Graham vs. Greenblatt (Session 5) Bringing it all Together

We made it to the final installment of our Graham vs. Greenblatt series. Throughout the series we examined each of the ratios that Greenblatt recommended in his book The Little Book that Beats the Market. The final posting will look at how Greenblatt draws the ratios together and bring this all back around, so lets get into it.

What is it?

Greenblatt says:

“It then assigns a rank to those companies, from 1 to 3,500, based on their return on capital. The company whose business had the highest return on capital would be assigned a rank of 1, and the company with the lowest return on capital (probably a company actually losing money) would receive a rank of 3,500...

Next, the formula follows the same procedure, but this time, the ranking is done using earnings yield...

Finally, the formula just combines the rankings.”

P53-54.The Little Book that Beats the Market

What does it tell us?

Greenblatt creates a simple formula, he takes a value component (Return on Capital) and a Investing component (Earnings Yield) he ranks all companies best to worst on both these criteria and then sums the two rankings. What this does essentially is value both components equally, ROC and Earnings.

So What Would Graham Think about these Rules?

• The Graham we see in The Intelligent Investor was all about buying value. When the value doesn't exist don't buy, sit on the sidelines. If one follows Greenblatt though you would buy in all conditions. Please note I am not making a comment about timing markets- merely that in an overpriced market Greenblatt would buy the cheapest of the expensive stocks while Graham would take the day off.
• Return on equity treated with equal significance as value measurements? Graham would not have thought too highly of this. Nothing should be as important as finding value.
  

Summary:

We have spent a considerable amount of time looking at Greenblatt from Graham's perspective. To conclude the series it is worthwhile to highlight some of the major points we raised in the series:

1. Graham believed in finding the true value of companies. Where Greenblatt uses Market Capitalization in his key ratios Graham would have cringed. Market Capitalization puts a value on the company based on what the market thinks; not what the company is intrinsically worth.
   
2. Graham wanted to look at companies over the long haul. His ratios pulled 5yr and 20yr data to get a picture of the company. Greenblatt on the other hand looked at the company today.
3. Graham was happy to sit on his wallet if the time wasn't right. If the value didn't exist walk away. Greenblatt on the other hand was prepared to buy on any given day.
   

Final Thoughts:

Greenblatt has a creative investment system with proven results. There can be no doubt it is a value based system, but he is far less strict than Graham's. Personally I think there is merit in the way that Greenblatt looks at investment opportunities. Bringing in an understanding of Return on Capital is a welcome addition to the value perspective, to hold it in the same high regard as Greenblatt though may be a mistake.


If you missed any of the earlier series please have a look at the earlier parts to the series:
Part 1 Graham vs. Greenblatt (Session 1)
Part 2 Graham vs. Greenblatt (Session 2) Buy America Buy Big
Part 3 Graham vs. Greenblatt (Session 3) Return on Capital
Part 4 Graham vs. Greenblatt (Session 4) Buy some cheap earnings

Graham vs. Greenblatt (Session 4) Buy some cheap earnings

In our last post we looked at Greenblatt's use of Return on Capital as a means of identifying quality companies that know how to turn a small investment into a substantial return. In this posting we will look at his next criteria earnings yield.

What is it?

EBIT
enterprise value

What does it tell us?

EBIT is defined as Earning before Interest and Tax, as we discussed in the last posting that works out to the raw income flowing into the company.

Enterprise Value is defined as market capitalization - cash and cash equivalents + preferred stock + debt

Market Capitalization is defined as the current number of outstanding stock multiplied by the current stock price.

So on the denominator what you have is the total of what it would cost to buy the company. To elaborate, if you bought the company outright you would have to buy all of the outstanding stocks + preferred stock + pay off all the current debt and only then could you access the cash reserves in the business.

Taking that into account what the ratio gives us then is an equation where you look at what percentage of the earnings you are buying if you paid for the company outright.

