The lineup of speakers included Seth Klarman of Baupost Group, Jim Chanos of Kynikos Associates, Bill Ackman of Pershing Square, David Einhorn of Greenlight Capital, Richard Pzena of Pzena Investment Management and my personal favorite — Joel Greenblatt of the famed Gotham Capital.

Greenblatt — a Harvard Business School graduate — founded Gotham Capital in 1985. He started with $7 million of outside capital — mostly from junk bond king Michael Milken. Over the next decade, he earned 50% a year — compounded. Even after paying back all of the original seed capital and factoring out expenses, Greenblatt grew his $7 million stake to over $350 million. Unbelievable!

A mere $1,000 investment was worth $57,665 in 1995. A $10,000 investment was worth more than a half a million dollars.

With returns like that you can see why I was so excited to listen to Greenblatt speak last week. The man is one of the best investors of all time. If there were a hall of fame for money managers, he would be in it — right next to Graham, Buffett and Templeton. No questions asked.

So when the famed Gotham-found manager said he had a simple two-part investment formula that could deliver far greater returns that the rest of the market — I listened. And now, I’d like to share it with you.

Joel Greenblatt: Solid Companies, Bargain Prices

Greenblatt’s formula is predicated on the idea that you should only buy solid companies for bargain prices. Sounds easy, right?

If it were, every one of us would be making as much money as Greenblatt. Unfortunately, it’s not that easy. Your average investor has no idea what it means to be a “good company.” He has no idea how to determine if a company is selling for a bargain price. In fact, he doesn’t even know where to look to find such companies.

Well, if you are one of those “clueless” investors, fear no longer. Greenblatt’s formula can help. Here’s how it works…

The first part of his formula insists that companies trade for a bargain price relative to earnings power (or yield). The idea is simple. If a company can’t earn more than 6% a year — the amount you can get from a no-risk, 10-year government bond — it isn’t a business you want to be in. Quite simply, it isn’t cheap relative to the risk you must take.

To calculate a company’s earnings yield, you divide its annual earnings per share by its share price. For instance…

If a company earns $1 per share for an entire year and its stock price is $10, its earnings yield is 10%. That’s higher than what you could get in a no-risk T-bill. So it may be a company worth looking into.

But if you find a company in the same industry that earns $2 per share and trades for $10, that may be an even better investment opportunity. It has an earnings yield of 20%! Obviously, the higher the earnings yield, the better the bargain.

Still, before you plop your money down into any company, you need to ask yourself a second question: Is the business a solid one? The last thing you want to do is to buy stock in a company that is cheap for a good reason — because it stinks.

Greenblatt determines whether a company is “good” or not by looking at its return on invested capital. In other words, is it investing its capital wisely — adding to its earnings power? Or is it wasting its cash on frivolous investments that will create no (or even negative) value for shareholders moving forward? For instance…

If a company spends $1 million in a new factory and it is able to crank out an additional $500,000 in profits the next year, the result is a 50% return on capital. That’s outstanding. It says management knows how to spend YOUR shareholder money to create added value. And over time, companies with high returns on capital will grow quicker than companies with low returns. Makes sense, right? Of course it does.

So Greenblatt wondered how much money you would make if you invested ONLY in good companies (those with a high return in invested capital) that trade for a bargain price (companies with high earnings yields).

Joel Greenblatt: Ranking the Companies from 1 to 3500

To answer that question, he went back and looked at the largest 3,500 companies (from your large behemoths like Microsoft on down to microcap companies with market caps of $50 million) from 1988-2004. He ranked each one in terms of earnings yield and return on capital — from 1 to 3,500.

The idea was to invest in the companies with the best combined score – those with the highest earnings yield AND the highest return on capital. So if a company ranked 100th in terms of earnings yield and 50th in terms of return on invested capital, it got a score of 150. And if another company ranked 6th in terms of earnings yield and 10th in terms of return on capital, it got a combined score of 16.

After generating a score for each company, Greenblatt created a portfolio of the top 30 companies. Those were the 30 best bargains on the market at the moment. And anyone who invested in them would have made a fortune.

From 1988-2004, if you would have bought the top 30 companies generated every year using Greenblatt’s formula, you would have averaged a 30.8% return for 17 years. During that same time frame, the market averaged a 12.3% return. So Greenblatt’s ideal portfolio (using his two-part formula) beat the market by almost three times over. And it gets even better…

There was NEVER a three-year period between 1988 and 2004 where this portfolio of high-yielding, cheap stocks was not profitable. Over every three-year stretch, it outperformed the market 100% of the time. And every $11,000 invested in 1988 would have been worth over $1 million by 2004.

Folks, you can’t ask for much better results that those. So I wondered, what small-cap companies in today’s market meet Greenblatt’s stringent value criteria? I ran some numbers of my own, and came up with 10 companies that had at least a 25% return on capital and an earning yield north of 9% Check ’em out…

Until then, have a great Thanksgiving. I’ll catch up with you next week.

Cheers,

James Boric
November 24, 2005

Joel Greenblatt: The Magic Investment Formula was originally featured in the Penny Sleuth.