Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Joel Greenblatt-inspired strategy and portfolio, which has averaged returns of about 8% per year since its inception while the broader market has been in the red. Below is an excerpt from today’s newsletter, along with several top-scoring stock ideas based on the Greenblatt investment strategy.
Taken from the October 15, 2010 issue of The Validea Hot List
Guru Spotlight: Joel Greenblatt
Anyone who has ever put cash in the market knows that making money in stocks is hard. But what a lot of investors don’t realize is that while it is difficult, it doesn’t have to be complicated. You don’t need incomprehensible, esoteric formulas and you don’t need to spend every waking hour analyzing stocks — Joel Greenblatt has proved that.
Back in 2005, Greenblatt created a stir in the investment world with the publication of The Little Book that Beats The Market, a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his “Magic Formula” — a purely quantitative approach had just two variables: return on capital and earnings yield.
Greenblatt’s back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8 percent return from 1988 through 2004, more than doubling the S&P 500’s 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.
Written in an extremely layperson-friendly manner, Greenblatt’s “Little Book” — it’s only 176 pages long and small enough to fit in your jacket pocket — broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves. Using several simple analogies, he explains a variety of stock market principles. One of these he often returns to involves Jason, a sixth-grade classmate of Greenblatt’s youngest son who makes a bundle selling gum to fellow students. Greenblatt uses Jason’s business as a jumping off point to explain issues like supply, demand, taxation, and rates of return.
In reality, the “Magic Formula” is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices — something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did. The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task — buying those good companies’ stocks on the cheap. The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.
To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number 1, the second number 2, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.
The slightly unconventional ways in which Greenblatt calculates earnings yield and return on capital also involve some good common sense — and are particularly interesting given the recent credit crisis. For example, in figuring out the capital part of the return on capital variable and the earnings part of the earnings yield variable, he doesn’t use simple earnings; instead, he uses earnings before interest and taxation. The reason: These parts of the equations should see how well a company’s underlying business is doing, and taxes and debt payments can obscure that picture.
In addition, in figuring earnings yield, Greenblatt divides EBIT not by the total price of a company’s stock, but instead by enterprise value — which includes not only the total price of the firm’s stock, but also its debt. This give the investor an idea of what kind of yield they could expect if buying the entire firm — including both its assets and its debts. In the past few months, we’ve seen how misleading conventionally derived P/E ratios and earnings yields could be, since earnings had been propped up by the use of huge amounts of debt. Greenblatt’s earnings yield calculation is a way to find stocks that are producing a good earnings yield that isn’t contingent on a high debt load.
In my Greenblatt model, I calculate return on capital and earnings yield in the same ways that Greenblatt lays out in his book.
We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past three years or so. So far, the model has been an exceptional performer. Since we began tracking our 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has fallen about 7%, but the portfolio has gained about 50%, or 8.7% per year.
The Greenblatt portfolio also did what few funds have done: limit losses in what for stocks was a terrible 2008, and handily beat the market in the 2009 rebound. It fell 26.3% in ’08 — not good, but much better than the S&P 500’s 38.5% loss — and surged 63.1% last year, vs. 23.5% for the S&P. This year it’s been volatile. Greenblatt stresses that the strategy won’t beat the market every month or even every year, and for much of 2010 the portfolio has significantly lagged the S&P. But it began to bounce back strongly recently, and is now in the black for the year (through Oct. 13), showing that patience is rewarded.
One note: Because of the way financial and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn’t include foreign stocks, so I exclude those from my model as well.
Here’s a look at the current holdings of my Greenblatt-based portfolio:
Bridgepoint Education Inc. (BPI)
H&R Block, Inc. (HRB)
China Yuchai International Limited (CYD)
GameStop Corp. (GME)
Almost Family, Inc. (AFAM)
United Online, Inc. (UNTD)
LHC Group (LHCG)
VirnetX Holding Corporation (VHC)
AmSurg Corp (AMSG)
“Magic”? Or Discipline?
While Greenblatt’s methodology is completely quantitative, one of the most important aspects of his approach is psychological — and it’s something that I believe is critical to keep in mind in the current financial climate. To Greenblatt, the hardest part about using the Magic Formula isn’t in the specifics of the variables; it’s having the mental toughness to stick with the strategy, even during bad periods. If the formula worked all the time, everyone would use it, which would eventually cause the stocks it picks to become overpriced and the formula to fail. But because the strategy fails once in a while, many investors bail, allowing those who stick with it to get good stocks at bargain prices. In essence, the strategy works because it doesn’t always work — a notion that is true for any good strategy.