I must admit to feelings of mild depression after writing last month’s article. In it, I described a new reality in which active managers are finding it increasingly difficult to match, let alone beat, average stock market returns (after fees are taken into account). Low-priced index funds have no such problem, however, leading in recent years to a steady flight of capital from managed funds to index funds.
The same problem exists for individual investors. All we want to do is buy shares in good companies at below their ’fair’ or true values. The quest for these shares spurs us on, and finding them is emotionally satisfying and financially rewarding. So what has changed to make this task so difficult?
The new investment landscape
Firstly, 95% of stock market trading is now carried out by large institutions. This means that the fair values of companies traded on the world’s stock exchanges are now calculated by the armies of smart, well-educated employees of a multitude of financial institutions. They use a common toolbox of techniques provided by business schools and professional bodies, and they employ super-fast computers, big data and smart algorithms.
Their goal is to estimate the future earnings of companies, the rate of return required by shareholders, and the riskiness of those future earnings. They ’mine’ massive quantities of historical data in a search for the drivers of value, and use scenario planning and the forecasts of the companies themselves to extrapolate their findings into the future.
So if a good company is found to be trading slightly below its fair value, these institutions act fast and snap up the shares, driving up the price and quickly eliminating any perceived benefit. The world is now their stage, so that no stock market escapes the attention of this new generation of financial techno-sleuths. ’Beating the market’ or earning a risk-adjusted return on invested funds, which exceeds the weighted-average return of the market as a whole, has now become nigh on impossible.
Factor in the management fees charged by active fund managers, and it’s easy to see why returns sink below market averages. In this world, cheap index or tracker funds that match market returns are increasingly becoming the go-to option for investors, and the 5% of individual investors have had the fun sucked out of their lives - bargains have become the stuff of history, snuffed out by the techno-nerds of our globalised markets.
It is this gloomy scenario that lowered my spirits last month. Is successful stock-picking by individual investors really a thing of the past, I asked myself? Should the 5% of non-professional investors finally admit defeat, throw in the towel and set up a monthly debit order in favour of a cheap tracker fund? Or is there some way in which the amateur investor can still beat the market with clever stock picks?
Light at the end of the tunnel?
It was while pondering this question that I came across a New York Times bestseller that had somehow escaped my attention. Described as one of the classics of investment literature, it first saw the light of day in 2005. So not much time in which to achieve ’classic’ status - this had to be a case of excessive hype, or perhaps the last glimmer of hope for the ordinary investor. The book, by Joel Greenblatt, is entitled ’The Little Book that Beats the Market,’ and was followed five years later by an updated version, now named ’The Little Book that (Still) Beats the Market.’
A bit of research into Greenblatt’s background further piqued my interest. He founded the investment firm Gotham Capital back in 1985, and over the next twenty years proceeded to earn investors an average annual return of 40%. Greenblatt is also a part-time professor at Columbia Business School, where he teaches a popular practical investment course. As part of the course he presents students with a simple formula for compiling a market-beating share portfolio, a formula which succeeds despite all of the clever analysts and smart technology employed by the professionals.
To understand how this might be possible, join me as we eavesdrop on the first class taught each year by Prof Greenblatt. As he faces his class of Ivy League students, he holds up a newspaper and opens it to the financial pages. He then invites his student to call out the names of any of America’s well-known and successful companies. IBM, General Motors and many other household names are shouted out.
The good professor then chooses one of them, and reads out the previous day’s closing share price, as well as the highest and lowest price at which the company has traded over the past twelve months. Invariably there is a significant difference between the three prices. How can this be, asks Prof Greenblatt? How can the share prices of these great companies change so much in such a short space of time?
We’ll pause at this point to ponder the message that Greenblatt is trying to convey. What should strike his students, and us, is the fact that the share prices of most traded companies move around significantly during a year (and even more so if we extend the period to, say, three years). And this is the case, even though the true value of these companies can’t have changed by much. So by implication, at some time during a year or a slightly longer period, we should be able to buy the shares of good companies at below their fair values!
After the first surge of euphoria, I’m sure the same thing occurred to you as it did to me. Even if this is true, how do we know what the fair value of a company is? This is based on expectations of future earnings and so on, so aren’t we back at square one?
