Graham passed away in September 21, 1976 well before Joel Greenblatt graduated from Wharton in 1979 but a linkage between the two men’s investment theories is not difficult to find. Greenblatt during his time at Wharton went to great lengths to study the value approach that Graham had devised (there are stories that Greenblatt entered vast amounts of stock data by hand into a mainframe and then ran tests on it using Graham’s system). He saw the benefit that could be returned from purchasing companies that were inexpensive.
Greenblatt struggled with Graham’s rules- like so many professional investors do. If you stick to Graham’s rules you make no estimation on the future and deal only with the past, you want strong companies with strong histories that are currently cheap. But if you do this you have two problems as a broker or hedge fund manager:
- You don’t buy much as there are few opportunities.
- Besides the research you are doing on the companies what value do you create for your investors? Brokers and Hedge Managers are forced by investors to be crystal ball readers- they have to see tomorrow, not yesterday.
To be successful Greenblatt devised an alternative system. Find companies that are inexpensive like Graham, but also have a great rate of return meaning they can turn around sizable profits with little investment. This high return on investment (ROC) would intuitively seem to indicate that the company will have a good future: as investment increases the return should logically jump higher. Should the ROC decrease then it was already pretty high to begin with so there is still safety in the position.
- Establish a minimum market capitalization (greater than $50 million is recommended).
- Exclude utility and financial stocks and any foreign companies (Non US).
- Determine company’s earnings yield = EBIT / enterprise value.
- Determine company’s return on capital = EBIT / (Net fixed assets + working capital)
- Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital.
- Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over a 12-month period.
In the coming short series we will break down each of these criteria and compare it back to Graham’s technique to see how they are similar and how they differ.