How does one select a good stock? One way to make a good selection is to track successful investors, but are their methods relevant for amateurs? We test the advice of some investment gurus and analyse whether it works for you.
Let us consider "the magic formula" of Joel Greenblatt. In The Little Book that Beats the Market, Greenblatt talks of a simple way to beat the market using only two fundamental variables - return on capital (RoC) and earnings yield (EY).
RoC measures the money a company makes with its assets and is calculated by dividing the firm's net earnings by its total assets. But Greenblatt derives it by dividing the profit before interest and tax (PBIT) by the tangible capital employed. He uses PBIT to avoid distortions related to variance in capital structures and tax rates. The tangible capital employed is taken as it is a better measure of the capital required to run a business than the total assets.
EY is calculated by taking the inverse price-earnings, or P-E, ratio, but Greenblatt does so by dividing PBIT by the enterprise value (EV). EV gives the cost of acquiring a business and is derived by adding the market value of equity and that of debt. Inverse P-E ratio isn't used as it does not account for the debt component.
The companies are separately ranked by descending order of RoC and EY. The two rankings are combined and those with the lowest ranks are the superior stocks. But, according to Greenblatt, it does not apply to small-cap stocks, financial companies and utilities, owing to the difference in their capital structures compared with other firms.
To test the formula, we used 2008-09 figures to select firms and compared their performance with the BSE-200 between March 31, 2009, and June 30, 2010. The companies with a market capitalisation of over Rs 1,000 crore and a positive PBIT, EV and tangible capital employed were chosen. After removing utilities and financial companies (excluding banks), we had 561 firms. On comparing their performances with BSE-200, we found that 69 of the firms had outperformed the index.
We selected the top 20 companies on the basis of the combined rank and found that the portfolio had an annualised return of 161 per cent against the 72.1 per cent by the index, and none of the companies had lost money. The formula seemed to be working. For a robust study, we repeated the exercise for 2007-08, comparing the portfolio performance with that of the index between March 2008 and June 2010. The annualised return was 22.3 per cent while the index's was seven per cent. Three stocks lost money and 17 profited.
So Greenblatt's strategy does work well for long-term investors (the holding period should last at least a year). As the guru asserts, the formula may not help beat the market every year, but it does unfold its magic over a longer duration.