A Magic Formula

The Daily Reckoning PRESENTS: Unlocking the market’s treasures – knowing which stocks to buy and sell – is a difficult mystery seemingly beyond most average investor’s powers. Luckily, Chris Mayer has found a book that seems to have cracked the code…

A MAGIC FORMULA

In some ways, the average investor is like a man looking for the right combination to get at the riches in a vault. Unlocking the market’s treasures – knowing which stocks to buy and sell – is a difficult mystery seemingly beyond his powers.

If there were only a simple and reliable way to find great stocks, a combination to look for or a magic formula of some kind…something the average investor can use and depend on.

One great investor seems to have cracked the code, or at least one of them. In fact, he even calls it his “magic formula.” You are probably skeptical of anything that smacks of a “magic formula.”

Rightfully so. The stock market has more than its share of snake oil salesmen and carnies. Not surprising, given the amount of money at stake.

As someone who loves old books and old ideas, I can tell you the search for a “magic formula” is as old as investing itself. The reality is investors of all stripes have been tinkering with such ideas for a long time. The goal is to find a simple way to cull through thousands of stocks to arrive at a reasonable number of names that have a high probability of working out.

If you’ve been reading my letter over the past year, you may remember me writing about Joel Greenblatt before. He’s one of my favorites. He is the founder and managing partner of a private investment firm called Gotham Capital. Since its inception in 1985, Gotham, with Greenblatt at the helm, has compiled one of the most astounding track records in the history of investing. He’s earned annualized returns of 40% since 1985.

That’s a truly ridiculous track record. Basically, a $10,000 investment in 1985 comes back as nearly $12 million by the end of 2004!

Greenblatt is one of the all-time greats, even though, strangely, he is not all that well known among casual investors. Certainly, his fame is nowhere near Warren Buffett’s or Peter Lynch’s. Yet his record speaks for itself. Clearly, here is a man worth listening to.

He’s already written a good book on investing titled You Can Be a Stock Market Genius. Despite its clownish title, this was an important contribution to the investment literature, as it dealt with special situations – such as spinoffs – and showed how and why such investments often worked out. It fleshed out, and brought to a wider audience, a set of strategic options previously known only to Wall Street insiders and certain enthusiasts.

Well, Greenblatt has done it again. This time in a new book titled The Little Book That Beats the Market. In it, Greenblatt divulges his own magic formula – a strategy that has, over the last 17 years, returned 30.8%, versus 12.4% for the S&P 500.

The basic goal of Greenblatt’s screen is to find good companies at bargain prices. To do that, Greenblatt relies on two basic ideas – both concepts used by value- minded investors for decades.

Finally, we get to the magic formula’s two simple ingredients, which are really just two ratios. All of the inputs are readily available on a company’s financial statements: The first is return on invested capital (ROIC) and the second is earnings yield (EY).

The first is a measure of quality. When comparing businesses, all other things being equal, the higher the return on invested capital the better. Let’s forget about stocks for a minute and just think about a very simple business. Think of invested capital as the amount of money you have to invest in a business. If you own a store and it requires $10,000 of your own money to open and returns $1,000 to you annually in profits, then you have an ROIC of 10%.

It’s probably pretty intuitive that a higher number is better, right? If you made $1,500 annually, your ROIC would be 15%. More return for the same amount of dollars invested. If a friend of yours had to invest $13,000 in his business to get the same $1,500, then his ROIC would be 11.5%. All other things being equal, you’ve got the better business (15% versus 11.5% ROIC).

So that’s the first measure. Greenblatt puts his screen to the thousands of stocks on the market today and ranks them, highest to lowest.

But that’s not all. This first test measures quality. We need something else to measure cheapness. We all know Microsoft or Wal-Mart are great businesses, but are they cheap? Just because a business is great doesn’t mean its stock price will rise.

That’s where earnings yield (EY) comes in. The basic idea is to compare what a business earns with what its price is in the market (enterprise value). Enterprise value is the market cap of the stock less cash plus debt. Basically, it’s how much, in theory, you’d have to pay to buy the whole company at current market prices. Therefore, the higher the EY the better. It means more earnings for your dollar.

It’s like a more comprehensive price-earnings ratio turned upside down. So a business with a 25% earnings yield is like a company with a price-earnings ratio of 4 (earnings yield = 1/4, or 25%). This is overly simplistic, because in Greenblatt’s formula, we’re making a number of adjustments to both the “P” and the “E” in the price- earnings ratio. But it may help you understand the idea better if you think of it this way. Obviously, a price-earnings ratio of 4 is pretty darn cheap – and that’s really what I’m getting at.

