Seriously clueless

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Sunday, March 05, 2006

Interesting little book

Shit, it’s been ages since I wrote. For the few that remotely care, sorry! Life’s been insanely busy over the last several weeks. I finally managed to make time to read as well, and am intrigued enough to write about the book I read.

Among my pet hates are 3 categories of books - those that tell the reader how to (1) lose weight, (2) be happy and (3) make more money. I view such books as a general attempt to swindle readers. The first category says ‘eat right, move your butt’ in various lengthy ways. On the second, if you can afford to buy a self-help book, you’re doing fairly ok to start with. Look around at the less fortunate, stop whining and be happy with what you have. The third typically goes down the ‘buy low, sell high’ route and are mostly written by people who weren’t that successful at making money anyway (or else, why’d they need to write such books for a living). Given my prejudice, when my colleague – Rob Stavis – sent across a book titled ‘The Little Book That Beats The Market’, my initial reaction was skeptical. Stavis himself ran arbitrage trading for Salomon Smith Barney, and knows a thing or two about beating the market. This book ia authored by Joel Greenblatt, whose hedge fund – Gotham Capital – has delivered over 40% annualized returns over a 20-year period! Further, the book didn’t look intimidating at all. In fact, it is a 150-page pocketbook that can be completed in one sitting.

I am really intrigued by what Greenblatt writes in this book. The central thesis is ‘buying good businesses at bargain prices is the secret to making lots of money’. Sure, that’s obvious. Greenblatt then goes on to propose a simple ‘magic formula’ to identify good businesses that are available at bargain prices. The two metrics he uses are:

1. Good business = one that generates high return on capital, as measured by EBIT/(net working capital + net fixed assets)

2. Bargain price = high earnings yield, as measured by EBIT/(market value of equity + net interest bearing debt).

EBIT stands for Earnings Before Interest & Taxes or pre-tax operating earnings. Note that both of these metrics do NOT require any estimates or projections, and are measured purely using past data (last 12-months EBIT & current balance sheet, equity values). All one needs to do is rank all listed companies on these 2 metrics, and invest in those that have a high rank on both counts.

This may sound very simplistic, but wait till you see the results. Greenblatt applied this ‘magic formula’ to a 17-year period from 1988 to 2004, and created a hypothetical portfolio of top-30 stocks that this formula throws out (the portfolio is juggled once a year, using the same formula). Such a portfolio would have generated annual returns of 30.8% over this 17-year period, compared to 12.4% for the S&P 500! Greenblatt goes on to perform various statistical tests, to show that this super-performance isn’t due to luck or some statistical aberration, and that the formula works across different scenarios. It may always be possible to find specific companies that rank poorly on these metrics, but go on to make spectacular stock returns. However, at a portfolio level (say, 20-30 stocks or more), this formula outperforms the market by a margin that’s doesn’t leave much reason for doubt.

This is the kind of book that left me scratching my head, with tons of questions (but, doesn’t the value of a firm depend on future earnings & growth?). At the same time, I cannot deny that this seems to work really well, in the face of hard data.

I’d encourage you to read the book, visit and enlighten me if you have any more insights on this matter.


At 4:28 PM, Anonymous AG said...

I also read the "little" book, and then, intrigued, also read his previous book (1999) with an equally tacky title ("You Can Be a Stock Market Genius").

While the approach in his "little" book makes sense (as he forcefully argues), it appears from the 1999 book that his own approach to investing has not been not exactly what he recommends in the little book. Greenblatt is famous for investing in "special situations" stocks, for example spin-offs. He discovered that these were not very efficiently covered by Wall Street and he found lots of bargains amongst these.

He points out that when a tiny spin-off stock arrives, people often don't know what to do with it and sell it right away. It does not match the reason they bought the parent stock, and if the holder is an insitution, the small cap may not fit the charter etc (in general the spinoff stock was "pushed" into investors hands and not really "bought" by them). All this selling causes the spinoff stock to become really cheap and Greenblatt was able to make hay. I identified with this reasoning since this happened to me with a stock I owned which is an internet based company whereas the spinoff was a temp agency. I promptly sold the temp's stock since it did not fit with my reason to buy the parent stock, and watched it promptly double to my chagrin!

According to an WSJ article, his 1999 book, detailing many such inefficient corners of the market, was quickly passed around amongst hedge fund managers.

Both books are excellent reads. I'm hoping to add more margin of safety to my portfolio by using his yield metric to compare alternatives.


At 1:32 PM, Blogger Krish said...

Hi Anand,

As usual, another great blog from AS. Keep them coming.

These yardsticks appear to be normally helpful but there are a few not so uncommon exceptions. One flaw you've already brought out - that it does not factor in the future earnings potential of the business ( which at least is theoretically predictable only with a reasonable degree of accuracy ). It sure has other handicaps too which may I humbly put across.

For eg. in our own backyard, we have firms like HLL, ITC and CASTROL. If you apply the GOOD BUSINESS formula, you may get fantastic values for HLL since it operates on Negative Working Capital ( longer supplier's credit + faster receivables realisation ) and its Fixed Assets are almost fully depreciated and they are no longer adding to Fixed Assets thanks to contract manufacturing. But would you call it a GOOD BUSINESS given today's deep discount Mall culture ( read little or no margins ) ? Just keeps it going since it has less direct costs to absorb and volume offtake guarantees inventory cleanup ! It shows up in its Balance Sheet Qtr after Qtr.

