Indian Stocks Filtered By Greenblatt's Formula - June 2016
Chapter two of the renowned investment book, Quantitative Value, is dedicated to Joel Greenblatt's very simple approach to investing - The Magic Formula.
The chapter begins with a quote from Buffett about why it makes sense to stay away from the geeks bearing formulas with esoteric terms such as 'beta', 'gamma', and 'sigma'.
Instead, the author of the book prefers the quantitative translation of Buffett's infamous quote 'It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price'.
A wonderful business earns strong return on capital. This is a better metric than the absolute figure of profits or revenues, or for that matter, growth rates. Sure, these are important, but their importance wanes if a company is not able to earn returns above its cost of capital.
Greenblatt has defined return on capital as:
ROC = EBIT / net property, plant, and equipment + non-cash net working capital
As you can see, the focus here is on tangible assets only. An excerpt from the book explains this further:
ROC measures how efficiently management has used the capital employed in the business. The measure specifically excludes excess cash and interesting bearing assets from this calculation to focus only on those assets actually used in the business to generate the return. The higher a stock's ROC, the more money earned per dollar of capital employed in the business - a capitalist's dream.
The EBIT figure is taken as it does not include the other income component; the aim here is to look at the core earnings. Similarly, cash and investments are excluded from the denominator to make for a fair comparison.
Please note that I used the last three-year averages.
The second part of the Magic Formula is the valuation. Here, Greenblatt prefers to use earnings yield as calculated by EBIT/ total enterprise value (TEV).
TEV is the price a buyer would pay for the entire business including net debt he would take on. The reason EBIT is in the numerator is because it nullifies the effect of the capital structure - as opposed to simply using the net profit number.
Using these two combinations, I ran a query on the BSE 200 companies. I sorted them in descending order of earnings yield. As for the ROC component, I only included companies with ROC in excess of 22%. This figure is a calculated as 15%/.67.
Fifteen percent is the minimum cost of capital (post-tax) one should expect; 0.67 is a result of 1 minus the tax rate (1-33%).
Here's the list I came up with...
Joel Greenblatt's Dream Team?
===============================================
S.No Company Name
===============================================
1 NMDC Ltd.
2 Cairn India Ltd.
3 Apollo Tyres Ltd.
4 Oil & Natural Gas Corporation Ltd.
5 Tata Motors Ltd.
6 Wockhardt Ltd.
7 Vedanta Ltd.
8 Coal India Ltd.
9 Gujarat State Petronet Ltd.
10 MRF Ltd.
11 Tata Chemicals Ltd.
12 GAIL (India) Ltd.
13 Tata Global Beverages Ltd.
14 Sun TV Network Ltd.
15 HCL Technologies Ltd.
16 Indraprastha Gas Ltd.
17 UPL Ltd.
18 Ipca Laboratories Ltd.
19 Jubilant Life Sciences Ltd.
20 Mphasis Ltd.
21 Hexaware Technologies Ltd.
22 Idea Cellular Ltd.
23 Steel Authority Of India Ltd.
24 NTPC Ltd.
===============================================
A certain amount of liberty can be taken when choosing the stocks. If you're not comfortable with one, move on to the next one.
Greenblatt himself usually avoids stocks in cyclical sectors (not excluded in the list above), sectors where ROEs are regulated, and banking stocks (excluded from the list above). But such exclusions are up to you.
While the list is not without fault, it's a good starting point to pick stocks that are not only attractively priced but have relatively better fundamentals than their peers.
Disclaimer-PLEASE NOTE THAT THESE VIEWS AND CALLS ARE AS PER THE ANALYSIS OF CHARTS AND MAY REVERSE ANYTIME. THIS POST IS PURELY FOR EDUCATIONAL PURPOSE ONLY AND NOT TO BE CONSIDERED AS A BUYING OR SELLING RECOMMENDATION. I AM NOT A SEBI REGISTERED RESEARCH ANALYST AND I REQUEST ALL STUDENTS AND READERS OF THIS POST THAT NOT TO TRADE THIS STRATEGY. THIS POST I HAVE POSTED ON THIS PAGE IS FOR MY FUTURE REFERENCE.