The formulas themselves are in the book, and I won’t rehash them here. For the purposes of this discussion, the basic concepts are more important than the actual formulas.

Greenblatt’s magic formula takes these two ratios, ROIC and EY, and screens thousands of stocks, ranking them from highest to lowest. As Greenblatt writes, “If you 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.”

As noted earlier, Greenblatt’s magic formula stocks returned 30.8% over the past 17 years, compared with 12.4% for the market. This is a remarkable result. Greenblatt has added yet another tool to the investor’s tool kit.

Ideally, formulas of any sort have to make sense intuitively and economically – such as Benjamin Graham’s net-nets and Greenblatt’s ROIC and EY combination. They are rooted in basic financial ideas that no one will refute. It’s not like betting on some odd chart pattern or abstract macro theory.

And also ideally, such a formula should be hard to stick with all the time. Otherwise, everyone would use it and the profits would soon disappear.

Graham’s net-net idea was like that. Most of the net-nets were troubled companies. Investors hated these companies, which is why they were trading where they were. And it’s also why the formula was able to work. It goes against human nature. People read it, they understood it, but they couldn’t follow it. Like the tenets of religion – there are just too many temptations and the vast majority of investors will not be able to stay on the righteous path.

It’s the same with Greenblatt’s formula. A lot of the companies you’ll find on the list are not popular names, and indeed, many of them have short-term clouds hanging over their heads. This makes sense, because it explains why they are so cheap. Still, these are tough buys for the average investor.

And it requires patience to stick with Greenblatt’s idea, something else the average investor doesn’t have a lot of – and that’s being charitable.

Graham, too, appreciated the stoic patience sometimes required to make good on cheap shares. In writing about his beloved net-nets, Graham warned readers not to lose patience with them if they didn’t immediately rise in price. “Sometimes, the patience needed may appear quite considerable.” He related his experience in holding a net-net for 31/2 years and making 165% – a 47% annual return. But almost the entire gain occurred in the fourth year. “Most of the bargain issues in our experience have not taken so long to show good profits,” Graham confided. But the lesson is there.

Again, some patience is required with Greenblatt’s magic formula. As Greenblatt readily noted, the magic formula doesn’t work every year. There are times when it will lag the market. But this is a good thing, in a way, because such underperformance will tax most investors’ patience and they will abandon the formula before it really has a chance to work its magic.

Regards,

Chris Mayer
for The Daily Reckoning

P.S. If you are interested in finding out more about Greenblatt’s magic formula, you can purchase his book at The Daily Reckoning bookstore:

The Little Book That Beats the Market

We’ve spent the week reading predictions and forecasts.

In the past, we have tried reading entrails ourselves, but we could never get the animal to stand still, and didn’t have the heart to kill it. Nor could we get a grip on soothsaying. We were willing to say a sooth, but we could never figure out what a sooth was.

Still, long-suffering Daily Reckoning readers will find our forecasts and reflections in this space tomorrow.

Today, we ridicule the competition, which is too easy. The competition makes itself ridiculous; we don’t have to do anything to make fun of it.

Take Abby Joseph Cohen…please. The woman makes her living by telling investors, on behalf of Goldman Sachs, that the stocks offered by her employer are going to go up. She says so every year. In a bull market, she is mostly right. In a bear market, she is mostly wrong. So, her reputation flew as high as Amazon or Global Crossing in the glory days of the tech bubble of the late ’90s. Then, when the bear market began in 2000, poor Abby took a beating.

Still, she remained loyal to her employer and faithful to her employment. Every year, she continues to tell us that stocks are going up. This year is no exception.

The reasons change, but the direction never does. This year, stocks are going up, she says, because investors are impressed by the “durability” of the expansion despite higher interest rates, and because corporations are about to begin investing their $2 trillion of cash in ways that will make the stock market go up.

As to the first point, it is surely correct that the longer the economy seems to survive injury, the more people think it will live forever. It is a little like a drug dealer in a shoot-out. A bullet in the leg barely annoys him. Then, he is shot through the arm. Still, he stands his ground. After a while, his friends begin taking bets about how long his will remain standing, and after another bullet to the stomach fails to bring him down, many of them begin to think he’s invincible.

This, of course, is a good time to bet against him.

The problem with Cohen is that she hasn’t lived in Baltimore. She hasn’t seen enough street gunfights, but the cops will tell her: the guy always goes down, sooner or later.

