When investment guru Joel Greenblatt (Trades, Portfolio) taught at an Ivy League college, he would welcome each new class with a request: Shout out the names of big, well-known public companies. After getting the names, Greenblatt would pull out a newspaper (yes, we depended on newspapers for that sort of thing in the not so distant past), then announce the current price, the 52-week low and the 52-week high for each of them.
You may recognize Greenblatt’s name from GuruFocus and other investing sites. You’ll even find his name in a couple of places on the Summary page for every stock at GuruFocus—quite an honor! He is also the founder and managing partner of Gotham Asset Management LLC.
He wrote a best-selling and influential book about investing titled, "The Little Book That Beats the Market (Little Books. Big Profits)" and a followup, "The Little Book That Still Beats the Market (Little Books. Big Profits)," as well as "You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits."
In this article, we’ll explore the key ideas in "The Little Book That Still Beats the Market." Greenblatt says he wrote the book for his five children (teens, or pre-teens, at the time), so it’s an easy book to read and understand. His perspective was very much informed by legendary value investor Benjamin Graham, but as he notes in the book, it’s not always easy to find bargains in modern markets. Therefore, he set out to create a new approach to value investing.
Lows & highs: what gives?
No doubt the intrinsic value of any major corporation changes a bit over the course of any 52-week period. But does that value change enough to explain the differences between the stock’s 52-week high and 52-week low?
Consider this 1-year chart of T. Rowe Price, the investment management company, which also has the distinction of being one of the S&P 500 Dividend Aristocrats. Inclusion in this group generally means it is a very solid and stable company. But look at how much its share price has varied over the past 52 weeks:
Now, if you were a student of Greenblatt’s, what would you make of this variation? After the students spend some time trying to explain this discrepancy between value and share prices, he simply says, “Who knows, and who cares?”
The point is that we want to buy on a low and sell on a high. After all, the intrinsic valuation will remain about the same over those 52-weeks, so why not buy when the price is low and sell when it’s high?
That gets us to the first of two key points that Greenblatt makes in "The Little Book That Still Beats the Market:"
“Paying a bargain price when you purchase a share in a business is a good thing. One way to do this is to purchase a business that earns more relative to the price you are paying rather than less. In other words, a higher earnings yield is better than a lower one.” [author’s italics]
And where does Greenblatt find Earnings Yield? We start with the income statement, which provides the earnings per share, then we divide the earnings per share by the price per share.
However, if you subscribe to GuruFocus that figure is already calculated and provided in the Valuation & Return section of the Summary page for each stock. For example, T. Rowe Price has an earnings yield of 10.33%, as we see in this screen capture:
Further, if you click on the hyperlinked words Earnings Yield (Greenblatt) %, you will be taken to a page that provides historical context and more information about the metric (it uses a different approach to the calculation).
Near the bottom of this page, GuruFocus notes this measure does not consider the growth of the company. It’s an objection Greenblatt has anticipated, and he writes about the difficulty of predicting, so “. . . let's not make any predictions at all. Instead, let's just look at what happened last year.” But, he doesn’t stop there: he now brings in Return on Capital (ROC).
Comments: Since share prices vary considerable over a year, we want to buy stocks at low valuations, and the metric we use to find those stocks is earnings yield, which can be calculated or simply noted on GuruFocus.
Seeking high rates of return
The second of two elements in "The Little Book That Still Beats the Market"Ă‚ is return on capital. Greenblatt says,
“For instance, what if we found out that it cost Jason $400,000 to build each of his gum stores (including inventory, store displays, etc.) and that each of these stores earned him $200,000 last year. That would mean, at least based on last year's results, that a typical store in the Jason's Gum Shops chain earns $200,000 each year from an initial investment of only $400,000. This works out to a 50% yearly return ($200,000 divided by $400,000) on the initial cost of opening a gum store. This result is often referred to as a 50 percent return on capital.” [author’s italics]
And,
“Buying a share of a good business is better than buying a share of a bad business. One way to do this is to purchase a business that can invest its own money at high rates of return rather than purchasing a business that can only invest at lower ones. In other words, businesses that earn a high return on capital are better than businesses that earn a low return on capital.” [author’s italics]
If we have to make a choice between two companies, then, we will choose the one that brings in a higher return on capital.
Again, GuruFocus subscribers can access this measure on a company’s Summary page, this time in Profitability & Growth section. For T. Rowe Price, ROC comes in at 254.95%:
Comments: Finding companies that earn high returns on capital, which is to say companies that can invest at high rates of return, is the second key to the Magic Formula.
Combining the elements
On their own, earnings yield and return on capital have some value for investors, but most of us would concede limited usefulness.
However, by combining the two elements, we invoke the magic in Magic Formula,
“. . . it turns out that if you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), you can end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away.”Â
And what happens if we do that? Greenblatt rhetorically asks,
“Well, I'll tell you what would happen: We would make a lot of money! (Or as Graham might put it, "The profits would be quite satisfactory!")”
It is, says Greenblatt, “…a disciplined strategy of buying good businesses at bargain prices….“
Comments: The Magic Formula (a combination of high earnings yield and high return on capital) forces us to buy above-average companies at below-average prices.
Implementation
Turning to specifics, an investor can execute the strategy by sorting a universe of stocks twice, once by earnings yield and once by return on capital. Each list is ranked from highest to lowest.
