Joel Greenblatt’s Forgotten Original Magic Formula

Joel Greenblatt has one of the best records on Wall Street. Aside from being an adjunct professor at Columbia University Graduate School of Business, he's also well entrenched in the Hedge Fund industry through his management of Gotham Capital. From 1985 to 2005, Greenblatt is reported to have racked up an even better record than Warren Buffett did during his partnership days, earning 48.5% compounded over 10 years through a combination of special situation and deep value investing.

If you've heard about Joel Greenblatt, it's probably due to his widely read book, "The Little Book That Beats the Market". In it, Greenblatt makes the case for a formula that investors can use to achieve superior results over the long run. Essentially, the formula looks for businesses with a large earnings yield and a high return on capital. The premise is that, over the long run, stocks of firms that are both cheap and good would vastly outperform the stocks of firms that are just cheap -- and it definitely seems to have worked. As Greenblatt reported in his book, from 1988 to 2009 the magic formula produced a CAGR of 23.8% versus a 9.6% CAGR for the S&P 500.

The Original Magic Formula

Joel Greenblatt's love for cheap stocks of good companies started long before he developed his latest Magic Formula, however.

It's probably no surprise that the backbone of Joel Greenblatt's original magic formula rested on Benjamin Graham's net net stocks strategy. Greenblatt had been following Graham for years, carefully studying the principles and philosophies of the Dean of Wall Street, and was deeply impressed by, in his words, "the dramatic success of companies that the market priced below their value in liquidation...".

Benjamin Graham's own NCAV stocks strategy was to buy a diversified list of net net stocks that were trading at least 1/3rd below their net current asset value. Graham screened out stocks that failed to show a decent past record and those that were losing money. By putting together a diversified list, Graham hoped to take advantage of the population returns of net net stocks and ride that fantastic statistical record to great profits.

In 1981, at just 24 years old, Joel Greenblatt teamed up with Richard Pzena (a great value investor in his own right), and Bruce Newberg to test their own version of Graham's NCAV investing approach. The result was a fantastic research paper called, "How the Small Investor Can Beat the Market: By Buying Stocks That Are Selling Below Their Liquidation Value" (The Journal of Portfolio Management 1981.7.4:48-52).

Defining Net Current Asset Value

According to Joel Greenblatt:

Current Assets (Cash, Accounts Receivable, Inventory, etc.), less…

Current Liabilities (Short Term Debt, Accounts Payable, etc), less…

Long Term Liabilities (Long Term Debt, Capitalized leases, etc), less…

Preferred Stock (Claims On Corporate Assets Before Common Stock)…

Divided by the Number of Shares Outstanding…

Equals Liquidating Value Per Share (NCAV Per Share).

In his paper, Joel Greenblatt wondered what would happen if he carved up the world of net net stocks even further, eliminating a lot of the terrible firms from contention. To do this he turned to one of the most widely recognized valuation metric in value investing: the PE ratio.

Using both Graham's net current asset value and value investing's classic PE ratio, he put together 4 different portfolios and compared those portfolios against the OTC and Value Line's own value index from 1972 to 1978. According to Joel Greenblatt, this period was characterized by an extreme amount of volatility which made for a much more robust test.

To select the stocks, Greenblatt only looked at firms in the Standard and Poor's Stock Guide with market caps of over $3 million and names that started with either an A or a B. He then drew net net stocks from the roughly 750 candidates left in order to put together his model portfolios.

Portfolio 1 Price below NCAV PE floating with corporate bond yields No dividends required	Portfolio 2 Price below 85% of NCAV PE floating with corporate bond yields No dividends required
Portfolio 3 Price below NCAV PE of less than 5x No dividends required	Portfolio 4 Price below 85% of NCAV PE of less than 5x No dividends required

Purchases were made based on the above criteria. Stocks were sold after a 100% gain or two years had passed, whichever resulted first. The portfolios themselves were equal weighted, so the actual yearly returns of each portfolio were just the average returns of the stocks within each portfolio.

All of the portfolios beat the indexes by a wide margin. By combining liquidation value with smaller PE ratios, however, results exploded.

Take a look at portfolio #4. The CAGR of portfolio #4, Greenblatt's original Magic Formula, blew the market away. While the OTC CAGR totalled just 1.3% for the 6 year period, and the Value Line index came to a slight loss, Joel Greenblatt's original Magic Formula was up over 42% compounded per year from August 1973 to April 1978!

Greenblatt et al even included returns after commissions and taxes, for those of you who aren't holding your portfolio in a tax free retirement account for some strange reason. Re-examined, Greenblatt's best performing portfolio still destroyed the market, up over 29% versus flat returns for the indexers.

It's important to realize what this means for average investors. Since the American market indexes return roughly 10% per year on average, Greenblatt's forgotten original Magic Formula should be good for between 29% and 39% on average over the long run.

Granted, Greenblatt's study only covered a period of 6 years, but in my experience buying net net stocks with tiny PE ratios has proven to be a very profitable strategy. In fact, most of my best performing stocks have been these sort of net nets. Also keep in mind just how tumultuous the markets were during that period which, as Greenblatt wrote, made for a much more robust test.

