Greenblatt: Large Caps Looking Better Than Small Caps

Standout hedge fund manager Joel Greenblatt says his “Magic Formula” is finding more value in large-cap stocks than small caps right now. Greenblatt told CNBC that, based on a review of decades of history, he’s finding that large-caps are in the 38th percentile towards expensive right now, meaning they’ve been cheaper than they are now 62% of the time over that several-decade span. From these levels, stocks on average have gone on to gain between 6% and 10% over the next year, he says. Small caps, however, are in the 5th percentile, meaning they’ve been cheaper 95% of the time. Such levels have historically led to average returns of -3% over the ensuing year. Greenblatt notes that those valuations involved averages, and that there are individual stocks trading for much cheaper. He also talks about his strategy, and how the “Magic Formula” works.

Validea’s Joel Greenblatt-inspired portfolio is up 113% since its late 2005 inception vs. 41% for the S&P 500. Check out its holdings here.

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Greenblatt’s Winning Formula: More Discipline than Magic

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Joel Greenblatt-inspired strategy, which has averaged annual returns of 10.0% since its December 2005 inception vs. 4.4% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Greenblatt-based investment strategy.

Taken from the December 6, 2013 issue of The Validea Hot List

Guru Spotlight: Joel Greenblatt

Anyone who has ever put cash in the market knows that making money in stocks is hard. But what a lot of investors don’t realize is that while it is difficult, it doesn’t have to be complicated. You don’t need incomprehensible, esoteric formulas and you don’t need to spend every waking hour analyzing stocks — Joel Greenblatt has proved that.

Back in 2005, Greenblatt created a stir in the investment world with the publication of The Little Book that Beats The Market, a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his “Magic Formula” — a purely quantitative approach had 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 percent return from 1988 through 2004, more than doubling the S&P 500′s 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.

Written in an extremely layperson-friendly manner, Greenblatt’s “Little Book” — it’s only 176 pages long and small enough to fit in your jacket pocket — broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves. Using several simple analogies, he explains a variety of stock market principles. One of these he often returns to involves Jason, a sixth-grade classmate of Greenblatt’s youngest son who makes a bundle selling gum to fellow students. Greenblatt uses Jason’s business as a jumping off point to explain issues like supply, demand, taxation, and rates of return.

In reality, the “Magic Formula” is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices — something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did. The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task — buying those good companies’ stocks on the cheap. The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.

The Details

To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number 1, the second number 2, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.

The slightly unconventional ways in which Greenblatt calculates earnings yield and return on capital also involve some good common sense — and are particularly interesting given the recent credit crisis. For example, in figuring out 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 taxation. The reason: These parts of the equations should see how well a company’s underlying business is doing, and taxes and debt payments can obscure that picture.

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 not only the total price of the firm’s stock, but also its debt. This give the investor an idea of what kind of yield they could expect if buying the entire firm — including both its assets and its debts. In the past few months, we’ve seen how misleading conventionally derived P/E ratios and earnings yields could be, since earnings had been propped up by the use of huge amounts of debt. Greenblatt’s earnings yield calculation is a way to find stocks that are 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.

We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past five years or so. So far, the model has been a strong performer, with some big ups and downs. Since we began tracking our 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has gained just 41.7%; the Greenblatt-based portfolio has gained 114.9% — that’s 10.0% annualized, vs. 4.4% annualized for the S&P (all performance data through Dec. 4). The portfolio beat the market in 2006 and 2007, and then did what few funds have done: limit losses in what for stocks was a terrible 2008, and handily beat the market in the 2009 rebound. It fell 26.3% in ’08 — not good, but much better than the S&P 500′s 38.5% loss — and surged 63.1% in 2009, vs. 23.5% for the S&P. After beating the market again in 2010, it struggled in 2011 and 2012, however. But Greenblatt stresses that the strategy won’t beat the market every month or even every year, which is important to remember. In fact, during that stellar 17-year period he covered in his book, there were even times when it lagged the market for three straight years. But that, he says, is why it works over the long haul: Undisciplined investors bail on the strategy, allowing those who stick with it to pick up the exceptional bargains they leave behind.

Indeed, in 2013, the Greenblatt-based portfolio has bounced back strong, returning more than 50%. Below is a look at its current holdings.

One note: Because of the way financial and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn’t include foreign stocks, so I exclude those from my model as well.

EBIX Inc. (EBIX)

Western Refining, Inc. (WNR)

DirecTV (DTV)

ITT Educational Services (ESI)

Science Applications International Corporation (SAIC)

Weight Watchers International, Inc. (WTW)

ConocoPhillips (COP)

AmSurg Corp (AMSG)

PDL BioPharma, Inc. (PDLI)

AFC Enterprises Inc. (AFCE

The Gurus Accessorize with Coach

In his latest Seeking Alpha column, Validea CEO John Reese takes a look at a luxury goods stock that’s getting strong scores from his guru-inspired models: Coach Inc.