We put those two columns of stock names in a spreadsheet, and each stock receives a rank based on its place in each list. The highest ranked stock receives a rating of 1, the second receives a rating of 2, and so forth to the bottom of the lists. At the end of this part of the exercise, each company has two numbers, one for its earnings yield ranking and one for its return on capital ranking.
We add those two numbers together for every stock in the two lists (the lists have identical sets of names, of course). The stocks then are ranked by the summed numbers; for example, a stock that receives a 3 for earnings yield and 12 for return on capital would outrank a stock that receives a 1 for earnings yield and a 27 for return on capital (15 is a better summed score than 28).
Greenblatt emphasizes,
“The formula isn't looking for the company that ranks best on return on capital or the one with the highest earnings yield. Rather, the formula looks for the companies that have the best combination of those two factors.” [author’s italics]
And, he has found a synergistic relationship between the two elements,
“. . . owning a business that has the opportunity to invest some or all of its profits at a very high rate of return can contribute to a very high rate of earnings growth!”
If you buy the book, you also receive a link to a website where you will find an online tool that does the manual work of creating the lists and ranking the companies for earnings yield and return on capital.
GuruFocus can do the same, with its Magic Formula screener (in a following article, I will show how we can use the All-In-One screener to create lists for different stock universes, such as large caps).
Comments: This is an easy formula to implement, assuming you buy the book or subscribe to GuruFocus.
Think groups, and think years
Now that you have one list of stocks, ranked from the highest to lowest summed scores, Greenblatt recommends you buy 20 to 30 of them at one time. Think in terms of portfolios, not individual stocks,
“. . . the magic formula doesn't pick individual stocks, either. It picks many stocks at one time. Looking at the whole portfolio of stocks, it turns out that using last year's earnings is often a good indicator of what earnings will look like in the future. Of course, for individual companies, this may not be the case. But on average, last year's earnings will often provide a pretty good estimate for normal earnings going forward.”
Greenblatt cautions that the magic formula will not work for the impatient or anyone whose time horizon is less than a couple of years,
“Although over the short term, Mr. Market may set stock prices based on emotion, over the long term, it is the value of the company that becomes most important to Mr. Market.
This means that if you buy shares at what you believe to be a bargain price and you are right, Mr. Market will eventually agree and offer to buy those shares at a fair price. In other words, bargain purchases will be rewarded. Though the process doesn't always work quickly, two to three years is usually enough time for Mr. Market to get things right.”
At the same time, Greenblatt suggests selling the whole lot off one year after buying them,
"...in our tests, each stock was held for a period of one year. Holding stocks for one year is still fine for tax-free accounts. For taxable accounts we will want to adjust that accordingly."
Comments: It’s the portfolio as a whole rather the stocks within it that matter, and you have to be prepared to wait for a couple of years to see results.
What kinds of results can we expect?
In the original edition of "The Little Book" (2005), Greenblatt reported he had backtested the formula extensively and found,
“Over a 17-year period from 1988 to 2004, owning a portfolio of approximately 30 stocks that had the best combination of a high return on capital and a high earnings yield would have returned approximately 30.8% per year. . . . .During those same 17 years, the overall market averaged a return of about 12.3% percent per year.” [author’s italics]
In the Afterword of the 2010 edition, he reports that the Magic Formula continued to outperform the S&P 500 over the previous 10 years,
"According to our backtests . . .the formula managed to earn 255 percent during this same period (more than tripling our money!). That's a 13.5 percent annualized return during a 10-year period when the S&P index was actually down 0.9 percent per year."
Comprehensive independent testing of Greenblatt’s thesis appears to be non-existent, and there are certainly concerns. A New York Times article two years ago noted,
“When readers clamored for ways to follow the “magic formula” strategy in real life, he developed a website that generated stock picks that also topped the market. But individuals who tried them actually trailed the market by mistiming their purchases and sales."
And, using the results of Greenblatt’s hedge funds to assess the Magic Formula don’t give us much of a guide either. In his real-life investing, the guru and his investment managers go short as well as long; short on stocks with the worst combination of earnings yield and return on capital.
A GuruFocus profile also notes several add-ons that go well beyond the simple formula in the book, including a search for catalysts, special situations and estimates of normalized earnings 3 to 4 years in the future.
Whatever the investing technique, the past few years have not been kind to Greenblatt’s Gotham Absolute Return Fund, as this table from GuruFocus shows:
Comments: The transition from theory to practice takes a toll here, as the reality of markets and trading hit home. In addition, we do not have a real-life mutual fund or hedge fund that actually sticks to the formula.
Conclusion
As an amateur or retail investor, I think Joel Greenblatt (Trades, Portfolio)’s "Little Book That Still Beats the Market"Â will help me make better short-lists and better decisions. But, I can’t see the full promise contained in the title.
Of course, I did learn from the book, learned a new perspective and a new way to consider the potential and pitfalls of individual stocks, and did gain further insight into the market. Most importantly, his emphasis on the highs and lows, as divorced from a stock’s ongoing value proposition, might make a believer out of anyone who remains unsure about value investing.
There’s more to like in this short and easily-read book, including snippets of investing wisdom and an engaging style with occasional flourishes of humor. It’s inexpensive and a pleasure to read, so worth putting on your to-read list.
In the end, however, "The Little Book That Still Beats the Market"Ă‚ should only be a starting point for investors. It does not offer the ready-to-buy-and-sell system that it appears to promise.
Disclosure: I do not own shares in any of the companies listed in this article, nor do I expect to buy any in the foreseeable future.
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