(As an aside: if you're stuck holding your funds outside a tax shelter, for some reason, you can boost the tax efficiency of your portfolio by just holding your stocks for longer. This becomes a lot more viable if you're investing in the highest quality net nets.)

Three Major Takeaways from Joel Greenblatt's Study

It's hard to argue with returns like that.

Still, the more observant of you might have noticed a few potential flaws with the study and results.

At first glance, it definitely appears that you can't hold a large number of stocks in a portfolio using Joel Greenblatt's criteria. If you look to the right of each period's return, you'll see exactly how many stocks he held. In fact, Greenblatt et al were out of the market entirely for a lot of 1972 and 1973.

I don't think this is a crippling flaw to his strategy at all, however.

It's important to realize that Benjamin Graham's obsession with wide diversification isn't really necessary. In Joel Greenblatt's first book, "You can Be a Stock Market Genius," he argues that you need fewer than 10 stocks to eliminate most of the systemic risk that you face while investing in stocks. Ultimately, you don't need 30 or 100 different stocks to diversify away most of your risk. You can do it with ten.

You can even leverage Greenblatt's original Magic Formula, portfolio #4, while maintaining a fully stocked portfolio during the upper reaches of a bull market. The trick is to put together a portfolio of other net net stocks and then replace the weakest links in your portfolio with a portfolio #4 type net net when new candidates become available. Doing so would allow you to leverage the returns of NCAV stocks as a group while still employing Greenblatt's original magic formula when available.

You could even chose the best net net stocks that don't meet Greenblatt's criteria by focusing on NCAV stocks that are trading at an incredibly cheap price to NCAV, have no debt, are growing NCAV per share, are buying back stock, or which have insiders who are buying big blocks of shares, themselves.

Lastly, remember that Joel Greenblatt et al only looked at companies with names that began with the letters A or B. That inevitably eliminated most net nets from contention. In my own experience, there are a lot of net net stocks available for smart investors willing to invest internationally. I send many of these stocks out to those who requested free net net stock ideas.

The second takeaway is that both quality and price have a major impact on returns. Looking at the results, when holding PE requirements constant, the cheaper portfolios in terms of price to NCAV outperformed the more expensive portfolioes. Likewise, when holding price to NCAV requirements constant, the portfolios that demanded more earnings for the price paid outperformed their peers. By combining both value and quality, as Greenblatt did in portfolio #4, an investor can do very well in the stock market.

Finally, it's fairly clear that Joel Greenblatt's original Magic Formula, and NCAV stocks in general, trumps Greenblatt's contemporary Magic Formula. Sure, the Magic Formula that Greenblatt champions in his latest book is a good investment strategy, on the whole, but it just doesn't live up to his forgotten original Magic Formula. While his contemporary Magic Formula was reported to return just north of 23% per year vs. the S&P 500's 9.6% return, Greenblatt's original Magic Formula spanked that return -- and did so during a flat market, as well!

 How I'm Leveraging Greenblatt's Original Magic Formula

As you can see, Greenblatt's original Magic Formula is magical indeed.

His study has had a huge impact on my own selection criteria. When selecting net net stocks, I look for firms that have a deep discount to NCAV but still focus on high quality situations. For example, I currently own two deeply discounted stocks based on NCAV and earnings: one trading at just over 5x earnings and just over 40% of NCAV; the other offering a PE of 6 and trading at 68% of NCAV. Joel Greenblatt would be proud.

The biggest challenge to earning 25-35% annual returns is not the actual investing -- it's finding the investment opportunities. Right now Net Net Hunter members have access to over 450 net net stocks in 5 countries, as well as Shortlists of the best possible net net stock opportunities in each country. Make the most of your time by quickly finding the best net net stocks available.

http://www.netnethunter.com/joel-greenblatt-original-magic-formula/

Joel Greenblatt’s Original Magic Formula (NCAV)

Most investors are familiar with Joel Greenblatt’s Magic Formula, made famous in his book, “The Little Book That Beats the Market”.

The key drivers of the Magic Formula we know today are Earnings Yield (EBIT / Enterprise Value) and Return on Capital (EBIT / (Net Fixed Assets + Working Capital)). Companies are ranked according to these two metrics — highest earnings yield and highest return on capital — then the 20 to 30 companies with the highest ranks are purchased at a rate of two to three positions per month over a 12-month period.

However, before Greenblatt came up with this quality-and-value screen, he built a strategy around Benjamin Graham’s net-nets strategy, which relatively unheard of and has since become known as Greenblatt’s Original Magic Formula.