But if you apply the BARGAIN PRICE formula, HLL should be a bargain on account of its little or no intt bearing debt and that its stock price has just started to rally. But would you buy HLL under normal market conditions given its business model which is more or less out of sync with the times ? I have doubts.

Here, I think Cash flows should matter more than Working Capital + Fixed Assets combo. Something like
[ NET CASH ACCRUAL = PAT - DIVIDEND + DEPRECIATION ]. It makes a lot of sense since CASH is realtime stuff and no legacy values cloud one's judgement.

The Good Business formula could surely suit relatively new businesses having large recent CAPEX like say Bharti Televentures etc., but it might get beaten on the yield curve in a runaway bullmarket like ours, where valuations defy all logic.

Similar is the case for CASTROL too, if you have noticed. But Castrol does not have the luxury of Negative Working Capital, but has deeply depreciated Fixed Assets. It has the added threat of Public Sector oil majors building up their lubricants side of the Business going by their high decibel Ads for Engine Oils etc. Hence the emerging picture would not always indicate GOOD BUSINESS.

I just thought I might as well sound this out. Would love to stand corrected, if my theory has some snafu in it.

At 2:55 AM, Anonymous Robin said...


But I wanted to comment on your response to Book Type #2. Your logic assumes that having the money to buy a book (or more accurately, the comparison of that amount of money to less fortunate people who have less money) should bring happiness.

Logically, if that's the case, then why do the psychology, psychiatry industries do so well? Why is "happiness" not just dealt with by a major cottage industry (think: Deepak Chopra), but also by medical disciplines? Why is that true on a world-wide basis, and not just in rich countries? And why is it historically true (the American Thomas Jefferson, no poverty-stricken man, dedicated one-third of the thrust of the Declaration of Independence to the "pursuit of happiness")?

I would suggest that being happy is not just a material concern. Of course, some people turn to materialism -- they shop for happiness. Some people turn to religion -- they God for happiness. Others, who tend to intellectualize, turn to books. Your assumption about the material wealth needed to buy the book is causing you to miss an entire market!

If the point of life is to be happy, I can see why there are so many books on the topic.

At 5:44 AM, Blogger Swimmer said...

Hi there -

I wanted to let you know about a real test I am doing based on the book - $50,000 all newly invested (2 weeks ago) - actual money (not a phantom portfolio) - and real pain that comes along with it.

Thought it may interest some people:

At 3:57 PM, Blogger Vikash Mantri said...

Havent read the book but definitely go forward doing it.

"the rearview mirror is always clearer than the windshield" - Warren Buffet

The trouble that i see forward in any analysis done so forth is the hindsight bias and survivorship bias. Any statistical test done on historical basis would undoubtedly be with some personal bias. Also the analysis must have probably been for all the stocks that have survived during teh 17 year period as those did not might not leave ample data behind for statistical analysis. Teh book " Fooled by randomness' proves this very finely.

However as to anlysis of comanies and is concerned i like the Piotrski screener. Joseph Piotoski suggested a 12 point screener for tracking companies. This consists of 12 signals that measure profitability, leverage, liquidity and operating efficiency. All you need to do is run teh screener and see the companies which have been performing well on the parameters garnering the highest scores. This would require some time , in case one cannot spare that one should run a random number generator and pick any stock in the indian market and then right a theory on why it made complete sense if it turns out to be a good investment.

At 6:44 PM, Blogger Ravi Purohit said...

Hi Anand,

Though I've not read this book, I think the two formula that you've pointed out need a little tweaking. Instead of taking EBIT in the numerator, I think one should take profit after tax + financial charges.

The purpose of taking EBIT seems to be to essentially to find out the return on capital employed. The capital is provided by both owners and lenders, therefore, we need to evaluate the return to both, ie. finacial charges and profit after tax.

Your take ?

Ravi Purohit.

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At 11:23 PM, Anonymous Hendrik Oude Nijhuis said...

I believe it’s interesting to combine Greenblatt Magic Formula with other models. It’s important to research the reason for the high ROIC. There are many factors which can lead to high ROIC on short and longer time frames.

What Greenblatt actually tries to do with his screening on high ROIC is to find companies which have (durable) competitive advantages. His screening will, of course, on average, have more companies with competitive advantages, than the average of the whole selection.

By checking manually, stock by stock, on competitive advantages, I believe it’s possible to create a portfolio which will outperform random Magic Formula portfolios. I have published (free) material about the way this can be accomplished:

Success in investing,
Hendrik Oude Nijhuis

At 6:13 AM, Anonymous robin w. said...

If you ask me, using working capital is an excellent way to gain funding for your business, especially if you are ineligible for a business loan (or equivalent). Your finances have been considered heavily when you are given your funding, so there's no question as to whether you can get in a bind with repayment.

At 10:10 AM, Anonymous Anonymous said...

Do you have any ideas on where to go for working capital loans? Thanks.

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