In an interview on CNBC last Thursday, Joel Greenblatt (Trades, Portfolio), Columbia professor and CIO of Gotham Asset Management, briefly discussed his strategy. Many people are aware of his Magic Formula strategy from his book, “The Little Book that Beats the Market.” The Magic Formula is designed to give the retail investor a simple investing strategy to follow. It is based on buying companies with high returns on capital (ROC) and earnings yields and rebalancing once a year. For the three long/short funds that he manages at Gotham Asset Management, he has a higher level of scrutiny in his investments. According to an interview with Morningstar in October, it took his team six to seven years to research all of the largest companies and be able to update them on a quarterly basis as new information comes out. His research involves going through every balance sheet, income statement, and cash flow statement and making adjustments from what the companies are reporting and what the economic reality is.
His strategy as described in the interview includes looking at the largest 2,000 companies in the U.S. and ranking them based on their discount to their assessment of value. He buys the 300 cheapest stocks and shorts the 300 most expensive stocks. His long portfolio can be followed at GuruFocus (Joel Greenblatt – Stock Picks). The difficulty is finding the stocks that he is short since they are not required to be disclosed. On CNBC he listed off three of them: Stratasys Ltd. (SSYS, Financial), Carnival Corp (CCL, Financial) and Salesforce.com Inc. (CRM). He says that these companies are eating through cash and destroying capital as they invest.
Stratasys Ltd. (SSYS)
Stratasys is one of the 3D printing stocks that have become fashionable over the past few years. It is a hot stock in a hot industry, just the type that Peter Lynch said to stay away from. It has increased 602 percent over the past five years, but has come back down recently with the rest of the momentum stocks. Year-to-date it is down 32 percent. Looking at its business predictability (4.5/5), financial strength (9/10) and profitability & growth (8/10), it seems like the fundamentals are solid at face value. The company is selling at 7.57 times sales. Greenblatt says that is too much to pay for a company that is not earning any cash, yet. He also gives increasing competition as a factor for shorting the stock. There are now enough 3D printing related stocks to have a mutual fund dedicated to the industry. The mutual fund has 42 holdings.
The return on capital of Stratasys was at 1.64 percent for the latest quarter and has been dropping since 2011. The earnings yield is currently at 0.70 using Greenblatt’s version of (operating income / enterprise value). Although 3D printing might have a bright future, Stratasys would need to bring its operating margins back to previous levels before I would consider purchasing the stock. The operating margin for the last quarter was 0.55 percent and has been dropping since 2011. Before margins began to destabilize, they were consistently in a range between 15 to 18 percent. The company would also have to reverse its share dilution at some point. Shares outstanding have increased by 33 percent over the past year. Losing a third of the value based on share dilution is a big hole to climb out of.
Carnival Corp (CCL)
Carnival Corp operates the Carnival Cruise Lines and nine other brands. It has 101 cruise ships in its fleet and operates in two segments: North America; and Europe, Australia and Asia. It is not a momentum stock like Stratasys. The price has increased 24 percent for the past 12 months and is up 1 percent year-to-date. Greenblatt says that it spends a lot of money to build these ships, and it does not make a very good return on them. The return on capital for the company supports his claim. ROC was at 4.11 percent for full-year 2013 and has been decreasing almost every year since 2005. The stock also has a low earnings yield of just 3.10.
As far as being a short candidate, I would pass on this one and just not touch it. I think that its low price-to-book value of 1.29 could keep it afloat. Its five-year median P/B ratio is 1.20. Even though the company has a low ROC, it is still positive and will keep the P/B ratio from dropping too low.
Salesforce.com Inc. (CRM)
Salesforce.com is viewed as one of the momentum stocks that lost favor this year. It is down about 20 percent from its peak in late February. The company is one of the pioneers of cloud computing and first offered its customer relationship management (CRM) solutions back in February 2000. Today, Saleforce.com is a leading provider of enterprise cloud computing solutions, with a strong focus on CRM service offerings to its customers. Although it is an established company, Salesforce.com has not been able to yet establish consistent earnings. Earnings per share (EPS) have been minimal for the first `0 years of operations and have been retreating since 2010. The trailing 12 months EPS is at $-0.48.
Greenblatt says that 7.27 times sales is also too much to pay for the company. It has been getting some of its growth through acquisitions and perhaps that growth is not sustainable. The company has made at least 30 acquisitions since 2006. Its ROC is -23.06 percent, and the earnings yield is at 0.4 percent. Revenue has been growing at a rapid rate throughout its history. It has been growing at an annual rate of 35 percent for the past 10 years and grew nearly 25 percent for the past 12 months. Although revenue is growing at a rapid rate, it does not help the shareholders if earnings continue to go deeper into the red.
Conclusion
Many of the gurus that we follow utilize long/short strategies. Joel Greenblatt (Trades, Portfolio) gave us a little insight into his strategy. He ranks the largest 2,000 companies in the U.S. based on his criteria, buys the top 300 stocks and shorts the bottom 300 stocks. If you want to check on how his long/short strategy has been performing, the three funds to follow are Gotham Absolute Return Fund (GARIX), Gotham Enhanced Return Fund (GENIX) and Gotham Neutral Fund (GONIX). His long positions can be viewed at GuruFocus (Joel Greenblatt (Trades, Portfolio) Stock Picks). Although I do not short stocks, it is interesting to see the opinions of the gurus for which stocks they think are likely to lose value.
Another interesting long/short strategy was developed by Joseph D. Piotroski. He earned his Ph.D. in accounting from the University of Michigan and is now an associate professor of accounting at the Stanford University Graduate School of Business. He developed the Piotroski F-Score with a scale of 0 to 9. During the testing periods, he found that he outperformed the market by buying stocks that scored the highest (8 or 9). He also found that he outperformed the market at a higher rate by shorting the stocks with the lowest F-Scores (0 or 1). The Piotroski F-Score is a criterion that can be screened for with the GuruFocus All-In-One Screener.
