Rule #1 Finance Blog

With Investor Phil Town

THE LITTLE BOOK THAT BEATS THE MARKET

People are curious about my take on Joel Greenblatt’s book.  Read on to find out what I think.

Phil,

Saw you at a “Get Motivated” seminar in Cleveland, want through InvesTOOLS training – lost $1,000 on options – and THEN read your book.  Now ready for Rule #1 – never lose money.  I also just read The Little Book That Beats the Market by Joel Greenblatt (Columbia Business School Professor and hedge fund manager)  – he also talks about finding good companies at bargain prices and calls it “magic formula investing”.

He talks about Benjamin Graham, the Margin of Safety, EPS and Return on Capital.  However, he adds in Earnings Yield – the bargain price is determined by a higher earnings yield.  Is he just computing Value by a different means?  Also he sets Return on Assets (ROA) at a minimnum of 25%, talks about being committed to holding the stock for a minimum of 3 to 5 years, and says this approach works best with companies with a market capitalization above $50 or $100 million.

How is this different from Rule 1 Investing – is it?  Are these just personalized embellishments?  Why is ROA important   (I’m obviously asking for your opinion on this)?  Thanks.

Carol

Here’s my response:

I like Joel Greenblatt’s approach to investing.  He uses a lot of the same key things we look for in Rule #1 investing.  But I thought I’d talk about what he calls the “magic formula” – the Earnings Yield.  Here’s how Earnings Yield works:

Divide the EPS by the Stock Price and you get a percentage called
Earnings Yield. 

Obviously for a dollar of EPS, the lower the price of
the stock, the higher the yield.  I love to look at Yield as an
indicator of good value, but since I’m not really a value investor, I
decided not to include it as a critical measure of getting a bargain.
Still, let me show you guys why it’s very cool.

Let’s say we want a great long term investment that will produce
greater and greater returns to us in the long run.  Further, let’s say
that the business we’re looking at should grow at 15% a year for the
next 20 years, and today’s TTM EPS is $1.  Historically it has a PE of
30.  It is selling for $20 a share today.  That gives it a Earnings
Yield of 5%. ($1 ÷ $20 = 0.05).

5% is good.  We like to see the Yield above the long term
T-Bill rate.

Now imagine that you own the entire business.  As Rule #1 investors we
like to do that, so that is no stretch.  As the sole owner, the Earnings
Yield is my money that I get back on my investment of $20.

So this
year my return on my investment of $20 is $1.  Since this is a great
business, I’d prefer, instead of taking the $1, to have the CEO
reinvest it to grow the business.  He does so successfully, and next
year my EPS has grown to $1.20.  My Yield on my $20 investment in the
second year of ownership is $1.20 divided by $20 or 6%.

Let’s fast forward into the future and see what happens if this
business does continue to grow at about 15% a year.  We know we will
double the EPS every 5 years at that rate, so our dollar of EPS grows to
$2 in 5 years, $4 in ten, $8 in fifteen years and $16 in twenty.  What
is the Yield on our $20 in the twentieth year?  $16 divided by $20 is
80%.  SWEET!!!!  Our little business investment twenty years from now
is throwing off an 80% return PER YEAR.  CRAZY.

And that is the joy of Yield.  Yield is the great secret that Warren
Buffett has told us about if we were listening.  It is the secret that
makes huge fortunes out of little ones.  It is the power of compounding
seen in our investment lives.  And as Rule #1 investors we benefit
entirely from Yield over time without even thinking about it.  Here’s
why:

To actually see your successful investment in Yield growth become
useful spending money to you, you must sell the business.

If we sell a
business with a $16 EPS and 15% growth expectations and a 30 PE, we
should expect it to have a Sticker of about $480 today.  (Do the Rule
of 72
thing.  16 to 32 to 64.  Times 30.  Divided by 4.  You can do
that now.  Easy!)

So we should sell it for that.  What’s our return on
our investment?  Well we paid $20 twenty years ago.  How many doubles
from 20 to 480?  20 to 40 to 80 to 160 to 320 is 4 doubles plus half
another one.  4.5 doubles into 72 is 16% per year.  Nice.

By using the 4M’s we have already gotten the benefit of Yield.

But there is one more reason I didn’t turn you guys onto the Yield
thing: by focusing on businesses that have a high Yield today as one
of the screens, we will miss many great businesses that have a low
yield today because of their high growth rate. 

Let’s take one of my
favorites — WFMI.  Whole Foods is by all accounts an awesome business
and will be for a long long time
But if we buy on Yield, we would
have to pass on this one. 

Why?  Because WFMI is projected to grow at
21% a year and is priced accordingly (although still undervalued in my
humble opinion).  Thus, today, $1 of EPS at WFMI sells for $60 or
so.  Which gives it a Yield of 2%, which eliminates it from
consideration.

Yet, if WFMI can sustain that growth rate, in twenty
years that $1 will become $45, and our $60 investment will be worth
almost $2000.  That translates into a 19% per year return.  Better than
our other example, even though the starting Yield is far lower.

Rule #1 will get you the results you want without making finding a
great business a miserable and nearly impossible process that requires
endless searching and enormous patience.  Nothing wrong with what the
professor is suggesting, except it makes our job more difficult without
increasing our return or decreasing our risk.

Remember these words from Warren Buffett and Charlie Munger:  we’d
rather find a wonderful business at a fair price than a fair business
at a wonderful price.

Now go play.