methodology as stated in the formula:

		Method 1	Method 1	Method 1	Method 2
	SENSEX	ROCE-PE (500 cr)	ROA-PE (500 Cr)	ROCE-PE (100cr)	M-Cap 500
2015-14	38.87%	159.25%	92.73%	128.28%	84.90%
2014-13	7.16%	9.22%	0.11%	17.60%	-1.96%
2013-12	7.77%	23.56%	21.34%	9.19%	-5.98%
2012-11	-1.58%	14.75%	6.81%	9.61%	28.99%
2011-10	7.74%	-11.63%	-13.52%	-7.86%	15.43%
2010-09	85.79%	147.59%	148.79%	139.65%	29.51%

P.S. This is the submission draft. The actual story had appeared in April 2015 issue of Money Today. To read the final version. Click here or copy paste the given below link - http://businesstoday.intoday.in/story/joel-greenblatt-magic-formula-to-invest-in-stocks/1/217520.html