In many of his first year classes, Joel Greenblatt opens with a simple observation. He shows the class the highs and lows of stocks at random.
As an example let’s look at three stocks that first popped into my head: Apple Inc. (NASDAQ:APPL), Evercore Inc. (NYSE: EVR) and Ford Motor Company (NYSE:F).
In 2017, all three diverged in price significantly. The table below shows the high and low of each throughout 2017.
All three moves pretty significantly throughout 2017. What more all three stocks didn’t move upwards, from low to high, in a linear fashion. They gyrated throughout the year.
Ford in particular returned almost nothing for the year. Yet there was still a differential of as much as 21% between the stocks high and low that year.
Evercore on the other hand hit its low towards the middle of the year. Apple was the only one that rose almost each month.
What does this tell us?
The market is not efficient. Was Apple really worth $115 and $177 per share in the same year? The same question goes for Evercore and Ford. Either all three companies had rapidly evolving earning potentials, or investors continued to overreact over newly acquired information.
There is money to be made in the market…Greenblatt tells his students. All you have to do is weed out the good from the bad.
But let’s go back a bit. How do you know a good investment from a bad investment?
How to Value that Sweet Sweet Candy
It’s actually a pretty simple process. Many investors stray from this process because they believe a complex, more complicated function will be their holy grail.
But all you need to look for is cheap stocks – stocks that are trading below their intrinsic value. Of course this just prompts more questions. How does one calculate a stocks intrinsic value?
There are a couple of ways to do it. First you might want to look at how much cash a company generates after necessary expenses. This is a company’s free cash flow, which you can then project out into the future, coming up with an estimated intrinsic value.
For example, say you owned a candy store. To keep the building in shape and to pay for your candy registration it costs you $25 per year.
But no matter. The business generates $100 per year in cash. That means you’re business can generate free cash flow of $75 per year. Let’s assume this is an average year.
With no assumption for growth, you believe your candy store could easily produce $75 annual for the next 10-years.
Using a discount rate 10% (money is worth more today than it is tomorrow) you believe your candy business has an intrinsic value of $461 in today’s dollars.
Therefore if someone was willing to offer you $1,000 for your business, it would be an amount worth thinking about. Such an offer would represent 117% return on what you believe your business is worth.
Another way to value a company is through assets rather than earnings. A lot of conservative investors like to deal with asset values as they’re more tangible.
They have no insight as to what earning or cash flow will be in a number of years. But they are pretty certain on the value of assets held by a company. And it’s this figure – sum of asset values – they use as an intrinsic value.
As an example, imagine the same candy business. You own the store (property and the building), the equipment within the store, inventory (the candy) and cash at the bank. All of this has value.
Below I’ve created a simplistic balance sheet.
The value of total assets is $180 and the value of total liabilities (what you owe to other people) is $45. Thus, assets minus liabilities gives you’re candy business a net asset value of $135.
As you can tell, this is a far more conservative valuation compared to add up future cash flows. Some investors like to take it even further and only give worth to the most liquid assets, current assets.
One more way to value a company is simply by the sum of its parts. This means to value a business on the basis of what it owns. Investors might only do this for a particular type of business – a closed investment holding company usually.
The idea is to tally the value of stocks held within the company’s portfolio. Going back to our candy analogy, had shut up shop and decided to buy and hold a 30% stake in three separate businesses which were listed, then using market value you could come to a reasonable intrinsic value.
OK so it’s not that tough right?
Yet, even those who focus on buying cheap stocks can underperform the market over the short-term.
Investing is easier said than done, which is why many investors fail to outperform the market. In a 2015 paper, S&P Dow Jones Indices showed more than 84% of US active funds underperformed the S&P 500 over a 12-month period.
As the years roll on, fund managers performance gets even worse. Over a 10-year period, only 2% of active funds outperformed their benchmark, according to the S&P study.
Similar results also popped up in Europe and the UK. Do you think these managers don’t know how to value businesses?
I doubt it. It’s more likely that they stray from conventional wisdom and let emotions get the better of them.
That’s why, for many investors, knowing what to look for and actually buying it isn’t as simple as you’d think. So how can you beat the market with a click of a button?
Follow the value approach which has succeeded time and time again, while also removing emotion from the equation.
Invest in a group of market beating stocks.
Ready for that Button Click?
In almost every research paper and study on the subject, its value that reigns supreme. Stocks that are cheap outperform ‘growth’ stocks (stocks expected to outperform). And that’s because investors overreact.
Like you saw earlier, stock prices change dramatically, even in the space of 12-months. Investors overly punish bad news and get over excited about good news. Thus, it’s the cheaper stocks, which have low expectations that outperform more often than not.
But as I’ve mentioned, you simply can’t buy a cheap stock and expect to do better than the market. And that’s because cheap stock outperform on average.
Thus holding a group of cheap stocks greatly improves your chances of outperforming year to year. This is exactly how many studies on the matter were done. The researchers grouped stocks from cheapest to most expensive.
And that’s exactly how you can beat the market will just one click of the button. All you need to do is search for around 20 cheap stocks and hold them.
Let me show you what I mean. Below I’ve searched for the cheapest stocks within the S&P 500 (largest 500 US companies).
I’ve defined cheap as:
Enterprise value (EV) / Earnings before interest and tax (EBIT)
This is probably a bit different from the price-to-earnings (P/E) ratio you’re familiar with. But it works on the same principle.
Instead of market cap (price), I’ve used EV. Unlike market cap, EV incorporates debt, cash, preference shares and minority interests. This then penalises companies for having too much debt or preference shares and rewards them for having lots of cash.
And instead of net income (earnings) I’ve used EBIT. This creates a level playing field. By excluding interest, I’ve removed the need to normalise various levels of debt each company has. The same goes for tax. Difference companies, even within the same industry have varying tax rates.
Thus, the more a company earns compared to what it costs, the lower the EV to EBIT ration and the cheaper it is.
But can this group of 20 cheap stocks really beat the market…let’s find out.
Below are returns for each stock during 2017.
What was the return of the S&P 500 over the same period? Only 19%…and thus we’ve come up with a group of stocks that have beaten the market.
Of course you don’t have to invest in all 20 stocks. You could use this screen, which is one of many as hunting grounds from individual stock picks to add to your portfolio.
For example you might have thought HP Inc. and First Solar were worth your investment putting $5,000 into both. Within the 12-month you could have almost doubled your money, far exceeding the 19% return of the S&P 500.