Exploring the heart of another book, in order to set up a discussion of your own investment model, is the task Tobias Carlisle set for himself in chapter five of "The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market."
That other book is “The Little Book That Beats the Market” by Joel Greenblatt (Trades, Portfolio), and the investment model is that of the Acquirer’s Multiple, which is fleshed out in the next chapter. It is an essential exercise for Carlisle, since his ideas build on those of Greenblatt.
This passage from Greenblatt’s book is not cited by Carlisle, but I believe it sets the stage well:
“What do you think would happen if we simply decided to buy shares in companies that had both a high earnings yield and a high return on capital? In other words, what would happen if we decided to only buy shares in good businesses (ones with high returns on capital) but only when they were available at bargain prices (priced to give us a high earnings yield)? What would happen? Well, I’ll tell you what would happen: We would make a lot of money!”
There are two key points to take from that passage: the quality of businesses is defined by their return on capital, and the value of the stocks are defined by their earnings yield.
Return on capital is calculated by dividing a company’s income by the amount of equity, its market capitalization. This metric tells us how well management is doing at allocating the capital with which it is entrusted.
Earnings yield is the reciprocal of the price-earnings ratio (which is also known as the earnings multiple), and it is calculated by dividing the earnings per share by the stock price. The price-earnings ratio, on the other hand, is calculated by dividing the stock price by the earnings per share. Earnings yield is helpful to investors because it allows them to compare returns across different types of securities, including bonds, which price-earnings cannot.
Return on capital and earnings yield are the two metrics on which Greenblatt’s Magic Formula was built. The formula itself involves two columns of figures, the first has companies listed by their ROC, from highest to lowest, and the second has companies listed by their earnings yield, again sorted from highest to lowest.
An overall score for each company is calculated by adding the scores for ROC and earnings yield together. The companies are then sorted and ranked, from highest to lowest, on their combined scores. Stocks with the highest combined scores are considered the best prospects (all else being equal).
In his book, Greenblatt showed how well the formula worked in backtesting:
Returning to Carlisle’s book, the author wrote in chapter five that Greenblatt’s book “promised an easy way to find Buffett’s wonderful companies at fair prices” (not that Greenblatt described his book that way).
Buffett used much the same formulation (before Greenblatt), except he used return on equity rather than return on capital. Return on capital is calculated by dividing a company’s income by the amount of equity invested in it. Return on equity starts in the same place, but also includes the total amount of debt (loans and bonds).
Carlisle reported that he and his associates had updated Greenblatt’s research for "The Acquirer's Multiple, " which was published in 2017. Data from 1973 to 2017 was available to Carlisle’s team, a longer period than Greenblatt’s.
The author says they were able to confirm Greenblatt’s thesis, and found the Magic Formula would have averaged 16.2% per year over the preceding 44 years—years that included the financial crisis of 2008. A $10,000 investment in 1973 would have compounded into $7.6 million by 2017 (before costs and taxes). That’s more than double the S&P average over those same years: 7.1%.
That average was based on a 3,500-stock universe and its smallest company was valued at $50 million (in 2005). When the market cap was raised to a minimum of $200 million, the average annual return increased to 17.2%. Taking this strategy even further, using a minimum market cap of about $1 billion (2005 dollars) saw the average annual return drop back down to 16.2%. Whatever the outcomes, they were, as Carlisle observed, “great results.”
The following chart from Carlisle underlines how dramatically the Magic Formula outperformed the S&P 500:
In this chapter of "The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market," author Carlisle confirmed Greenblatt’s Magic Formula strongly outperformed the market (the S&P 500). It does that by combining companies with the best return on capital with the companies that have the best earnings yield.
That sets the stage for Carlisle to make the case for his investment model: “What if we remove the need for high profits and just buy undervalued companies using the Acquirer’s Multiple? What if we buy fair companies at wonderful prices?”
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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