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John Huber
John Huber
Articles (105)  | Author's Website |

Thoughts on Return on Capital and Greenblatt’s Magic Formula Part 2

February 12, 2014 | About:

In part 1 of this post, I mentioned I caught a video interview with Joel Greenblatt at Morningstar. In the video, Greenblatt talks about indexing, and things that are not necessarily interesting to me and my investment strategy, but he also had some brief comments on return on capital. In the last post, I discussed the basic method that Joel Greenblatt (Trades, Portfolio) uses to define return on capital. I also discuss some of the fundamentals and the importance of this key business metric, so check out that post first, if you haven’t yet.

The interesting thing was when Greenblatt specifically said he looks to fill his portfolio with businesses that have historically produced 50% returns on capital.

Greenblatt uses the often repeated example from his Magic Formula book:

  • Suppose you have a gum shop that costs you $400,000 to buy the land, build the store, stock the shelves, etc.
  • Suppose this $400,000 investment gets you a pretax earnings of $200,000.

So even though I’ve probably heard him reference this example 10 times or more (and I’ve also read the Magic Formula book, which is basic — not nearly as good as his Genius book, but still quite good), his comment where he actually quantified the amount of return that he looks for (50% ROIC) was something I hadn’t heard him say previously. This really isn’t groundbreaking. We all know that high ROIC is better than low ROIC, valuation and everything else being equal. But it got me thinking about the example from a business perspective.

That hypothetical gum shop is a very good business (50% return on capital). It takes $400,000 to build out a store that produces $200,000 in pretax earnings. In fact, it’s a business that we’d all probably enjoy owning. And over time, if the business can be scaled and replicated into more locations that produce similar returns, the owner of that gum shop business will likely become quite wealthy over time.

Pretty Logical, Right?

It’s just interesting because we often lose sight of what we are looking for as value investors. We are owners of businesses, and all else being equal, we want good businesses over bad businesses (i.e Greenblatt says 50% ROIC is obviously much better than, say, 10% ROIC).

The 50% comment also got me thinking about a Munger comment I heard once where he basically said that over time, the owner of a business will likely see investment results that (over very long periods of time) begin to approximate the internal returns that the business produces. Now, it’s absolutely crucial to understand this in the context of valuation. Much of the early shareholder returns depend on valuation (the price paid), but over time, this “gap” between valuation and quality closes.

Munger used an example: A shareholder of a business that produces 6% returns on capital over time cannot expect to see investment results much better than 6%. Conversely, a shareholder of a business that makes 18% returns on capital over time will likely see superb investment results that begin to approximate this result as time goes on.

Of course, the hard part is determining durability, competitive positioning, etc., and that’s why valuation (paying a low price) gives us an all-important safety net that Graham taught us about. But the math is easy to follow. Over time, a stable 18% ROIC over a multidecade period will dominate a stable 6% ROIC in terms of shareholder returns.

I once looked at numerous examples of this in real life, and it’s certainly true over very long periods (15 to 20 years), but valuation is the most important factor (in my opinion) in the early years and even the first decade. So valuation must not be forgotten. And of course Greenblatt factors in valuation into his investment decisions. But over time, Munger is right: Imagine buying Walmart in the '70s, Fastenal in the '80s, etc. You could have paid 50 times earnings, and your long-term results (if you held from then until now) would likely come close to the returns on capital that those businesses have produced over time (near 20% over time).

Now I’m not interested in predicting the next Walmart (well I guess I’d be interested in predicting the next Walmart, but I don’t think I have the foresight to do that on a consistent basis), so I choose to place a heavy Ben Graham emphasis (valuation) on my investment ideas.

But within that context, it is interesting to think about looking for businesses that produce 50% or more returns on capital. Those are basically the “gum shop” businesses that Greenblatt likes. They produce $200,000 or more of earnings for every $400,000 of capital invested, and for whatever reason, they are cheap at the moment. I took a look at Greenblatt’s latest 13-F, and indeed, there are a lot of businesses that are producing very high returns on capital (but note: His new investment approach is not very helpful to follow, because he owns so many businesses, but it would be interesting to use it as a list to read annual reports from).

Another idea is to build a very simple screen that looks for businesses with high returns on capital, or alternatively high ROA or high ROE without much leverage. I wrote a post that summarizes one such screen I like to occasionally glance at from time to time.

My hunch is that one could do better by using these concepts and studying the businesses, focusing on the more predictable businesses that can be easily understood. But it’s worth noting and respecting the results of the Magic Formula over time:

  • 23.8% annualized returns from 1988 to 2009 (according to the book)

Last year, I started tracking two “mock” magic formula portfolios (both have 30 stocks that I took from Greenblatt’s Magic Formula on Jan. 1, 2013 — one is composed of stocks with market caps over $250 million, and the other has market caps over $2 billion) and both have done incredibly well, although one year isn’t really a good indicator in my mind.

So who wouldn’t want to use this formula to invest? Well, although I think over time the results will be difficult to beat, I feel that risk management (i.e. understanding what I own and quantifying the downside with each stock) is the most important aspect of my investment philosophy. I find it hard to do that with a computer screen telling me what to buy, so I don’t personally invest using this method. This is despite the fact I agree with the system’s concept (cheap and good). I just don’t feel comfortable allocating capital to businesses that I don’t understand and haven’t researched.

But to each his own, and hopefully for Greenblatt, he’ll be able to do very well using his mechanical stock picking system over time.

For me, I’ll take his concepts (basically Graham, Buffett and many other value investors) and keep plugging along looking for low-risk 50-cent dollars.

By the way, in the last post I mentioned an interesting study that Buffett discussed in the 1980s about high return on capital businesses, and I’ll have to delay that for a post some other time since this post is getting long (what else is new?).

In media, they call that a teaser. I’m sure the anticipation is unbearable...

About the author:

John Huber
I am the portfolio manager of Saber Capital Management LLC, a Registered Investment Advisor (RIA). Saber is an investment firm that manages separate accounts for clients. I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

By using separate accounts, Saber offers its clients complete transparency and liquidity (the funds are held in the name of the client and cannot be accessed by the investment manager). Saber looks to partner with like-minded clients who are interested in a patient, long-term approach to investing that is rooted in the principles of value investing.

I also write at the blog www.basehitinvesting.com.

I can be reached at [email protected]

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