Reese notes that Coach shares have stumbled over the past year and a half, with the latest negative catalyst being a downward revision to its forward guidance. “Some weakness in North America, in part due to increased competition, is a driving factor behind the guidance change. Investors also may be nervous that Coach is in the process of changing up its business model, shifting from a handbag/accessory specialist to more of a ‘lifestyle brand,’ a la Louis Vuitton,” Reese explains. “But it looks like the declines are an overreaction. That’s what my Joel Greenblatt- and Benjamin Graham-based approaches … are telling me. Both of these models look for companies with strong balance sheets that are trading at attractive prices, and that’s just what they see in Coach.”

Reese says the Graham- and Greenblatt-inspired models recently triggered a “Trade Alert” for Coach. Historically, stocks that have triggered this alert have gone on to gain an average of about 19% over the next six months, beating the S&P 500 about 70% of the time. Reese looks at the specific reasons why these two models are high on Coach, and why the firm has the sort of “durable competitive advantage” that Warren Buffett likes to see.

For Greenblatt, Simplicity Equals Success

In his latest RealMoney column, Validea CEO John Reese takes a look at Joel Greenblatt’s remarkably simple — and remarkably successful — investment strategy.

“For many years, I have been studying how great investors invest, and almost always, they use five or 10 or more variables, so they can look at a stock and its underlying company from a variety of perspectives,” writes Reese. “I’ve never seen an exceptional strategist use one variable, but there is one of note [Greenblatt] who uses just two, and this is as simple as stock analysis gets.”

Reese looks at the unique ways Greenblatt calculates those two metrics — return on capital and earnings yield. He also looks at three stocks that currently get high marks from his Greenblatt-based model, which is up more than 50% in 2013. Among them: Weight Watchers International.

The Real Trick Behind Greenblatt’s “Magic” Formula

Hedge fund guru Joel Greenblatt has produced remarkable returns over the long haul using what he calls his Magic Formula. But in his latest column for Forbes.com, Validea CEO John Reese says there is much more to Greenblatt’s approach than magic.

“While the remarkably simple strategy includes just two variables, Greenblatt — much like the magician who pulls a rabbit from his hat — possesses no real magical powers,” Reese writes. “Instead, his success, too, is the product of hard work, an understanding of human nature, and lots and lots of discipline.”

Reese talks about how Greenblatt’s strategy works, and how the Guru Strategy he bases on Greenblatt’s approach has fared. He also talks about just how important a good mental approach is when using such a strategy, which often targets unloved, beaten-down stocks. Reese offers five picks from his Greenblatt inspired model. Among them: much-maligned Herbalife.

Beating The Market With Simplicity — And Discipline

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the Joel Greenblatt-inspired strategy, which has averaged annual returns of 6.6% since its December 2005 inception vs. 2.4% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Greenblatt-based investment strategy.

Taken from the February 1, 2013 issue of The Validea Hot List

Guru Spotlight: Joel Greenblatt

Anyone who has ever put cash in the market knows that making money in stocks is hard. But what a lot of investors don’t realize is that while it is difficult, it doesn’t have to be complicated. You don’t need incomprehensible, esoteric formulas and you don’t need to spend every waking hour analyzing stocks — Joel Greenblatt has proved that.

Back in 2005, Greenblatt created a stir in the investment world with the publication of The Little Book that Beats The Market, a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his “Magic Formula” — a purely quantitative approach had 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 percent return from 1988 through 2004, more than doubling the S&P 500′s 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.

Written in an extremely layperson-friendly manner, Greenblatt’s “Little Book” — it’s only 176 pages long and small enough to fit in your jacket pocket — broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves. Using several simple analogies, he explains a variety of stock market principles. One of these he often returns to involves Jason, a sixth-grade classmate of Greenblatt’s youngest son who makes a bundle selling gum to fellow students. Greenblatt uses Jason’s business as a jumping off point to explain issues like supply, demand, taxation, and rates of return.

In reality, the “Magic Formula” is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices — something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did. The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task — buying those good companies’ stocks on the cheap. The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.

The Details

To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number 1, the second number 2, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.

The slightly unconventional ways in which Greenblatt calculates earnings yield and return on capital also involve some good common sense — and are particularly interesting given the recent credit crisis. For example, in figuring out 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 taxation. The reason: These parts of the equations should see how well a company’s underlying business is doing, and taxes and debt payments can obscure that picture.

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 not only the total price of the firm’s stock, but also its debt. This give the investor an idea of what kind of yield they could expect if buying the entire firm — including both its assets and its debts. In the past few months, we’ve seen how misleading conventionally derived P/E ratios and earnings yields could be, since earnings had been propped up by the use of huge amounts of debt. Greenblatt’s earnings yield calculation is a way to find stocks that are 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.

