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Quality stocks at great prices is a combination that might be better than chocolate and peanut butter. (Stephanie Eddy For The Globe and Mail)
Quality stocks at great prices is a combination that might be better than chocolate and peanut butter. (Stephanie Eddy For The Globe and Mail)

Strategy Lab

The magic formula for investing? Put cheapness first Add to ...

Norman Rothery is the value investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

Investors love to buy quality stocks at great prices. It’s a combination that might be better than chocolate and peanut butter.

Warren Buffett loads up on such stocks, and has become one of the richest people in the world as a result. Problem is, very few investors can spot quality businesses at reasonable prices quite as well as Mr. Buffett. So, instead of trying to weigh the intangibles as he does, many of us scrutinize the numbers.

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One of the most famous number-crunching methods was invented by money manager Joel Greenblatt, who promoted a simple way to marry value with quality in The Little Book That Beats the Market. He favoured stocks with a combination of high earnings yields (an indicator of value) and high returns on capital (a signal of quality).

Mr. Greenblatt says his so-called magic formula delivered average annual gains of 23 per cent for large stocks from 1988 to 2004. That’s nearly double the return from the market, which yielded only 12 per cent over the same period.

But is the magic formula really magic? Some recent research suggests there’s a better way to go about hunting for great stocks. Just as important, it indicates that quality should not be the first thing you think about.

Money managers Wesley Gray and Tobias Carlisle examine Mr. Greenblatt’s approach in their new book Quantitative Value. According to their figures, Mr. Greenblatt’s magic formula actually performs a subtle vanishing act.

Mr. Gray and Mr. Carlisle studied the magic formula using a database of U.S. stocks that covered a longer period than Mr. Greenblatt examined. They found that, from the start of 1974 to the end of 2011, the magic formula gained an average of 13.9 per cent per year. That handily beat the 10.5 per cent generated by the S&P 500, but the level of performance, both absolute and relative, was lower than that reported by Mr. Greenblatt.

In addition, the returns don’t look as good when you saw the magic formula in two.

To pinpoint promising value stocks, Mr. Greenblatt compared the ratio of a company’s earnings before interest and taxes (EBIT) to its enterprise value (EV). The higher the ratio, the more cash a company is generating in comparison to the market value of its equity plus net debt.

To discover quality, he looked at a firm’s EBIT in comparison to the amount of tangible capital it employs. A high ratio indicates a company is generating lots of profits with minimal capital – usually an indicator that a firm enjoys a strong competitive position.

Intuition says such signals of quality should matter a lot. The facts, however, disagree. If you had simply used return on capital as your sole measure for finding stocks, you would have trailed the market with gains of only 10.4 per cent a year.

On the other hand, if you had selected the cheapest stocks (the ones with the highest EBIT/EV ratios) you would have gained an average of 16.0 per cent a year over the same period.

In other words, EBIT/EV alone outperformed the magic formula’s combination of ratios. Investors would have been better off simply looking for cheap stocks and not paying any attention to quality.

However, all is not lost for lovers of value plus quality. One of the problems with Mr. Greenblatt's method is the way the two ratios are combined. The magic formula ranks all stocks by one ratio and again by the other. The two ranks are then added and the top scoring stocks are selected. Thing is, this method can lead investors to stocks with very high returns on capital that are also far too expensive.

Mr. Gray and Mr. Carlisle suggest several fixes. One of their simplest ideas is to simply stick to the 10 per cent of stocks with the highest EBIT/EV ratios and then to pick the quality firms from within this group. Call it a value first and quality second method.

Who qualifies these days? According to S&P Capital IQ, the top contenders include Apollo Group (APOL), Apple (AAPL), Exxon (XOM), Herbalife (HLF), ITT Educational (ESI), Lockheed Martin (LMT) and Nu Skin (NUS).

If you’re looking for some interesting stocks, take a close look at these candidates. And, in general, put value first when considering stocks. Sometimes chocolate by itself is just fine.

 

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