The chapter begins with a quote from Buffett about why it makes sense to stay away from the geeks bearing formulas with esoteric terms such as 'beta', 'gamma', and 'sigma'.
Instead, the author of the book prefers the quantitative translation of Buffett's infamous quote 'It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price'.
A wonderful business earns strong return on capital. This is a better metric than the absolute figure of profits or revenues, or for that matter, growth rates. Sure, these are important, but their importance wanes if a company is not able to earn returns above its cost of capital.
Greenblatt has defined return on capital as:
ROC = EBIT / net property, plant, and equipment + non-cash net working capital
As you can see, the focus here is on tangible assets only. An excerpt from the book explains this further:
ROC measures how efficiently management has used the capital employed in the business. The measure specifically excludes excess cash and interesting bearing assets from this calculation to focus only on those assets actually used in the business to generate the return. The higher a stock's ROC, the more money earned per dollar of capital employed in the business - a capitalist's dream.
The EBIT figure is taken as it does not include the other income component; the aim here is to look at the core earnings. Similarly, cash and investments are excluded from the denominator to make for a fair comparison.
Please note that I used the last three-year averages.
The second part of the Magic Formula is the valuation. Here, Greenblatt prefers to use earnings yield as calculated by EBIT/ total enterprise value (TEV).
TEV is the price a buyer would pay for the entire business including net debt he would take on. The reason EBIT is in the numerator is because it nullifies the effect of the capital structure - as opposed to simply using the net profit number.
Using these two combinations, I ran a query on the BSE 200 companies. I sorted them in descending order of earnings yield. As for the ROC component, I only included companies with ROC in excess of 22%. This figure is a calculated as 15%/.67.
Fifteen percent is the minimum cost of capital (post-tax) one should expect; 0.67 is a result of 1 minus the tax rate (1-33%).
Here's the list I came up with...
Joel Greenblatt's Dream Team?
===============================================
S.No Company Name
===============================================
1 NMDC Ltd.
2 Cairn India Ltd.
3 Apollo Tyres Ltd.
4 Oil & Natural Gas Corporation Ltd.
5 Tata Motors Ltd.
6 Wockhardt Ltd.
7 Vedanta Ltd.
8 Coal India Ltd.
9 Gujarat State Petronet Ltd.
10 MRF Ltd.
11 Tata Chemicals Ltd.
12 GAIL (India) Ltd.
13 Tata Global Beverages Ltd.
14 Sun TV Network Ltd.
15 HCL Technologies Ltd.
16 Indraprastha Gas Ltd.
17 UPL Ltd.
18 Ipca Laboratories Ltd.
19 Jubilant Life Sciences Ltd.
20 Mphasis Ltd.
21 Hexaware Technologies Ltd.
22 Idea Cellular Ltd.
23 Steel Authority Of India Ltd.
24 NTPC Ltd.
===============================================
A certain amount of liberty can be taken when choosing the stocks. If you're not comfortable with one, move on to the next one.
Greenblatt himself usually avoids stocks in cyclical sectors (not excluded in the list above), sectors where ROEs are regulated, and banking stocks (excluded from the list above). But such exclusions are up to you.
While the list is not without fault, it's a good starting point to pick stocks that are not only attractively priced but have relatively better fundamentals than their peers.
Disclaimer-PLEASE NOTE THAT THESE VIEWS AND CALLS ARE AS PER THE ANALYSIS OF CHARTS AND MAY REVERSE ANYTIME. THIS POST IS PURELY FOR EDUCATIONAL PURPOSE ONLY AND NOT TO BE CONSIDERED AS A BUYING OR SELLING RECOMMENDATION. I AM NOT A SEBI REGISTERED RESEARCH ANALYST AND I REQUEST ALL STUDENTS AND READERS OF THIS POST THAT NOT TO TRADE THIS STRATEGY. THIS POST I HAVE POSTED ON THIS PAGE IS FOR MY FUTURE REFERENCE.
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