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The magic formula for share market success

In 2006, Joel Greenblatt, the founder of Gotham Capital and an adjunct professor at the Columbia Business School, wrote a book called The Little Book That Beats the Market. The book details a value investing approach that claims to beat the market over a long period.

Value investing was first championed by investment legends Benjamin Graham and David Dodd in the early 1900s and was later given huge exposure by long-term Fool favourite Warren Buffett. Value investing is essentially the practice of buying businesses at less than their intrinsic value. While it is a simple concept, the difficulty comes when trying to assess the intrinsic value of a company.

Over the years investors have used price to earnings (P/E) ratios, book value, loan value, future earnings potential and a million other variables in order to accurately put a price on a company’s intrinsic value.

The Little Book That Beats the Market proposes a different method to most before it by ranking stocks based on two variables; valuation and profitability.

The valuation side of the equation is determined by a measure of earnings yield (i.e. the earnings potential of the company). The earnings yield is calculated from the company’s ratio of earnings before interest and tax (EBIT) to enterprise value, which itself is the company’s market cap plus debt minus cash. This ratio (EBIT/EV) is taken as a percentage and if it’s above the long-term interest rate at the time then it may be a good time to buy.

To determine profitability, the book uses return on capital, which is a measure of the ability of the company to generate earnings from its assets. Return on capital is measured by dividing EBIT by net working capital (current assets-current liabilities) plus net fixed assets.

The results are interesting when the formula is used on the ASX. When financials and utilities are excluded due to their large loans, the top 20 stocks are an interesting mix of mining, technology and retail companies. Noticeably these are the companies that have underperformed in 2013 and are undervalued by many historical metrics.

 

Company Name Code Business Type Share price 1 year return EBIT/EV ROC
Decmil Group DCG Engineering

$1.80

-19.5%

23.4%

422%

Codan CDA Mining

$0.65

-71.1%

25.8%

148%

Thorn Group TGA Lending

$2.23

20.5%

19.5%

178%

Premier Inv PMV Retailer

$7.71

22.2%

26.1%

60%

DWS Limited DWS IT

$1.32

-7.7%

14.9%

93%

Data#3 DTL IT

$1.05

-3.8%

21.5%

59%

Vision Eye Institute VEI Opthamology

$0.71

52.4%

12.3%

169%

Seven Group SVW Media

$7.60

1.4%

20.3%

49%

Macquarie Radio MRN Media

$1.03

94.1%

12.8%

110%

Calibre Group CGH Engineering

$0.37

-66.4%

18.8%

57%

STW Comms SGN Advertising

$1.45

40.6%

11.0%

272%

Lycopodium LYL Engineering

$4.29

-15.8%

17.2%

47%

Credit Corp. CCP Debt

$8.91

15.8%

11.4%

117%

Blackgold Int BGG Mining

$0.16

-5.9%

29.0%

35%

Mastermyne MYE Mining

$0.70

-43.2%

30.5%

34%

Seven West Media SWM Media

$2.13

40.8%

11.4%

89%

Hills Limited HIL Manufacturing

$1.73

96.6%

22.3%

38%

Logicamms LCM Engineering

$1.29

34.7%

16.7%

41%

CI Resources CII Mining

$0.85

62.3%

48.8%

31%

Collection House CLH Debt

$1.64

75.5%

11.4%

73%

Ausenco AAX Engineering

$0.62

-74.6%

37.1%

31%

Chandler Macleod CMG HR

$0.46

1.7%

10.2%

138%

Collins Foods CKF Fast food

$1.83

50.6%

12.0%

62%

Tribune Resources TBR Mining

$2.80

125.8%

27.0%

32%

MaxiTRANS Ind MXI Transport

$1.17

16.7%

15.4%

39%

Boom Logistics BOL Cranes

$0.12

-55.7%

14.4%

42%

Nine Ent Co. NEC Media

$1.88

N/A

20.2%

34%

GR Engineering GNG Engineering

$0.50

-22.4%

16.8%

36%

Saunders Int SND Storage

$0.90

30.4%

12.7%

46%

CMI Ltd. CMI Mining

$1.70

-0.6%

26.2%

29.50%

Foolish takeaway

When using the strategy from The Little Book That Beats the Market investors should be careful not to pick stocks at higher risk of earnings downgrades. The analysis is skewed towards companies with recent sharp price drops, or that have underperformed the market. The top three stocks, Decmil, Codan and Thorn Group, have all seen their share prices retreat from mid-year highs due to downgrades, underwhelming forecasts or poor confidence in their respective sector. Similarly, retailers and IT companies are well represented in the table as they have had a tough year and underperformed the market.

To avoid being wiped out by companies that deliver poor earnings guidance, Greenblatt encourages buying between 20 and 30 of the stocks and re-calibrating every 12 months.

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Motley Fool contributor Andrew Mudie owns shares in Codan.

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