Greenblatt’s original Magic Formula

Greenblatt developed his Original Magic Formula with Richard Pzena, who currently manages Pzena Investment Management LLC, a value oriented global investment management firm with $28 billion in assets under management, and Bruce L. Newberg. The three money managers published their findings within the The Journal of Portfolio Management Summer issue 1981, Vol. 7, No.4, in an article entitled, “How the Small Investor Can Beat the Market: By Buying Stocks That Are Selling Below Their Liquidation Value”

Greenblatt and his co-authors argued within the article that only way the small investor can beat the market, is by looking for undervalued stocks. To do this successfully, the investor has to look outside the realm of Wall Street’s analyst coverage:

“We should recall, however, that Wall Street research houses limit their coverage to fewer than 500 actively traded issues…Meanwhile the NYSE trades 2000 stocks, Amex trades 1000 companies, and the OTC market trades another 7000 issues…Under these circumstances, the individual may in fact be able to locate unrecognised values in the nearly 9000-stock second tier not closely followed by the “experts”.

The figures are different today, but the underlying argument remains the same. Greenblatt built up his deep value strategy from there:

“In an effort to discover whether inefficiently priced, undervalued securities do exist, we turned to the acknowledged father of security analysis, the late Benjamin Graham…decided to update Graham’s studies to see if his simple fundamental approach still provided the returns that could not be explained by an efficient market.”

To start, Greenblatt used Graham’s traditional net-nets formula to screen for bargains:

Current Assets – Current Liabilities – Long Term Liabilities – Preferred Stock / Number of Shares Outstanding = NCAV Per Share

After using this formula to build a rough list of qualifying NCAV stocks, Greenblatt went further, in an attempt to remove any ‘junk’ firms from the list — something that’s been a thorn in the side of the deep value investors ever since the strategy was first conceived. To try and remove the wheat from the chaff as it were, Greenblatt enlisted the help of the P/E ratio.

Separating out the chaff

Benjamin Graham’s last will was a set of ten rules used for stock selection based on Graham/s five decades of stock market experience. The list of ten points, published around the time of Graham’s death, will be familiar to most value investors:

1. An earnings-to-price yield at least twice the AAA bond rate
2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
3. Dividend yield of at least 2/3 the AAA bond yield
4. Stock price below 2/3 of tangible book value per share
5. Stock price below 2/3 of Net Current Asset Value
6. Total debt less than book value
7. Current ratio greater than 2
8. Total debt less than 2 times Net Current Asset Value
9. Earnings growth of prior 10 years at least at a 7% annual compound rate
10. Stability of growth of earnings in that no more than 2 declines of 5% or more in year-end earnings in the prior ten years are permissible.

There’s no denying that this list of rules is extremely onerous and in most markets the number of stocks that meet all ten criteria is likely to be minimal. (Société Générale publishes a monthly stock screen based on the Graham criteria —the April update can be found here — the bank’s analysts note that in the past two decades, only three companies have passed all ten criteria out of a universe of FTSE World Developed, FTSE 350 stocks and FTSE World Emerging stocks.)

When Joel Greenblatt set out to create his new NCAV strategy he clearly wanted it to be less restrictive than Graham’s criteria. However, Greenblatt also wanted his new deep value strategy to outperform, with less risk than the wider market.

To accomplish these goals, Graham’s list and put together and added the P/E ratio to his NCAV screening criteria. Greenblatt tested four different four portfolios, each with a different P/E screening criteria.

Portfolio one

• Price below NCAV
• P/E floating with corporate bond yields
• No dividends required

Portfolio two

• Price below 85% of NCAV
• P/E floating with corporate bond yields
• No dividends required

Portfolio three

• Price below NCAV
• P/E of less than 5
• No dividends require

Portfolio four

• Price below 85% of NCAV
• P/E of less than 5
• No dividends required

Stocks with a market cap of less than $3 million were discarded from the study. Stocks were sold after a 100% gain or two years had passed, whichever resulted first. The portfolios themselves were equally weighted, so the actual yearly returns of each portfolio were just the average returns of the stocks within each portfolio. The returns of the four portfolios were compared to the Value Line’s own value index.

The results show that portfolios three and four, which demanded qualifying stocks trade at a P/E of less than five, racked up the best performances of the group.

The average performance of portfolio three was 32.2% p.a. per annum excluding tax and commissions — the high portfolio turnover meant that returns were impacted significantly when including commissions (12.1% p.a. after including taxes and commissions).

Portfolio four returned 42.2% p.a., although this dropped to 29.2% p.a. after excluding taxes and commissions. Interestingly, these two portfolios performed better than Greenblatt’s second Magic Formula, which boasts of 30% p.a. returns.

http://www.valuewalk.com/2015/04/original-magic-formula/

Meredith Whitney Says She's Done With Hedge Funds After Struggle

By Max Abelson


Meredith Whitney, who turned fame as a banking analyst into a stint running her own hedge fund, is through with managing other people’s money.

“I think that chapter of my life is over,” she said in an interview with Fox Business on Wednesday. “This whole experience has been highly unfortunate and I’m putting it behind me.”

Whitney’s prescient warning before the financial crisis that Citigroup Inc. would cut its dividend turned her into a Wall Street star and put her on magazine covers. Her firm Kenbelle Capital and its American Revival Fund started investing in heartland stocks in November 2013, after she predicted on TV and in a book that the center of the U.S. would boom.

