A Simple Strategy With Strong Performance

 | Nov 08, 2013 | 1:00 PM EST
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When analyzing stocks, most investors use a variety of measures and variables. For many years, I have been studying how great investors invest, and almost always, they use five or 10 or more variables, so they can look at a stock and its underlying company from a variety of perspectives. 

I've never seen an exceptional strategist use one variable, but there is one of note who uses just two, and this is as simple as stock analysis gets. The strategist in question is Joel Greenblatt, who in 2005 wrote the appropriately titled The Little Book That Beats the Market, which is all of 155 pages long.

Years ago, I automated the strategies of great investors, and I use these to choose stocks to recommend. Greenblatt's strategy, which I have been following since 2005, has been an exceptional performer. This year, it is up 50.9%, more than double the S&P 500's gain of 24.1%. Since 2005, it is up 115.7%, compared with the S&P 500's uptick of 40.0% in the same period.

The first variable in Greenblatt's approach is return on capital (ROC), which is a way to see how much money a company is making by using its assets. This is a focus of Greenblatt, because he found that companies that have high returns on capital often had a special advantage over the competition, such as a strong brand name or strong competitive position.

Don't confuse Greenblatt's ROC with return on assets (ROA). Rather than using a company's reported earnings, as is done when calculating ROA, he uses earnings before interest and taxes (EBIT), so that debt payments and taxes do not hide how well a company's operating business is doing.

Another difference is that Greenblatt does not divide the earnings portion of the equation by total assets (as is done when calculating ROA) but divides it by "tangible capital employed," which is equal to net working capital plus net fixed assets.

Greenblatt's second variable is earnings yield, which lets you know how much the business earns relative to the company's purchase price. As with ROC, he uses EBIT. And he divides EBIT by "enterprise value," which includes not only the price of the company's shares but also the amount of debt it uses to generate earnings.

Greenblatt takes these two variables for any company he is looking at and ranks the company by these variables from among the 3,500 largest stocks in each of these categories. He then combines these rankings to come up with a final ranking.

Here are three companies that the Greenblatt strategy is hot on:

  • Weight Watchers International (WTW): With a great brand name and a service that never goes out of style, this company is doing well. Its rank among all stocks: 9.
  • ValueClick (VCLK): This company is in major player in the online advertising and marketing world. It provides consulting and technology to help companies achieve their marketing objectives. The company reports that it is the largest independent ad network. ValueClick is ranked 16.
  • Joy Global (JOY): Joy Global manufactures and services mining equipment used to mine coal and other minerals and ores. Joy's ranking is 40 among all stocks.

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