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Borrowing key principles from legendary investors Benjamin Graham (buy companies that are cheap) and Warren Buffett (buy companies that are cheap and good), New York-based Gotham Capita l has devised a fundamental value strategy that targets investing in companies with above average returns on capital at times when the shares are undervalued by the market.
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The logic behind the Gotham strategy is simple. First, it is desirable to invest in businesses that earn more rather than less relative to the prices paid for their shares. Therefore, a higher earnings yield is preferable to a lower one. Second, buying shares of more profitable companies is better than buying shares of less profitable companies. Therefore, companies that earn high returns on capital employed are better than those that earn low returns on capital employed. Over time, these undervalued shares should "tend towards the mean" and go up in price as their value is recognised by the market.
The Gotham two-factor value model can be applied to a wide range of industry sectors, although not to financials, property, insurance and utilities. The selection process ranks companies based on two parameters: 1) earnings yield and 2) return on capital, and Gotham includes the top 25 to 45 shares in its indices.
Gotham requires companies for ranking to have market capitalisations of at least $1bn (£665m) or to be among the top 1,000 companies by market capitalisation. Second, a minimum daily trading value of $250m must have been recorded over each of the previous three months, or the share must be among the 1,000 most liquid shares in the market. Finally, there can be no more than four companies from the same industry group in any one index.
Methodology
The methodology involves ranking all companies by earnings yield and return on capital and then identifying the companies with the best combined rank of both parameters. First, the shares are ranked by earnings yield and the company with the highest earnings yield is assigned the top ranking of "1", the company with the second highest yield is assigned "2", and so on. Second, the shares are ranked by return on capital employed, with the top-ranking company again being assigned "1", the second highest "2", and so on.
Finally, the two rankings for each company are added together to give a combined ranking. The company with the lowest (ie best) combined score is ranked "1", the company with the second lowest combined score is ranked "2", and so on. The ranking process is carried out quarterly and each share is given equal weighting in the index.
"It's a simple idea," says Gotham's managing partner Joel Greenblatt, "but it can be difficult to follow." He explains that this is a long-term strategy that strives to identify what is available now that is cheap and good; the strategy can be regarded as almost the opposite of momentum investing.
The indices have not worked every year, although simulated past performance shows that the Gotham US Enhanced Value Index would have returned on average 20 per cent a year from August 1999 to August 2009, against 8 per cent for the Berkshire Hathaway Index and a 1 per cent less per year over that period for the S&P 500.
Investing in Gotham indices
For investors who like the Gotham principles but don't want to undertake the rankings themselves, Royal Bank of Scotland has partnered with Gotham Capital to launch a series of funds that will track the Gotham value indices. The first will be the US Enhanced Value Index, which will invest in US shares only and is expected to be available in listed (similar to ETFs) and unlisted form. The fund is expected to launch in April, although it's possible to invest in the meantime through RBS tracker certificates. We've included a table of the top 10 constituents of the index below.
More esoteric investments based on the Gotham indices will also be available, such as the Gotham Alpha US Strategy, which invests long on the US Enhanced Value Index and short on the S&P 500. And RBS also plans to launch the Global Enhanced Index, which will provide exposure to the Americas, Europe, Asia and Australia in equal geographical weighting, and the International Enhanced Index, which will invest in worldwide shares outside the US. The minimum investment will be £100, and details will appear at www.rbs.co.uk/markets.
Gotham's superheroes
| NAME | Ticker | Sector | Price ($) | Market Capitalisation ($m) | Last 12m change (%) | Forecast PE (x) |
|---|---|---|---|---|---|---|
| PFIZER | U:PFE | Pharm. & Biotech | 17.48 | 141070 | 38.0 | 8.0 |
| LOCKHEED MARTIN | U:LMT | Aerospace & Defense | 81.27 | 30376 | 35.7 | 10.9 |
| ACCENTURE | U:ACN | Support Services | 41.18 | 26043 | 48.6 | 15.1 |
| RAYTHEON 'B' | U:RTN | Aerospace & Defense | 57.11 | 21649 | 59.6 | 11.5 |
| NATIONAL OILWELL VARCO | U:NOV | Oil Equip. & Services | 43.66 | 18270 | 77.3 | 13.5 |
| VIACOM 'B' | U:VIAB | Media | 30.34 | 16838 | 124.7 | 11.1 |
| REYNOLDS AMERICAN | U:RAI | Tobacco | 54.74 | 15953 | 66.1 | 11.2 |
| LORILLARD | U:LO | Tobacco | 75.5 | 11688 | 31.9 | 11.9 |
| FLUOR | U:FLR | Construct. & Material | 44.65 | 7983 | 44.4 | 15.0 |
| MCGRAW-HILL | U:MHP | Media | 35.28 | 11138 | 97.2 | 13.4 |
Source: RBS/Thomson Financial Datastream
Earnings yield
Earnings yield is defined as the ratio of earnings before interest and tax (EBIT) to enterprise value and is calculated as follows:
Earnings yield = EBIT / (Market value of equity* + Net interest-bearing debt)
*Includes preferred equity.
EBIT is used rather than the more standard price/earnings ratio to prevent distortions from comparing companies with different gearing levels, and thus different levels of interest payments, and companies located in different tax jurisdictions.
Return on capital
Return on capital is defined as the ratio of pre-tax operating earnings to tangible capital employed (excluding intangible assets such as goodwill) and is calculated as follows:
Return on capital = EBIT / (Net working capital + Net fixed assets)
EBIT is again used in place of recorded earnings to create a level playing field across companies that have different levels of debt, and therefore interest payments, and which operate under different tax regimes.
Net working capital and net fixed assets are combined to give "tangible capital employed" - an estimate of how much capital a company is actually using to carry out its business.
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More information on how to put this strategy into action can be found in Gotham partner Joel Greenblatt's The Little Book That Beats the Market, which you can buy from the IC Bookshop here.
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