More from Bloomberg.com: A $3 Trillion Traffic Jam Is Seen Looming in Credit by Citigroup

Her top investor, a fund tied to billionaire Michael Platt’s BlueCrest Capital Management, sued in December to get back its $46 million after months of losses. A court filing this month showed the two had resolved the claims. Whitney didn’t immediately respond to messages left at her office.

In a brief phone call Wednesday, Stanley Arkin, a lawyer for Whitney, wouldn’t elaborate on her interview.

“She’s an honest woman,” he said. “I’m not at liberty to say anything more than that.”

Starting her debut fund without a staff of analysts to help choose investments and relying too much on one investor’s money helped lead her astray, a person with direct knowledge of her firm told Bloomberg earlier this year, after her New York office went on the market and top executives left.


“At the end of May I returned money to every single investor,” she said in the Fox interview. Whitney is now focused on analyzing financial stocks, including the company that made her famous. “Citi’s interesting,” she said.


http://finance.yahoo.com/news/meredith-whitney-says-shes-done-171526255.html

Enterprise Value (EV)

DEFINITION OF 'ENTERPRISE VALUE (EV)'
Enterprise Value, or EV for short, is a measure of a company's total value, often used as a more comprehensive alternative to equity market capitalization. The market capitalization of a company is simply its share price multiplied by the number of shares a company has outstanding. Enterprise value is calculated as the market capitalization plus debt, minority interest and preferred shares, minus total cash and cash equivalents. Often times, the minority interest and preferred equity is effectively zero, although this need not be the case.

EV = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments.


INVESTOPEDIA EXPLAINS 'ENTERPRISE VALUE (EV)'
Enterprise value can be thought of as the theoretical takeover price if the company were to bought. In the event of such a buyout, an acquirer would generally have to take on the company's debt, but would pocket its cash for itself. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm's value.

The value of a firm's debt, for example, would need to be paid by the buyer when taking over a company, thus enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation.


ENTERPRISE VALUE AS AN ENTERPRISE MULTIPLE
Enterprise multiples that contain enterprise value relate the total value of a company as reflected in the market value of its capital from all sources to a measure of operating earnings generated, such as EBITDA.

EBITDA = recurring earnings from continuing operations + interest + taxes + depreciation + amortization
The Enterprise Value/EBITDA multiple is positively related to the growth rate in free cash flow to the firm (FCFF) and negatively related to the firm's overall risk level and weighted average cost of capital (WACC).



EV/EBITDA is useful in a number of situations:

The ratio may be more useful than the P/E ratio when comparing firms with different degrees of financial leverage (DFL).
EBITDA is useful for valuing capital-intensive businesses with high levels of depreciation and amortization.
EBITDA is usually positive even when earnings per share (EPS) is not.


EV/EBITDA also has a number of drawbacks, however:

If working capital is growing, EBITDA will overstate cash flows from operations (CFO or OCF). Further, this measure ignores how different revenue recognition policies can affect a company's CFO.

Because free cash flow to the firm captures the amount of capital expenditures (CapEx), it is more strongly linked with valuation theory than EBITDA. EBITDA will be a generally adequate measure if capital expenses equal depreciation expenses.

Another commonly used multiple for determining the relative value of firms is the enterprise value to sales ratio, or EV/Sales. EV/sales is regarded as a more accurate measure than the Price/Sales ratio since it takes into account the value and amount of debt a company has, which needs to be paid back at some point. Generally the lower the EV/sales multiple the more attractive or undervalued the company is believed to be. The EV/sales ratio can actually be negative at times when the cash held by a company is more than the market capitalization and debt value, implying that the company can essentially be buy itself with its own cash.



Read more: http://www.investopedia.com/terms/e/enterprisevalue.asp#ixzz3cfQD34E6
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Warren Buffett's Investing Formula Revealed

With his humble Midwest beginnings, plainspoken wisdom and wit, and incredible wealth, Warren Buffett has become the most-watched investor in the world. But as interesting a character as Buffett is, the more important piece of the Buffett puzzle for investors is this: How did he do it?

My Buffett-based Guru Strategy attempts to answer that question. Based on the approach Buffett reportedly used to build his fortune, it tries to use the same conservative, stringent criteria to choose stocks that the “Oracle of Omaha” has used in evaluating businesses. The model is based on the book Buffettology, written by Mary Buffett, Warren’s ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.

The Forbes E-book On Warren BuffettThe $59 Billion Philanthropist, chronicling 50 years of Buffett’s investment savvy and unprecedented giving, is available now for download.

Some of Buffett’s broader strategy is well known. He likes, for example, to invest in companies that have very recognizable brand names, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have. One example of a current Berkshire holding that meets this criterion is Coca-Cola, whose name is engrained in the culture of America, as well as other parts of the world.

In addition, Buffett also likes firms whose products are simple for an investor to understand—food, diapers, razors, to name a few examples.