So, do stocks always go down when their time has come? Has the time come in 2006? Abby knows no more than we do, but she is way ahead of us. Nobody ever lost his or her job at a major brokerage house for saying that next year will be a lot like last year…or that stocks will go up.

Abby’s second point is that corporations are about to undertake more capital spending projects. They have the cash, she points out. What they’ve lacked so far is the will. This theme – capital spending replacing consumer spending – is a standard feature of this year’s forecasts. Everyone sees that consumer spending is vulnerable. Yesterday, it was announced that new house starts had dipped for the fourth week in a row – to a three-and-a-half-year low. Oil is over $60. And borrowed money is more expensive. The consumer will probably be forced to cut back.

Maybe capital spending will take up the slack. There is no sign of it yet, however. Companies with cash have used the money to shore up their health plans, beef up executive compensation plans, or goof up their merger and acquisition plans. Business culture, in America circa 2006, is short-term oriented. Companies spent billions on information technology in the late ’90s, when they thought it would bring them a windfall. We’ve yet to see a new factory built, or much real capital spending in the United States. Instead, the capital is being spent in Asia, where so much of it has been dumped into new factories that are already over capacity. Why U.S. companies would want to add still more capacity is a mystery.

But wait, Abby is probably talking about the New Economy…not the old manufacturing economy. Elsewhere, we read a forecast that GM shares may lose another 33% this year. Wall Street is writing off the old economy. We’re not going to make cars in the United States anymore. We’re in the more-profitable service business. That’s right, we’re going to wash them! Maybe there will be a new spurt of investment in carwashes and parking garages. We don’t know, but we wouldn’t count on it.

More news from Aussie Joel and The Rude Awakening…

Bill Bonner, back in London with more opinions and thoughts…

*** The housing slowdown makes it to front-page news in the mainstream media. Yesterday’s WSJ featured a story on the housing slowdown, saying, “As home sales start to slow and the inventory of unsold homes climbs, many economists believe that home prices will rise more gradually, or even decline, delivering a jolt that causes consumers to rein in spending. That, in turn, may cause economic growth to slow.”

And as if that isn’t reason enough for consumers to restrain their over-the-top spending habits, as we flip further into the WSJ, we find an article on spending outpacing earnings in 2005 – the first year since The Great Depression that this has occurred.

Apparently, American consumers spent about $39 billion more than they saved, and the rise in home values actually contributed to a lower savings rate – as many homeowners draw on their home equity as a source of cash.

“It’s a well-documented relationship in economics: One dollar of extra housing wealth translates into a reduction in savings of five cents a year,” Dean Baker, co-director of the Center of Economic and Policy Research, tells the WSJ. “We saw the same sort of thing with the stock bubble [in the late 1990’s]. You had this big run-up in stock prices, and the saving rate went down.”

*** Jeez, we can’t help but wonder: What are we going to write about now? The WSJ is picking up two of our themes, and Senators are actually agreeing with the sentiment expressed in Empire of Debt and the letters that we wrote them.

Senator Russell Feingold (D) of Wisconsin, the only Senator who didn’t vote for the Patriot Act the first time around recently sent Addison a two-page letter…

“I share your concerns about wasteful government spending and spiraling budget deficits,” writes Senator Feingold, “and for that reason I have led the effort to reinstate the pay-as-you-go (PAYGO) budget rule. Under this requirement, Congress must find offsets to pay for new spending on entitlement programs or new tax cuts…The PAYGO requirement is a proven tool of fiscal restraint that was instrumental in reducing annual budget deficits during the 1990’s leading eventually to a balanced budget.”

*** Gold rose again yesterday. It is now over $530. We expected more of a correction and are disappointed that we didn’t get one. But the metal merely dipped below $500 briefly. We’d like to see a more serious correction – giving us an opportunity to take a “final” position before things get out of hand.

*** “I can’t believe how expensive this place is,” said Jules, visiting us here in London during his Christmas break. “I just bought a roundtrip subway ticket. It cost me $10. It only cost one-and-a-half euros to get a ticket on the subway in Paris.

“And look at all these expensive cars. I’ve never seen cars like this. Lamborghinis. Maseratis. If you drive a Mercedes in this neighborhood people must feel sorry for you. They probably want to take up a collection at church. How can people afford to live in this place?”

We had been wondering the same thing. Subway fares rose with the New Year. Everything else was already very expensive – at least to Americans. The English don’t seem to notice.