Not according to Greenblatt. What we can know, in the first instance, is the actual earnings yield of any chosen company. This is the actual bottom-line earnings per share, expressed as a percentage of the share price. And of course, at different share prices the same earnings per share will provide different yields. We can calculate earnings per share from the latest published income statement of the company, and obtain share prices from online websites such as Sharenet. So step one is not difficult.
Step two is to determine our required yield. Greenblatt suggests we take the yield on a ten-year government bond as a starting point (being the nearest thing to a risk-free rate there is), and add a premium to account for risk. As inflation expectations will be built into the bond rate, we just need to add a percentage that would make us happy (and that is not excessively greedy). If we then take the earnings per share and divide this by our required yield (expressed as a decimal fraction), this will give us the share price at which we should buy. So if earnings per share are R5 and our required earnings yield is 20%, the share price at which we would look to buy would be R5/0.20 = R25.00
Is that all?
Not quite. As Goldblatt goes on to explain, we want to make sure that the company we invest in is a good company. And good companies tend to earn better returns on invested capital than do bad companies. This may be because they have strong brands, good management, a competitive advantage in their markets, or any number of other reasons.
To do the calculation, we need to refer back to the latest financial statements of our chosen company. From the income statement we need to determine the bottom-line earnings, and we need to divide this by value of the net assets owned by the company (i.e. purchased with its invested capital, and calculated as Total Non-Current Assets plus Net Current Assets). These figures can be obtained from the company’s balance sheet. Net income divided by Assets and multiplied by 100, gives us the percentage return on capital.
The magic formula
Amazing as it may sound, these two simple calculations provide a ’magic formula’ for selecting a winning portfolio. Lets’ see how Greenblatt did it, and what results he achieved by applying the formula.
Starting in 1988, Greenblatt ranked some 3,500 US stocks on the basis of their earnings yields and returns on assets. So if a company had the tenth best EY and the 100th best ROA, it obtained a score of 10 + 100 = 110. If it was 1 000th on the list in terms of EY and 1 500th in terms of ROA, its score was 2 500. So by selecting the 30 companies with the lowest total scores, Greenblatt was satisfied that he had chosen the 30 ’best’ companies as ranked by the magic formula.
Between 1988 and 2005, Greenblatt’s portfolio earned an average annualised return of 30,8%. By comparison, the market earned a return of 12,3% and the S&P 500 a return of 12,4%.
So what is the catch?
Greenblatt’s portfolio did not beat the market in every year, and sometimes it fails to beat the market for two successive years. But over every three-year period measured, his selected portfolio comfortably exceeded the market return.
Greenblatt explains this by pointing out that ’Mr Market’ often gets share prices wrong, in that the price quoted may be below the fair value of the company. At these times, the share will underperform the market. But for good companies, within three years at most Mr Market comes to his senses and values these companies correctly, with a resultant improvement in returns for anyone who has bought below fair value (i.e. all magic formula users).
And it gets better...
Sometimes, company earnings in the most recent year do not represent a norm, and may be depressed by certain one-off events or circumstances. In these cases, Goldblatt suggests that earnings be ’normalised’ by referring to a few years’ history, and that this normalised figure be used in the magic formula calculations. By selecting a portfolio on this basis, Goldblatt’s firm has achieved the annualised returns of around 40% mentioned earlier.
Despite the march of technology, share prices are driven by irrational moods and subjective assessments of future performance. As a result, there are always likely to be times when good companies trade at levels below their fair value. By using Greenblatt’s magic formula, individual investors may therefore still be able to beat the professionals at their own game.
Please be aware that my brief introduction has not done justice to Joel Greenblatt’s very good book. Equally importantly, actual calculations of the magic formula, per Prof Greenblatt, also differ slightly from my illustrated examples, and are explained very well in the book.
If you are a disillusioned investor struggling to earn decent returns, I would heartily recommend Joel Greenblatt’s little book. It is entertaining and informative, and to my mind deserves the ’classic’ tag appended by the media. So buy it and apply it, and prove to yourself that you, too, can still beat the market!
Reference: The Little Book that Still Beats the Market, by Joel Greenblatt. Published by John Wiley and Sons, Inc., 2010.
AJ is an academic and a freelance financial journalist who has written for Sharenet for some 15 years. He spent 25 years as an accountant and financial manager in various South African companies before moving into academia. He has a broad range of interests, including all aspects of business and stock market investing. Apart from a bachelor’s degree in Accounting, AJ holds a Master’s degree in Financial Management. He is also a Fellow of the Chartered Institute of Management Accountants.