What a lot of people don’t realize, however, is that in the end, for Buffett, it doesn’t come down to a subjective assessment of whether a company meets these vague criteria. It comes down to cold, hard numbers—those on a company’s balance sheet and those that represent the price of its stock. And that’s where my Buffett-based Guru Strategy comes in. It looks at a myriad of figures on a company’s balance sheet and in its fundamentals to find only the most attractive stocks of solid companies.

In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years. There are a few exceptions to this, one of which is that a company’s EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company’s long-term earnings history is solid).

Click here for 10 Stocks Warren Buffett Would Love

Another part of Buffett’s conservative approach: targeting companies with manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes firms with enough annual earnings that they could use those earnings to pay off all debt in two years or less, if need be.

Smart Management, and an Advantage

Two qualities Buffett is known to look for in his buys are strong management and a “durable competitive advantage.” Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital. The model I base on Buffett’s approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12% over those time frames.

Another way Buffett has examined a firm’s management is by looking at how it spends the company’s retained earnings—that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model takes the amount a company’s earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. The result shows how much profit the company has generated using the money it has reinvested in itself—in other words, how well management is using retained earnings to increase shareholder value.

The Buffett method requires a firm to have generated a return of 12% or more on its retained earnings over the past decade.

The Price Is Right?

The criteria we’ve covered so far all are used to identify “Buffett-type” stocks. But there’s a second critical part to Buffett’s analysis: price—can he get the stock of a quality company at a good price?

One way my Buffett-based model answers this question is by comparing a company’s initial expected yield to the long-term treasury yield. (If it’s not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)

To predict where a stock will be in the future, Buffett uses not just one, but two different methods to estimate what the company’s earnings and stock’s rate of return will be 10 years from now. One method involves using the firm’s historical return on equity figures, while another centers on earnings per share data. (You can find details on these methods by viewing an individual stock’s scores on the Buffett model on Validea.com, or in my latest book, The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies.)

This notion of predicting what a company’s earnings will be in 10 years may seem to run counter to Buffett’s nonspeculative ways. But while using these methods to predict a company’s earnings for the next 10 years in her book, Mary Buffett notes: “In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders’ equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made.”

A Strong Rebounder

One of Buffett’s mantras is that investors “should try to be fearful when others are greedy and greedy only when others are fearful,” and he’s lived up to that recently—while others have run from stocks during the recent downdraft, he says he’s been buying quite a bit. Not surprisingly, my Buffett-based model has tended to do best coming out of downturns. In 2009, for example, after the market had been pounded, it gained 47%—doubling the S&P 500′s 23.5% return. The reason: While other investors overreact and ditch quality stocks when times are tough, the value-focused Buffett-based approach—like Buffett himself—scoops up the bargains they leave behind. And over the long term, that can pay off big-time.

In the end, Buffett-type stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors’ eyes; instead, they are proven businesses selling at good prices. That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay (allowing him to buy when others are fearful), is how Buffett has become the world’s greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.

The stocks currently on my Buffett-inspired portfolio are an interesting group, and some of the holdings might not seem like “Buffett-type” plays on the surface. But they have the fundamental characteristics that make them the type of stocks Buffett has focused on while building his empire. Among the stocks that made the cut are two off-price retailers,  a pet pharmacy, a maker of nutritional products and a manufacturer of medical devices.

Click here for 10 Stocks Warren Buffett Would Love

http://www.forbes.com/sites/investor/2011/10/11/warren-buffetts-investing-formula-revealed/

This is a very good thing.

Keeping a long-term perspective will continue to be the key to success.

As long as you have picked a long-term strategy that makes sense and you believe in.

Which company is cheaper? (Understanding P/E, Earnings yield and EBIT/EV.)

Consider two companies, Company A and Company B.

They are actually the same company (i.e. the same sales, the same operating earnings, the same everything) except that Company A has no debt and Company B has $50 in debt (at a 10% interest rate).

All information is per share

Company A

Sales                     $100
EBIT                         10
Interest expense          0
Pretax Income           10
Taxes @ 40%             4
Net Income               $6


Company B

Sales                     $100
EBIT                         10
Interest expense           5
Pretax Income             5
Taxes @ 40%             2
Net Income               $3


The price of Company A is $60 per share.
The price of Company B is $10 per share.

Which is cheaper?

P/E of Company A is 10 ($60/6 = 10).  The E/P or earnings yield, of Company A is 10% (6/60).
P/E of Company B is 3.33 ($10/3 = 3.33). The E/P or earnings yield of Company B is 30% (3/10).

So which is cheaper?
Using P/E and earnings yield, Company B looks much cheaper than Company A.

So, is Company B clearly cheaper?


Let's look at EBIT/EV for both companies.

Company A
Enterprise value (Market price + debt)   60 + 0 = $60
EBIT   $10


Company B
Enterprise value (Market price + debt)   10 + 50 = $60
EBIT   $10

They are the same! Their EBIT/EV are the same.

To the buyer of the whole company, would it matter whether you paid $10 per share for the company and owed another $50 per share or you paid $60 and owed nothing?

