Joel Greenblatt is a modern value investor, his approach as we outlined in our previous post was to find value companies like Graham, but he also wanted a company that has potential for the future. The first set of criteria looks very similar to Graham.
What is it?
- Establish a minimum market capitalization (greater than $50 million is recommended).
- Exclude utility and financial stocks and any foreign companies (Non US).
What does it tell us?
“small capitalization stocks did not appreciably outperform large caps”
“for larger stocks (market caps over $1 billion) the results for the magic formula remain incredibly robust”
So basically go big because it works.
Greenblatt excluded Non US companies. The conclusion is based around the fact that some countries have loose regulations around investing. Greenblatt also seems to argue that there is no need to take on the additional risk if there are a sufficient number of American companies to invest in.
The final rule of excluding financial and utility companies is a bit confusing and is only addressed in a footnote:
“Utilities, financial stocks and companies where we could not be certain that the information in the database was timely or complete were eliminated.”
So What Would Graham Think about these Rules?
- Graham would have scratched his head a bit about the market capitalization. Market Capitalization is large as a result of investor consensus and is not tied to any true financial element of the company. Terrible companies can have a huge market capitalization, just look at the dot com bubble companies if you need examples. The way Greenblatt seems to say he used it because it works for his system would probably also cause some concern to Graham. If a consistent element for success was that the company had a ‘G’ in its name would Greenblatt have used this? I think we can temper this point though due to the manner that the book is presented- it is not intended to be a financial study it is intended for the junior investor.
- Excluding foreign companies would not have been a point too difficult for Graham to understand. He recommends against some foreign endeavors:
“But we do know that, if and when trouble should come, the owner of foreign obligations has no legal or other means of enforcing his claim.”P. 138 The Intelligent Investor.
The avoidance of utility and financial companies based on the reasoning presented would be a bit surprising for Graham though as he often recommended such endeavors.
Hope you enjoyed part two of the series. Drop me a line with your thoughts or questions and stay tuned for the next session where we will look further at some of the other criteria that Greenblatt put forward.
Be sure to check the previous parts in this series: