We made it to the final installment of our Graham vs. Greenblatt series. Throughout the series we examined each of the ratios that Greenblatt recommended in his book The Little Book that Beats the Market. The final posting will look at how Greenblatt draws the ratios together and bring this all back around, so lets get into it.
What is it?
“It then assigns a rank to those companies, from 1 to 3,500, based on their return on capital. The company whose business had the highest return on capital would be assigned a rank of 1, and the company with the lowest return on capital (probably a company actually losing money) would receive a rank of 3,500…
Next, the formula follows the same procedure, but this time, the ranking is done using earnings yield…
Finally, the formula just combines the rankings.”
What does it tell us?
Greenblatt creates a simple formula, he takes a value component (Return on Capital) and a Investing component (Earnings Yield) he ranks all companies best to worst on both these criteria and then sums the two rankings. What this does essentially is value both components equally, ROC and Earnings.
So What Would Graham Think about these Rules?
- The Graham we see in The Intelligent Investor was all about buying value. When the value doesn’t exist don’t buy, sit on the sidelines. If one follows Greenblatt though you would buy in all conditions. Please note I am not making a comment about timing markets- merely that in an overpriced market Greenblatt would buy the cheapest of the expensive stocks while Graham would take the day off.
- Return on equity treated with equal significance as value measurements? Graham would not have thought too highly of this. Nothing should be as important as finding value.
We have spent a considerable amount of time looking at Greenblatt from Graham’s perspective. To conclude the series it is worthwhile to highlight some of the major points we raised in the series:
- Graham believed in finding the true value of companies. Where Greenblatt uses Market Capitalization in his key ratios Graham would have cringed. Market Capitalization puts a value on the company based on what the market thinks; not what the company is intrinsically worth.
- Graham wanted to look at companies over the long haul. His ratios pulled 5yr and 20yr data to get a picture of the company. Greenblatt on the other hand looked at the company today.
- Graham was happy to sit on his wallet if the time wasn’t right. If the value didn’t exist walk away. Greenblatt on the other hand was prepared to buy on any given day.
Greenblatt has a creative investment system with proven results. There can be no doubt it is a value based system, but he is far less strict than Graham’s. Personally I think there is merit in the way that Greenblatt looks at investment opportunities. Bringing in an understanding of Return on Capital is a welcome addition to the value perspective, to hold it in the same high regard as Greenblatt though may be a mistake.
If you missed any of the earlier series please have a look at the earlier parts to the series:
Part 1 Graham vs. Greenblatt (Session 1)
Part 2 Graham vs. Greenblatt (Session 2) Buy America Buy Big
Part 3 Graham vs. Greenblatt (Session 3) Return on Capital
Part 4 Graham vs. Greenblatt (Session 4) Buy some cheap earnings