It is the same thing!

*You would be buying $10 worth of EBIT for $60, either way!




Additional note:

* For example, whether you pay $200k for a building and assume a $800k mortgage or pay $1 million up front, it should be the same to you.  The building costs $1 million either way!

[Using EBIT/EV as your earnings yield provide a better picture than E/P, of how cheap or expensive the asset is.]

Pretax operating earnings or EBIT (earnings before interest and taxes) was used in place of reported earnings because companies operate with different levels of debt and differing tax rates. Using EBIT allowed us to view and compare the operating earnings of different companies without the distortions arising from the differences in tax rates and debt levels.  For each company, it was then possible to compare actual earnings from operations (EBIT) to the cost of the assets used to produce those earnings (tangible capital employed) and to the price you are paying.

Returns on Capital
= EBIT / (Net Working Capital + Net Fixed Assets)

Earnings Yield
= EBIT / EV
= EBIT / Enterprise Value

As an investor, you are looking for companies with high Returns on Capital and selling for a bargain or high Earnings Yield (EBIT / EV).

REF:  The Little Book that still Beats the Market by Joel Greenblatt

Take risks (but protect yourself) - Peter Lim

Image Credit: futbolfinanzas.com

Much of Lim’s wealth was the product of an unlikely venture. His single investment of US$10 millionin Wilmar, an Indonesian palm oil startup, seemed far from promising in the late 90s, when Indonesia was facing political and social unrest. At the time, the currency fell from 2,500 to 16,000 rupiah against the US dollar. But against all odds, Wilmar began to pick up the pieces and Lim’s faith in the company paid off — in 2010, he cashed out his shares for US$1.5 billion.

“My Indonesian partner was asking me the other day: ‘How the hell did we make so much money?’

Up to a point after people tell you a story and a vision, don’t write it off. Sometimes it comes true. You just make sure that if it doesn’t come true, you don’t get hurt too much.”

(Source: The Business Times, AsiaOne News)

 https://sg.news.yahoo.com/8-wise-lessons-wealth-singapore-053251357.html

Comments:

1998. US$10 million
2010. US$1,500 million (1.5 billion)
Period 12 years

Compound Annual Growth Rate:
51.82%. (WoW.  )


2015.  US$ 3,000 million (3 billion). His present net worth.
CAGR from 2010 to 2015.  14.87%

CAGR from 1998 to 2015.  39.87%


He bought Wilmar in 1997/1998.
It was at the time of the Asian Financial Crisis.
Prices of stocks were very low.
Indonesian currency and regional currencies were at historical lows compared to US dollars and Singapore dollars.
He made a big investment.  (Fat pitch when the opportunity came.)
He was in the position to make this investment and he took the risk, knowing his downside was protected. (My analysis.) (Luck = preparation + ability to seize opportunity when this presents)
He stayed with the company long term (12 years).
He cashed out in 2010. (Perfect timing or pricing.  How did he do this?)
Since 2010, he has grown his wealth around 15% per year, doubling in 5 years.

There are many lessons one can learn from this investing behaviour of Peter Lim (almost sounds like Peter Lynch).  :-)



For references.
CAGR
61.41%      (Land - short term frenzyl)
8.14%        (Property capital appreciation)
9.75%        (Plantation capital appreciation)
17.79%       (Land - long term)
9.65%         (Property Total Return)
10.61%       (Plantation Total Return)
15%+          (Equity)
Unlimited     (Business)

Investing in decline

British American Tobacco (BATS) published a gargantuan number this week: CAD$15.6bn (£8.2bn). Unfortunately, this has nothing to do with its financial results - the group made pre-tax profit of £4.8bn last year - but is instead the amount awarded to smokers by a Canadian court for "moral and punitive damages". BATS' Canadian subsidiary is liable for two-thirds of the sum.

Shareholders need not fret yet: the legal battle has already been rumbling on for 10 years, and the three tobacco companies inculpated will challenge the judge's ruling. The public smoking bans and tax increases introduced in countries ranging from Brazil through the Philippines to Turkey are of more immediate consequence. Manufacturers used to rely on emerging markets to offset falling volumes in Europe and North America, but this growth engine has stalled.

The latest government crackdown is in China, the world's largest cigarette market. On the same day as the Canadian legal judgement, Beijing banned smoking in restaurants, public transport and offices - the strictest restrictions yet introduced in the country. The direct impact on BATS and Imperial Tobacco (IMT) will be limited, as the Chinese market is virtually monopolised by China National Tobacco Corporation (although BATS did launch a joint venture with CNTC in 2013). But the move does highlight the direction of travel across the developing world.

But the fascinating thing about tobacco companies is just how successful they have been at managing decline. In 2006, BATS sold 691bn cigarettes and was worth £29.6bn on New Year's Eve. In 2014, it sold 667bn fags and attracted a year-end market valuation of £65.2bn. The figures for Imperial Tobacco show the same pattern. For investors, this is a very instructive contradiction.

Tobacco groups have wrung growth out of a shrinking market in three ways. 

1.  Firstly and most importantly, they have continually increased prices. This has worked because demand for cigarettes is infamously 'inelastic': consumers pay up even if prices rise. Moreover, in many countries the price of a packet of cigarettes consists mainly of tax. In Britain a full 77 per cent of the typical price of a premium packet is paid to the government, according to the industry lobby group. Mathematically, that means manufacturers can increase their prices by 5 per cent without pushing the total packet price up by much more than 1 per cent.

For example, in the first quarter BATS reported a particularly disappointing 3.6 per cent decline in volumes, led by shrinking markets in Brazil, Russia and Vietnam. Yet revenues at constant exchange rates rose 1.7 per cent, "driven by strong pricing, in part due to price increases in high-inflation markets".

There is a parallel here with the big brewers, notably SABMiller(SAB). Investors need not be too concerned by flat volumes, because consumers pay up for beer in the same way they pay up for cigarettes. SAB's lager volumes showed no underlying growth in the year to 31 March, but the company still delivered organic top-line growth of 5 per cent.

2.   The second key strategy for countering industry decline is consolidation. The most recent mega deal is the acquisition of Lorillard, the number three cigarette group in the US, by Reynolds, the number two. To placate the anti-trust authorities, the companies agreed to sell various brands to Imperial Tobacco, the number four, for $7.1bn (£4.7bn). The regulator finally blessed this ménage à trois last month, although the deal has yet to formally complete. Lower-profile 'bolt-on' acquisitions are more common. BATS this week announced the purchase of TDR, the market leader in Croatia and a player in other Balkan states, for €550m (£395m).

Such deals are a vehicle for cost-cutting, which boosts profits even if top-line growth is sluggish. Imperial Tobacco in particular has a strong track record for extracting value from deals. Thanks to a seemingly endless programme of cost savings - aided by advertising bans - the operating margin in its tobacco business reached an astonishing 44 per cent in the six months to March.

3.   Finally, cigarette companies have been buying into new technology: cigarette alternatives. In 2013 BATS launched the UK's first e-cigarette brand, Vype, while the Reynolds-Lorillard merger will bring Imperial Tobacco blu, a rival brand. Here the parallel is with the oil majors and their flirtations with clean energy. This month the key European players tried to stress their green credentials by writing a high-profile open letter to the UN in support of a carbon-pricing system.

Cigarette and oil alternatives make headlines and allow producers to brag about corporate social responsibility and growth. But they are a very, very long way from paying for the dividends that have long underpinned the investment case for Britain's largest companies. Fortunately, the lesson of big tobacco is that decline can be managed successfully for much longer than one might think.

 By Stephen Wilmot , 03 June 2015

http://www.investorschronicle.co.uk/2015/06/03/comment/chronic-investor-blog/investing-in-decline-g0QBVswahNlGhiO1XtymXK/article.html

The graph that shows Chinese shares are in a bubble

The Shanghai market has more than doubled in a year, while another crucial measure suggests investor demand is unsustainable

A lot of attention has been focused on the Chinese stock market recently following its spectacular rise. The SSE Composite, the main index for the Shanghai exchange, has risen by about 140pc in the past year.

This has, naturally enough, given rise to fears of a bubble, although not all commentators are convinced. Using the popular "price to earnings" or p/e measure of value, the market is trading at about 20 times earnings, well below its previous high in 2007 of around 40 times. For comparison, the London market currently trades at about 15.5 times earnings.

• Chinese stock market hits seven year high

But one graph (below) has convinced investors at Monogram, a London-based fund manager, that the market is indeed in a bubble.

It plots the combined value of all the share trades placed in Shanghai each day and shows that the figure has risen hugely since 1997 but at a much greater pace over the past year or so. A yuan is worth about 10p, so shares worth about £83bn are currently being traded every day.

“If this is not a bubble then it’s hard to imagine what one looks like," said Paul Marson, Monogram's chief investment officer. "The average daily stock market turnover has increased 10-fold in the past year to 830bn yuan from 80bn."

He said the root cause was an increase in lending by China's banks, allied with increased appetite for shares as the Chinese property loses its appeal.

"An enormous amount of liquidity has gone from inflating the property market, which is now deflating, to inflating stock prices,” Mr Marson said.

He added: “This is a very unhealthy sign for the global economy. It can only end in tears. Bubbles always leave behind more problems than they resolved.”

• Tom Stevenson: China’s stock market bubble shows no sign of bursting yet

By Richard Evans

27 May 2015

http://www.telegraph.co.uk/finance/personalfinance/investing/shares/11630704/The-graph-that-shows-Chinese-shares-are-in-a-bubble.html

Confused about what stocks to buy? The answer could be as medieval as moats

When deciding where to put money in the stock market, how can investors wade through the barrage of information and tell a great business from a poor one?

Look for moats.

