Anyone with more than a passing interest in value investing should have heard of Joel Greenblatt. He's the manager of renowned hedge fund Gotham Capital and creator of the so-called "magic formula". It's an approach that's made him one of the world's most respected value investors, beating the market year in, year out for decades. But it's no black art. Like most good conjuring tricks, the basis of the magic formula is a very simple one. And all investors can put it to good use.
Conventional thinking says that if you want the best, you usually have to pay more. This is typically true in the stock market, as it is in every other walk of life. Shares in efficient companies ought to cost more than shares in less efficient ones – at least in theory. But real-life experience shows that it’s not always as simple as that. Maybe we can invest in high-quality companies without paying through the nose - and achieve better returns by doing so.
Identifying efficient companies that use their assets well but still come at a reasonable price is what the Greenblatt formula is all about. It defines the efficiency of a company in terms of its return on capital: the higher the return on capital, the more efficient the company. As a measure of cheapness, Greenblatt uses the earnings yield, which is a company's operating profit expressed as a percentage of the total value of its stock-market valuation and debt. The higher this earnings yield, the cheaper the company is deemed to be.
Greenblatt back-tested his formula on the US stock market for the period between 1988 and 2004. He found that the average return of a portfolio of 30 stocks meeting his criteria was approximately 30.8 per cent per year. During those same 17 years, the overall US market averaged a return of only 12.3 per cent. But can the formula work for the UK stock market today?
Andrew Lapthorne and Georgios Oikonomou at investment bank Société Générale (SG) have built a database of the Greenblatt strategy's performance from December 2005 to August 2012. An initial investment of £10,000 in the FTSE All-Share index would have grown to £13,645 by the end of that period, including reinvested dividends. By contrast, the same holding invested in UK 'Greenblatt' stocks would have increased to £17,506.
While clearly superior for the period as a whole, Greenblatt didn't have the upper hand at every moment. In particular, the strategy markedly underperformed UK equities during much of the savage bear market from July 2007 to December 2008. This seemed a bit odd to us. After all, if the Greenblatt formula identifies higher-quality companies, surely they should do better during times of stress?
As a result, we decide to run a few tests in order to find out what the real drivers of UK 'Greenblatt' stocks have been. In order to do this, we looked at the performance of SG’s UK Greenblatt index relative to the FTSE All-Share index, alongside various distinct investment styles, including 'value' and 'growth', 'cyclicals' and 'defensives' and large-cap versus mid-cap.
Given that Greenblatt involves looking for shares with a high earnings yield, we thought that this strategy might move in line with value shares more generally. During the 2007-08 equity market slump, Greenblatt's performance versus the rest of the UK market was similar to that of value versus growth stocks. Thereafter, though, Greenblatt's relative showing improved, whereas that of value took much longer to pick up.
We then examined whether Greenblatt stocks had a relationship with 'cyclical' or economically sensitive stocks. To do this, we looked at Greenblatt's relative performance to the UK market and compared it with that of cyclicals versus defensives. This time, there appeared to be a positive relationship. Greenblatt beat the market at the same time as cyclicals beat defensives. The correlation between the two was 0.5, the most positive relationship being 1 and the most negative being -1.
Gem Diamonds has an earnings yield of 6 per cent (see our Greenblatt portfolio below).
Our next question was to what extent UK Greenblatt stocks' performance is a result of the size of the companies involved. So, we tested the Greenblatt relative performance against the wider UK market versus that of mid-caps versus large caps. What we found was that Greenblatt tended to beat the All-Share index at the same time that the mid-caps of the FTSE 250 index were beating the giants of the FTSE 100. The correlation between the two series was a very strong 0.8.
What might lead the Greenblatt strategy to flourish or flounder in the months ahead? The most obvious answer is the monetary onslaught from the world's main central banks. America's Federal Reserve, the European Central Bank and the Bank of Japan are all engaged in or set to engage in aggressive quantitative easing (QE) or 'money printing' programmes.
The experience of previous episodes of QE suggests this could have a big impact on financial markets, causing certain types of share to do much better than others. Cyclical and mid-cap shares - with which Greenblatt stocks are correlated - are particularly likely beneficiaries of QE. UK Greenblatt stocks also did very well during those earlier rounds of QE.
Still, we should also consider reasons why Greenblatt might not do well in the coming period. One possibility is that all the money flooding into the markets from the central banks fails to do the trick, and stocks suffer another 2008 or 2011 style bear market.
Like any other strategy, it does throw up individual duds from time to time. A prominent example was the 2008 case of Crocs, the maker of the ubiquitous rubber shoes. The stock scored highly on Greenblatt characteristics, but then dropped by a sickening 94 per cent over the following 12 months.
