http://www.magicformulainvesting.comIn his book "The Little Book that Beats the Market", Joel Greenblatt presents a formula for investing in companies based on two factors. The factors are from two of the most influential people in teaching investors how to think about investing - Ben Graham and Warren Buffett. From Graham, Greenblatt takes the concept of price, specifically looking for cheap stocks not necessarily great companies, just a great price (Graham famously called these "cigar butts"); from Buffett & Munger, Greenblatt uses the concept of looking for good companies.
The stocks are evaluated on price via an inverse P/E calculation; and "good" companies are defined as those earning a high return on capital. Then in true value investing style (i.e. not over-complicated), Greenblatt combines the two factors using a simple 50/50 format. So all companies are rated by price and quality, if your company comes up 11 on price and 27 on quality then it gets a 38. His book goes into more details, and you can use this
website to screen for companies.
What do you think would happen if we simply decided to buy shares in companies that had both a high earnings yield and a high return on capital? In other words, what would happen if we decided to only buy shares in good businesses (ones with high returns on capital) but only when they were available at bargain prices (priced to give us a high earnings yield)? What would happen? Well, I'll tell you what would happen: We would make a lot of money! (Or as Graham might put it, "The profits would be quite satisfactory!")
A lot of the time you find pretty boring companies doing something profitable and necessary, but not too exciting. There are generally not very many tech companies on the list - Microsoft is there now because of the Yahoo stuff, Microstrategy has been there for awhile, and now we have Sun (
JAVA) there as well.
Being on the Magic Formula list is not necessarily a good thing for your present stock price. It means you are being beat up, fairly on unfairly going forward is the question. Greenblatt's formula suggests its worth looking at Sun's potential going forward. Their P/E is 15 (for comparison
Oracle's is 22 and
Red Hat's in 59!), good news for Sun shareholders is the company continues to make money. One problem seems to be margins - Sun is earning 4.6% net profit margins whereas Oracle and Red Hat are at 24% and 14% respectively. Of course, in general margins on hardware are not generally as good and Oracle and Red Hat are software plays.
In any case Schwartz seems to be doing some smart things and positioning Sun for quite satisfactory returns. Sun's Price/Book ratio is just above 1.5 which makes a value investor sit up and take notice. A pretty impressive
list of investors, notably Mason Hawkins, has been buying in. As much as Sun has struggled with its post-dotcom identity, it is rare to see a company with this much upside on the Greenblatt list.
Anyhow, Sun's residency on the Greenblatt is not a good thing for the company this instant. It could mean good opportunities for them and investors going forward - after all its a list of good companies selling at cheap prices. I have no position in any of the companies mentioned, and I have no business giving people investing advice, but I am interested observer. If you are thinking of buying JAVA based on Greenblatt's quantitative methods, read his book first to understand how to manage risk in his methodology. In any case I wholeheartedly recommend Greenblatt's book, its short, and packed with good stuff.
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