That advice comes from Heather Brilliant and Elizabeth Collins of the investment research firm Morningstar Inc. Similar to the way medieval castles are protected by moats, investment-worthy companies have “economic moats,” or structural barriers that can fend off competitors and can earn high returns for many years, Brilliant and Collins write in their newly published book, “Why Moats Matter: The Morningstar Approach to Stock Investing.”

It’s a method that is based on a concept by billionaire investor Warren Buffett and one that Chicago-based Morningstar(Nasdaq: MORN) has used for many years as a basis for the firm’s successful stock-investing approach, the authors say. (Brilliant is co-chief executive of Morningstar Australasia and global head of equity and corporate credit research for Morningstar, and Collins is Morningstar’s director of equity research for North America.)

Now, with the book, Brilliant and Collins are looking to show investors how they themselves can find good stock picks and determine when to buy them.

"When you focus on a company's fundamental value relative to its stock price, and not on where the stock price is today relative to a month ago or a day ago or five minutes ago, you start to think like an owner rather than a trader,” Brilliant says. “It's this mindset that we believe is key to helping people become successful stock investors."

Collins says economic moats stem from five sources of competitive advantage:

Cost advantage, when a company has high profit margins and sustainably lower costs than competitors;
Intangible assets, such as brand recognition and patents that can keep competitors at bay;
Switching costs, the expenses in terms of time, hassle, money or risk a customer would incur if it switches to a competitor;
Efficient scale, when the company is in a limited market with few competitors;
Network effect, when the value of the good or service increases as the company wins more customers.

A company needs to have at least one of these elements to be considered to have an economic moat, says Collins.

“Companies with a moat have benefits that are so structural that it's inherently part of the business itself,” says Brilliant.

One example is computer technology company Oracle Corp. (NYSE: ORCL), which benefits from switching costs. Even though other software companies provide similar products and services, Redwood City, Calif.-based Oracle is deemed to have a wide moat because once its enterprise software is embedded into its clients’ systems, it is extremely difficult for the client to switch to another software provider.

“Even if something came along that was twice as good and half the price, the customer would have to think twice about switching because of the major disruption it would cause,” says Brilliant.

In contrast, Morningstar gives Apple Inc. only a narrow moat, mainly based on the switching cost of its operating system rather than its devices. Apple’s iOS may keep its users loyal, but as popular as iPhones and iPads are, it would be relatively easy for other companies to launch rival devices, the analysts say.

“We give Apple a narrow moat because the product cycle for devices and computers are still so fast,” says Brilliant.

Another company with a wide moat is San Jose, Calif.-based Ebay Inc. (Nasdaq: EBAY), which has a powerful network effect. It has not only become a leader in online auctions but also has expanded its business to payments through its acquisition of Paypal.

“Having both sides of the transaction was part of Ebay’s success,” says Brilliant. “As they grew, they became the obvious choice that nobody else could catch up.”

An example of a company that didn’t have that same network effect was Chicago-based Groupon Inc. (Nasdaq: GRPN).

“I love to talk about Groupon because that’s one where our moat methodology made it very clear from the very first day it was in existence that it was not a ‘moaty’ business,” says Brilliant. Even when Groupon’s stock was soaring, Morningstar held off on recommending it.

“We said, 'It doesn’t have a moat so it’s not going to last, and it ended up being the case, which is how our moat ratings work,” notes Brilliant. “It was very easy [for customers] to switch to Living Social, or other offerings, like Amazon. Groupon would’ve liked a network effect there, but we didn’t see it.”

In addition to determining economic moats, Morningstar’s analysts also give moat ratings to companies, which forecast whether a company will generate sustainable profits for a decade or more. “Moaty” businesses will be able to survive short-term fluctuations in stock prices and unpredictable changes in the market or industry.

So when the stock price falls on a company that has a moat, look at it as a buying opportunity.

“Each time your reevaluate your portfolio, think about the valuation question: Are the companies that I hold today undervalued, fairly valued or overvalued? Don’t put a discrete timeline on things. It all depends on the valuation and if it’s performing to expectation," Collins says.

Collins adds that there are two reasons to sell a stock. “One is that it’s no longer a compelling buying opportunity or has appreciated to the fair value estimate; the second is you no longer think the future is going to play out as you once did,” she says.

Understanding the value of a stock also requires looking beyond just the price. A $200 stock may sound expensive, but it may be a better value than a $20 stock that won’t bring you good returns.

“You’ll wait for a $500 pair of shoes to go on sale for $350,” says Brilliant. “In your mind, it's worth $500. But if you paid $350 for a $30 pair of shoes, you'd be feeling hugely ripped off. So it’s not really about the price; it’s about the underlying value of the item your buying."

Brilliant says the important thing to do as an investor is to focus on the long term and not get sucked in by the "movings" of the market at any given moment.

“Apply a framework like this and stick to it — because we know you’ll have better performance than following those waves in the market,” she says.

I-Chun Chen, Correspondent
Aug 26, 2014

http://www.bizjournals.com/bizwomen/news/profiles-strategies/2014/08/confused-about-what-stocks-to-buy-the-answer-could.html?page=all