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We are reproducing an interesting article that had appeared in the Economic Times a year ago, on the methodology to spot multibaggers, as done by Joel Greenblatt, an eminent investor and fund manager.

Ace investor Joel Greenblatt says investors should follow a long-term investment strategy in order to be able to invest in above-average companies when they are available at below-average prices.

Quoting Warren Buffett, he says, “Buying a business at a bargain price is great. However, buying a good business at a bargain price is even better.”

This, Greenblatt says, can be achieved by following his Magic Formula, which can help one buy mispriced stocks with top earnings yield and high return on invested capital (RoIC).

Greenblatt is an eminent investor and hedge fund manager, who in 1985 started the investment company Gowtham Capital, which is famous for giving an impressive 40 per cent annualised return for over two decades. He authored the bestselling book The Little Book That Beats the Market.

Greenblatt’s says his Magic Formula is a simple and an effective way to make profit in the long run, if one has the required patience.

“To earn high returns on capital even for one year, it’s likely that, at least temporarily, there’s something special about that company’s business. Otherwise, competition would already have driven down returns on capital to lower levels,” he wrote in The Little Book That Beats the Market.

Know business fundamentals before investing

Greenblatt says the market can be very unpredictable in the short term. However, the stock market is quite efficient in the long run.

“Stock prices move around wildly over very short periods of time. This does not mean the values of the underlying companies have changed very much during that period. Stock markets act much like a crazy guy named Mr Market. It is Mr Market’s constantly changing emotional state that creates bargain opportunities,” he writes.

Greenblatt says a value investor must understand the underlying business in order to be able to value a stock. Some comparatively simple math related to the business performance and understanding the fundamentals of a business are key steps that need to be followed before investing in a stock.

“Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot,” says he.

The ‘Magic Formula’ to spot multibaggers
Revealing what prompted him to deduce his Magic Formula for finding valuable investment bets, Greenblatt says he became fascinated by Warren Buffett’s investment philosophy about acquiring fantastic businesses at reasonable prices. He studied Buffett’s letters to Berkshire Hathaway shareholders in an attempt to compute two variables: 1) fantastic businesses, and 2) reasonable prices.

After studying the two variables, Greenblatt came up with a two-variable formula, called The Magic Formula.

1. Evaluate stocks based on earnings yield and return on capital: He says the Magic Formula evaluates stocks and ranks them based on two financial ratios 1) earnings yield, and 2) return on invested capital (ROC).

The ROC shows how good a company is (fantastic businesses) and the earnings yield tells you whether the company is available for investment at an attractive price (reasonable prices).

Earnings yield = Ebit (Earnings Before Interest & Taxes + Depreciation – Capex) / Enterprise value (Market Value + Debt – Cash).

Greenblatt says earnings yield reveals how expensive a company is in relation to the earnings it generates. While looking at earnings yield, certain adjustments can be made to its market capitalisation to estimate what it may take to buy the entire company.

The process also caters to penalising firms that have excess debt and rewarding those that have a lot of cash.

2. Return on capital employed (ROIC) = Ebit (Earnings Before Interest & Taxes + Depreciation – Capex)/ (Net working capital + Net Fixed capital).

Here, ROC is the ratio of the pre-tax operating earnings (Ebit) to tangible capital employed (net working capital + net fixed capital).

Greenblatt says the return on the invested capital shows how efficient a company is in turning investments into profits. This ratio deduces the cash a company generates in relation to the amount of capital tied up in its business.

As the value of ROIC increases, all else being equal, a business can be said to be performing better, as higher the ROIC of a business, the more money an investor is able to earn every year in relation to the money invested in the business.

Greenblatt says he uses the ROIC ratio in place of the other commonly used financial ratios like ROE (return on equity) or ROA (return on assets) because Ebit avoids the distortions due to the differences in tax rates for different companies while making a comparison.

Also, net working capital plus net fixed capital is used in place of fixed assets as it gives a better picture of how much capital is needed to run the business.

Pick winning companies by combining these two factors and rank them
The ‘Magic Formula’ provides both the ratios equal weightage while selecting companies. The formula ranks all possible firms by Good Company (ROIC) and also by Good Price (earnings yield). Then, each firm’s ROIC and earnings yield ranks are added.

The formula finally gives the best combined rankings of companies that an investor can buy and hold for at least a year. After one year, one should review all the companies and move funds to the new highly-ranked companies using the same formula.

Greenblatt says this approach is simple enough and is especially beneficial for investors who are just starting their careers in investing or the ones who are considering to manage their own equity portfolios.

Be patient: Greenblatt advises investors to remain patient while using this formula for investment, as in individual years, it often may not do well.

He says lack of patience is often the reason why investors fail to implement the Magic Formula properly. He advises investors to remain invested for the long term to see the actual magic of the formula.

“If you’re actually willing to stick with it over several years, through the thick and thin, then it will pay off. If you’re not willing to do that and just let it ride, then this investing concept won’t necessarily work. The toughest thing about investing is that you have to be lazy, must behave and keep yourself out of new trouble, once you’ve set a good plan,” says he.

Consistency is the key: Greenblatt says consistency is the key to success with this formula and investors should stick with the long-term strategy and not get pushed out of it due to short-term underperformance.

“Over the years, many studies have confirmed that value-oriented strategies beat the market over longer time horizons. Several different measures of value have been shown to work. These strategies include, but are not limited to, selecting stocks based on low ratios of price-to-book value, price to earnings, price to cashflow, price to dividend.

These simple value strategies do not always work. However, measured over longer periods, they do. Though these strategies have been well documented over many years, most individual and professional investors do not have the patience to use them. Apparently, the periods of underperformance makes them difficult, and, for some professionals, impractical to implement,” says he.

Diversify your portfolio: Greenblatt says the core of a good investment is diversification of investments. “One should have a diversified portfolio to survive bad times or bad luck, so that skill and good process can have the chance to pay off over the long run,” he says.

Be an independent thinker: The top money manager insists that it is important for an investor to be an independent thinker and not get into the trap of listening to others when they feel they are right. “There’s a virtuous cycle when people have to defend challenges to their ideas. Any gap in thinking or analysis becomes clear pretty quickly when smart people ask good, logical questions. You can’t be a good value investor without being an independent thinker – you’re seeing valuations that the market is not appreciating. But it’s critical that you understand why the market isn’t seeing the value you do. The back and forth that goes on in the investment process helps you get at that,” says he.

(Disclaimer: This article is based on Joel Greenblatt’s book The Little Book That Beats the Market and his presentation at Talks @ Google.
This article has been reproduced by Team Capital Portfolio Advisors. Any part of the content of this article should not be construed as, an offer or solicitation to buy or sell any securities or make any investments. The content shall not to be relied upon as advisory or authoritative or taken in substitution for the exercise of due diligence and judgement by any user nor should it be used as a basis for making any decisions, without exercising user’s own judgment or diligence. As a condition for using this Blog, the user agrees that Capital Portfolio Advisor (CPA), its Founder or any of it’s employees make no representation and shall have no liability for any loss or damage, direct or indirect, arising from the use of the Blog. CPA reserves the right to change the content of the Blog without prior notice.)

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