We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past five years or so. So far, the model has been a strong performer, with some big ups and downs. Since we began tracking our 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has gained just 18.8%; the Greenblatt-based portfolio has gained 58.2% — that’s 6.6% annualized, vs. 2.4% annualized for the S&P. The portfolio beat the market in 2006 and 2007, and then did what few funds have done: limit losses in what for stocks was a terrible 2008, and handily beat the market in the 2009 rebound. It fell 26.3% in ’08 — not good, but much better than the S&P 500′s 38.5% loss — and surged 63.1% in 2009, vs. 23.5% for the S&P. After beating the market again in 2010, it has struggled the past two years, however. But Greenblatt stresses that the strategy won’t beat the market every month or even every year, which is important to remember. In fact, during that stellar 17-year period he covered in his book, there were even times when it lagged the market for three straight years. But that, he says, is why it works over the long haul: Undisiplined investors bail on the strategy, allowing those who stick with it to pick up the exceptional bargains they leave behind.

One note: Because of the way financial and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn’t include foreign stocks, so I exclude those from my model as well.

So far in 2013, the Greenblatt-based portfolio has bounced back strong, returning more than 10% already. Here’s a look at its current holdings.

USANA Health Sciences Inc. (USNA)

Express Inc. (EXPR)

Strayer Education Inc. (STRA)

C&J Energy Services Inc. (CJES)

CACI International Inc. (CACI)

InterDigital, Inc. (IDCC)

CA, Inc. (CA)

Belo Corp. (BLC)

AmSurg Corp (AMSG)

PDL BioPharma, Inc. (PDLI)

Without Discipline, The Numbers Won’t Help You In The Market

In a recent column for Canada’s Globe & Mail, Norman Rothery says that using simple numerical stock-picking models can lead to strong returns — but that sticking to those strategies is both critical and very difficult.

“A huge pile of research points to an array of simple numerical stock strategies that boosts returns over the long term,” Rothery writes. “Such methods range from low-ratio value strategies to momentum-oriented schemes. If the studies are to be believed, it should be easy as pie to make a small fortune on Bay Street. (Even when you don’t start with a large one.)” But, he says, numerous studies show that when humans try to tinker with statistical forecasting models, they end up hurting their results — whether it be in investing or other fields. “In other words, investors might get the best performance from following simple stock screens to the letter, rather than using them as a short list to pick and choose from,” he says. “The extra intelligence brought to bear on the problem might actually hurt returns.”

Rothery points to data from top investor Joel Greenblatt that seems to confirm this. “Mr. Greenblatt … offers investors two types of accounts,” he says. “In one type, investors follow [Greenblatt's statistical stock-picking] method automatically. In the other, they start with his list and then pick individual stocks they want to buy.” Over a period of nearly three years from 2009-2012, the mechanical accounts produced total gains of 84% after expenses, handily beating the S&P 500′s 63% return. Those who picked and chose stocks from Greenblatt’s screens gained just 59%, however.

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Greenblatt Talks Market Valuation, Value Investing, and Much More

In a wide-ranging interview with the Columbia Business School’s Graham & Doddsville newsletter, hedge fund guru Joel Greenblatt says the stock market is in the “87th percentile towards cheap” right now, and discusses a myriad of aspects of his investment approach.

Greenblatt says that, using the market-cap-weighted free cash flow yield of the Russell 1000 as a gauge for cheapness, the market has been cheaper only 13% of the time over the past 23 years. When the market has been that cheap over those 23 years, the forward return for the Russell has been about 17% over the next year, and about twice that after two years. “That’s not to say that the market’s prospects are better or worse going forward — they’re probably a little below average for the forward period and therefore you could say that perhaps you won’t do quite as well as would be implied by historical returns,” he adds. “But, even in the 50th percentile, you would expect to make 8% or 9% based on the history of the last twenty-something years, so I would just say that if I had a choice between being more long or more short, I’d be more long. It’s a very attractive time to invest in the market, despite the run-ups that we’ve seen in the last year.”

Greenblatt also talks about value investing, portfolio size, and a variety of other issues. “My definition of value investing is figuring out what something is worth and paying a lot less for it,” he explains. “I make a guarantee the first day of class every year that if you’re good at valuing companies, the market will agree with you. I just don’t guarantee when. It could be a couple weeks or it could be two or three years. And the corollary is simply that, in the vast majority of cases, two or three years is enough time for the market to recognize the value that you see, if you’ve done good valuation work.”

He also says that the investing world has become more institutionalized in recent years, which actually helps the little guy. “If you’re an active manager, you may have a long-term horizon but your clients probably don’t,” he says. “So, most managers feel that they need to make money over the short term. Therefore, professionals systematically avoid companies that are perhaps not going to do as well in the short term. In some ways, there’s actually more opportunity in those areas now than ever before due to the greater institutionalization of the market.”

The institutionalization of the market, the emotional nature of investors, and “the fact that there are still lots of nooks and crannies out there that even successful hedge funds can’t pursue” mean that Greenblatt is “not concerned about the size of the existing opportunity set.”

Greenblatt Finding Value in Tech, Retail

Hedge fund guru Joel Greenblatt is finding value in the technology and retail sectors. Greenblatt tells CNBC that he’s high on tech firms like Apple and Microsoft, and retailers like Best Buy. He says some of the firms are facing headwinds, but that the headwinds are actually good, because they’ve lowered expectations and baked negative scenarios into the prices already. “If you put together a diversified portfolio of companies that are out of favor and they’re high free cash flow generating, and in good businesses — that’s very powerful over time,” he says.