With the start of the new year, I have added a new Guru Strategy to the 11 I have been following for some time. The new strategy is based on the writings of Joel Greenblatt. And while I have just "officially" added him to my portfolio of strategies, I have actually been carefully following his strategy's performance for the last three years.
It is this performance that convinces me now is the time to start formally incorporating this strategy into my stock-picking efforts. In this column, I will tell you about three stocks that the Greenblatt strategy favors. But first let me tell you something about Greenblatt and his strategy, so you can understand why this strategy seems especially well suited for the market we have today.
Greenblatt is a hedge fund manager (Gotham Capital) who reports producing annual returns of 40% over 20 years. He is also an author, including You Can Be a Stock Genius: Uncover the Secret Hiding Places of Stock Market Profits. But it is another book Greenblatt wrote that has brought his name to a wider public, and on which I base my Greenblatt Guru Strategy: The Little Book That Beats the Market, which came out in late 2005. This is literally a little book (small format, 176 pages) that became a big seller.
In it, Greenblatt explained how investors could produce outstanding long-term returns using his simple "Magic Formula." The strategy involves just two variables: return on capital and earnings yield. Greenblatt's back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8% return from 1988 through 2004, more than doubling the S&P 500's 12.4% return during that period.
The strategy seems well suited for today's market because, as Greenblatt explains, it focuses on buying good companies at bargain prices. The return on capital variable helps identify good companies because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the search for a bargain. Think of earnings yield as similar to the inverse of the price/earnings ratio, where stocks with high earnings yields take in a relatively high amount of earnings compared to the price of their stock. Of course, Greenblatt wasn't the first to like solid companies whose stocks trade at an unfair discount; Warren Buffett and his mentor Benjamin Graham loved such stocks, too.
To choose stocks, Greenblatt simply ranks all stocks by return on capital, with the best being number 1, the second number 2, and so forth. Then, he ranks them in the same way by earnings yield. Finally, he adds up the two rankings, and invests in the stocks with the lowest combined numerical ranking.
In calculating the capital part of the return on capital variable and the earnings part of the earnings yield variable, he doesn't use simple earnings; instead, he uses earnings before interest and taxes (EBIT) in order to see how well a company's underlying business is doing, and taxes and debt payments can obscure that picture. In the current market, this is a valuation worth paying attention to.
In addition, in figuring earnings yield, Greenblatt divides EBIT not by the total price of a company's stock, but instead by enterprise value -- which includes the total price of the firm's stock plus its debt. This gives investors an idea of the yield they can expect if buying the entire firm -- including both its assets and debts. In the past few months, we've seen how misleading conventionally derived P/E ratios and earnings yields can be, since earnings can be propped up by the use of huge amounts of debt. Greenblatt's earnings yield calculation is a way to find stocks producing a good earnings yield that isn't contingent on a high debt load. In my Greenblatt model, I calculate return on capital and earnings yield in the same ways that Greenblatt lays out in his book. Greenblatt, by the way, only invests in US stocks, and never in financial companies or utilities (because of their high degree of leverage).
One stock the Greenblatt Guru Strategy favors is ValueClick (VCLK), the largest independent online advertising agency in the US. Among the company's services are Internet-specific marketing strategies, including lead-generation, search, and e-mail marketing. The first criterion that this strategy looks at is the earnings yield. As noted above, this methodology ranks all stocks based on their earnings yields and then combines that ranking with each firm's ranking based on its return on total capital to determine the strategy's level of interest. ValueClick's earnings yield is 26.15%, which ranks it 41 among the stocks in our database. The second criterion used is return on total capital. The company's return on capital is 44.93%, which ranks it 153 among the stocks in our database. Combining the ranking from the first two criteria, we find that ValueClick ranks 13 among the thousands of stocks in our database. This is excellent.
DISH Network (DISH) is a satellite television provider and describes itself as the third largest pay-television provider in the US. DISH's earnings yield ranks it 84th among all the stocks in our database, while its return on capital places it 51st among all stocks. Combining the two, DISH ranks 8th among all stocks, which is, of course, an impressive position to be in.
The Corporate Executive Board Company (EXBD) is the last Greenblatt Guru Strategy pick I want to tell you about. This consulting firm provides best-practices research and analysis to thousands of companies, including more than 80% of the Fortune 500, according to the company. The company's earning yield ranks 104 among all the stocks in our database, while ranking 8 for its return on capital. Overall, it comes in at number 5 among all stocks.
All of these companies are well run with stocks priced on the cheap side. In today's market, these are the types of stocks you need in your portfolio.
Published by Globes [online], Israel business news - www.globes.co.il - on February 11, 2009