It also doesn't account for companies with looming financial issues. In 2008, the screen picked Idearc (IAR), a phone book publisher, at about $10. The screening didn't guard against Idearc's massive debt and declining sales, and the company went bankrupt the next year. If planning on adopting Greenblatt's strategy, it's important to stick with it for the long term. Strictly keeping to Greenblatt's criteria would mean purchasing the recommended basket of 20 to 30 stocks every year for 17 years. This type of long-term investing in large baskets of stock isn’t realistic in bull and bear markets, where other strategies that deliver sexier stocks with quicker results are far more appealing. For the majority, it's just no fun.
OUR GREENBLATT PORTFOLIO
We've taken the formula and applied it to the FTSE All-Share in order to come up with our own 'Greenblatt' portfolio. To recap, this involves identifying shares that combine a high return on capital with a high earnings yield. We followed some of Greenblatt's other rules, namely excluding companies with a market value of less than £50m and also those from the financial and utilities sectors. We therefore ranked all qualifying companies in the All-Share index by their latest return on capital and earnings yields. To ensure a reasonable spread of different companies, we decided to include no more than one from each industry group.
1. Ferrexpo (FXPO)
A nasty combination of falling iron ore prices and rising costs has shafted this Ukraine-focused mining group of late, causing its share price to crumble by more than 50 per cent in the past 12 months. Despite the challenges facing its business, however, Ferrexpo exploits its assets well. Its return on capital of 30.3 per cent was the highest in our portfolio of the top 10 Greenblatt shares. It also looks reasonably financially robust, with a fairly modest ratio of debt to equity.
2. Gem Diamonds (GEMD)
Natural resources companies were heavily represented in the initial results of our Greenblatt screen. Six of the raw top 10 firms make a living by digging stuff out of the ground. Gem Diamonds was the pick of the bunch, although it has not had such shining results of late. A fall in diamond prices has caused the diamond mining company's cash profits to slump 42 per cent year on year. Still, the company possesses a healthy balance sheet and a not-so-shabby earnings yield of 6 per cent.
3. RM (RM.)
This supplier of educational products and services has undergone some costly corporate alterations. The sale of loss-making non-core operations boosted the operating profit, but this was virtually washed out by costly exceptional items - not to mention the governmental cuts in education spending, which resulted in a halving of the dividend. The now leaner company shows a 5.4 per cent earnings yield and a reasonable 20.1 per cent return on capital.
4. CPP (CPP)
It's been a bad year for identity theft and credit card insurer CPP. Falling profits, compensation payouts and a costly investigation by the Financial Services Authority threw the company into turmoil. But, as Greenblatt warns, the formula often picks "unattractive" companies. CPP measures up well on Greenblatt metrics, however, with the highest earnings yield in our portfolio at 9 per cent.
5. AstraZeneca (AZN)
Like many of the giants of the pharmaceuticals industry, AstraZeneca is struggling to develop new star products to replace its existing blockbuster drugs whose patents are expiring. Still, a tie-up with US rival Pfizer to market a new heartburn treatment, Nexium, should provide a measure of relief to this colossus of the UK healthcare industry. This over-the-counter product is set to sell globally, bringing in welcome royalties. And the dividend yield of 6 per cent offers clear attractions.
6. EnQuest (ENQ)
While production at EnQuest's North Sea oil facilities has fallen of late, that is set to change. It is currently working towards development at the Kraken field, a discovery off Shetland. By 2014, the company could be pumping 33,000 barrels a day, up from between 20,000 and 24,000 barrels this year. And Enquest's financial position is comfortable, too, with both net cash and borrowing facilities at its disposal.
Topps Tiles is dealing constructively with its problems.
7. Topps Tiles (TPT)
More than a few cracks have appeared in Topps Tiles' business in recent times. Fewer customers have frequented its stores due to the tough economic climate. Since 2007, Britons have pared back their spending on home improvement. However, Topps is responding constructively, trying to persuade higher-end customers to trade down to its mid-market products. The company is even looking to open more stores, while many other retailers are reducing their physical presence.
8. Anglo Eastern Plantations (AEP)
Despite selling more palm oil of late, this producer has suffered declining profits on the back of lower prices. However, the outlook really isn't all that bad. The El Niño weather phenomenon is set to lower south-east Asian palm-oil production, which should feed through into higher pricing. A cash-rich balance sheet and low earnings multiple provide a measure of financial security, too.
9. Premier Farnell (PFL)
Both sales and profit margins are getting squeezed at next-day electronics delivery firm Premier Farnell. The company has had to turn to price-cutting to hang on to its share of the market, and first-half pre-tax profits fell by more than half. For future growth, it is looking partly to emerging markets such as Taiwan and Thailand. Besides capital efficiency, Premier Farnell also offers a dividend yield of 5.7 per cent.
10. Smiths News (NWS)
Magazine and newspaper distribution is a tough business, given waning demand for print products and a highly consolidated market. Despite shrinking revenues from these operations, Smiths News is reinventing itself in educational publishing, a growth area. And the company is trying to make efficiency savings on the traditional side of its business. The 6 per cent dividend yield is attractive, too.
