Let me say, at the outset, that, in my opinion, Joel Greenblatt has put together a very useful little book on a Fundamental approach to company analysis.
He makes several practical and valuable recommendations, which are also in line with Warren Buffett’s own investment strategies.
These include his comments on page 105 of his book where he states, "As a general rule, if you are truly doing good research .... owning just 5 to 8 stocks in different industries can safely make up at least 80% of your total portfolio."
He also goes on to say, on page 108 and 109, "The more confidence I have in each of my stock picks, the fewer companies I need to own in my portfolio ..."
There are quite a few SI "Value Investing" contributors, including a Moderator or two, who apparently don’t see it that way !!
His is also one of the first publications I’ve read that uses a pre-tax form of profit divided by Capital Employed as an indication of a company’s fundamental Quality.
Most use Net Income divided by Capital Employed.
However, I would differ with him regarding the use of EBIT instead of the "Profit Before Tax" number in the first of two of his "Magic Formula" factors.
He supports his use of EBIT because "companies operate with different levels of debt and differing tax rates."
Well, we believe that the effect of Debt on a company’s Income Statement is an important consideration. And that effect is represented by the "Interest Expense". Excluding that number in the Capital Employed ratio is counter-productive. One doesn’t want to have too high an "Interest Expense", especially when compared to a company’s EBITDA number. You are just reducing the amount of original Turnover reaching the Bottom Line.
However, we do go along with his contention that one should exclude the Tax number in the C.E. ratio. It does sometimes happen that a company can get a once-off tax break because of an approved tax loss which is contained within another company it may have purchased.
The second "Magic Formula" component is the ratio of EBIT/EV.
Well ... EV is supposed to represent the takeover value of a company. But who is to say that that is what will occur. It may be more, it may be less. And if we have a company that is firing on all its financial cylinders, making above average and ongoing profits, what are the chances that it will be up for sale ? Because only in a sale, or takeover, can any form of EV be realised. So one could question its relevance.
As far as we’re concerned, one should just use the P/E ratio, with two additional considerations ....
1) Exclude, from the Bottom Line, those extra-ordinary, once-off costs or revenues obtained, for example, from the sale of a property or asset which does not form part of a company’s usual line of business.
2) Take note of the change, if any, in the number of shares available to the public. If many more shares have been recently issued, this will effect the EPS number and, in turn, the value of the P/E ratio.
By considering these two aspects, one is closer to getting a Bottom Line EPS which should better represent the general business process of a company.
In our opinion, this form of EPS is a more relevant number than EV.
Although Joel Greenblatt gets closer to identifying Fundamental Quality than many others, we believe that his "Magic Formula" goes only part of the way to getting a comprehensive insight to a company’s Fundamental Quality.
It’s not enough, we believe, to look JUST at the relationship between pre-tax profit on the Income Statement as compared to Capital Employed from the Balance Sheet.
One needs to also take into account several other items on the Income Statement and Balance Sheet, and the interaction of several of them with each other.
These include Turnover, EBITDA, Interest Expense, Profit before Tax, Attributable Income, Long Term Debt and Shareholder’s Interest.
Once these are taken into account, and, preferably, target percentages assigned to several critical financial ratios constructed from those items, one then has several useful yard-sticks against which to judge an Industrial company’s Fundamental Quality and ability to generate ongoing profits, especially if that company Simultaneously meets or exceeds ALL of those ratios.
Looking at BLDR we have a below average Operating Income, a reduced Annual Bottom Line and falling Quarterly Turnover.
PACR’s Turnover is generally flat, and its Operating Income is also not very high.
CECO’s fundamentals were looking good a while back, but its last few Quarterly Turnovers and Bottom Lines have been falling.
In my opinion, WDC and FCX have the better set of current fundamentals.
Let’s see what happens "going forward" ! |
