How does one select a good stock? This deceptively simple question has probably consumed more mindspace and solicited more advice than any other. Yet, the road to a winning stock is fraught with lame strategies. One way to make a good selection is to track successful investors, but are their modi operandi effective for amateurs?
Money Today will test the advice of popular investment gurus to check whether these work for you. In the first part of this series, we consider Joel Greenblatt, whose strategy is enticingly titled the 'magic formula'. 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. Earnings yield is calculated by taking the inverse PE 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 PE ratio isn't used as it does not account for the debt component.
The companies are separately ranked in the 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 2008-9 figures to select firms and compared their performance with the BSE-200 between 31 March 2009 and 30 June 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 firms on the basis of the combined rank and found that the portfolio had an annualised return of 161% against the 72.1% by the index, and none of the firms had lost money.
The formula seemed to be working. For a robust study, we repeated the exercise for 2007-8, comparing the portfolio performance with that of the index between March 2008 and June 2010. The annualised return was 22.3% while the index's was 7%. Three stocks lost money and 17 profited. We also applied the formula to 2009-10, though it's a short-run evaluation of the portfolio.
Its performance between March 2010 and June 2010 revealed that seven stocks had lost money, while 13 had gained. The portfolio returned 12.3%, while the index gave only 2.2%. 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.
