How does Greenblatt’s method work?
In his short, well-written book, The Little Book That Beats The Market
, Greenblatt explains his simple approach, Phil Oakley in Money Week
explains. His method boils down to looking at company returns as if they were interest rates.
The best businesses out there earn the highest rates of interest on the money they invest.
So how do you work this out?
You calculate a company’s return on capital. That is its trading profits (earnings before interest and tax - EBIT) divided by its tangible capital invested. (This is the firm’s stock inventory, plus money owed by debtors, less money owed to trade creditors, plus fixed assets.)
When looking at the price to pay, you search for firms with the highest earnings yield. That’s what the business earns compared with its purchase price. This is a company’s trading profits divided by the market value of the business (market capitalisation plus net financial debt).
Greenblatt focuses on EBIT so he can see the profits the whole business is making. And it allows easy comparison across different companies. By relying on other measures, such as earnings per share (EPS) and price earnings (PE) ratios, debt levels and different tax rates can make this more complex.
Greenblatt doesn’t use any forecasts in his method. He uses only current profits and prices.
How to apply Greenblatt’s stock screening method
Select shares with a minimum market cap of say R500 million. This means the shares should be liquid enough to easily buy and sell.
Decide on a minimum return on assets or return on investment of 25%. Rank the companies, with 1 being the best, according to highest returns.
Look for companies with low PE ratios and rank them, with the lowest PE being 1.
Eliminate all financial shares.
Add the rankings together to get a combined score.
Buy the top ranking five to seven companies.
You then repeat the above process every few months until you have a portfolio of 20 or so shares.
After holding a share for a year, you sell and replace it with a new one selected with the same method.
Stick to the method for three to five years.
Greenblatt’s method has a market beating track record. Between 1988 and 2009, his method delivered annual returns of 23.8% against 9.6% for the S&P 500 Index.
Of course it had some great years and some poor years of performance. No method consistently works. But if you fancy applying a different strategy to selecting shares, this could be worth a try.
So there you have it, an investment strategy that could help you select a winning portfolio.