An example: the company has 1M stock outstanding at a current price of $4, they have no cash on hand (or units easily converted to cash) they do not have any preferred stock, and they have $1M in debt. This gives you a market capitalization of:

$4 *1M (stock) - $0 (Cash) + $0 (Preferred stock) + $1M (Debt) = $5M
So to buy the company outright would cost you approximately $5M

If the company in question raises $.5M per year in outright earnings you have an earnings yield of .5/5 or .1 or 10%. To put it another way if you took the $5M out of our pocket and bought the company it would take you 10 years to get the $5M back in your pocket again- assuming you are able to take the raw earnings directly.

What Greenblatt has done then is selected an alternative to Price Earnings Ratio to find companies with value.

So What Would Graham Think about these Rules?

As we stated in a previous post I can't imagine Graham would have been wild about using equations with Market Capitalization. Market Capitalization is a measure of how the investing community values the stock, it is an emotional assessment and is not a valuation of the actual bricks and mortar company itself.
Same as the last posting he might also be frustrated by the fact that this is one period- a company can always leap up and have one great period and then plunge back- it is called regression back to mean and it happens.

Be sure to check the previous parts in this series:

Part 1 Graham vs. Greenblatt (Session 1)
Part 2 Graham vs. Greenblatt (Session 2) Buy America Buy Big
Part 3 Graham vs. Greenblatt (Session 3) Buy Some Cheap Earnings

Graham vs. Greenblatt (Session 3) Return on Capital

Greenblatt in his book The Little Book that Beats the Market advocated a simple method for attaining substantial stock returns. In this series we are looking at the particulars of this investing theory to both understand why he advocated the elements of this theory and what Benjamin Graham would have thought of the approach that Greenblatt was advocating. The next part in this series looks at Return on Capital or ROC.

What is it?

Earnings Before Interest and Tax (EBIT)
Net Working Capital + Net Fixed Assets

EBIT is a raw calculation of the regular company income excluding the income from irregular or non-reoccurring activities.

In the denominator Greenblatt doesn't use the traditional element of Enterprise Value. (Should he have we could have jumped all over him for using another equation that leverages Market Capitalization otherwise known as shareholder sentiment) Instead he uses:

Net Working Capital = Total Assets - Total Liabilities
Net Fixed Assets = Purchase Price of All fixed assets (Land, buildings, equipment, machinery, vehicles, leasehold improvements) - Accumulated Depreciation

What Does it Tell Us?

By taking EBIT and putting it over Capital + Fixed Assets you have an earnings formula. You are saying what does it cost to run this money making machine? Let me explain.

Consider any company to be a money making factories- as essentially that is what we, as investors, hope it will be. If the company bought one machine that costs $100M (Net Fixed Asset), they own the machine outright and require no other assets (Net Working Capital) and the machine creates 10 $1M bills per year (EBIT) then you have:
$10M/ ($100M-$0) or return on capital of 10%. Or it put it another way for every dollar invested into the core of the company $.10 are generated in raw earnings.

The higher the number the better the return the company gets from buying the money making machine. A company therefore that has the same machine but is only capable of producing 1 $1M bill is therefore a less appealing investment.

So What Would Graham Think about this Rule?

Graham would have seen the value of understanding the return on capital. One can imagine though that the most recent return on capital would not suffice for Graham. He wanted a company with a past. There are always flash in the pan companies that have a phenomenal return on capital for one year. Just look at the company that makes croks if you need an example, for the year they were popular they had a fabulous ROC but the year before and the year after showed dismal results. One can imagine Graham would have thought that a year was simply not long enough. True, Graham believed in P/E ratio which can be accused of the same shortcomings, but he complimented that with an insistence that the company also possess

“Some earnings for the common stock in each of the past ten years.”

P348 The Intelligent Investor

This would mitigate some of the flash in the pan potential.

Be sure to check the previous parts in this series:

Part 1 Graham vs. Greenblatt (Session 1)
Part 2 Graham vs. Greenblatt (Session 2) Buy America Buy Big