General ThoughtsInvestment PhilosophyJoel GreenblattSuperinvestorsWarren Buffett

Thoughts on Return on Capital and Greenblatt’s Magic Formula Part 1

I recently watched a video of Joel Greenblatt with Morningstar. Most of the video discusses the index approach to investing using a value weight (as opposed to equal weight or market weight, which most indexes use).

I’m not that interested in indexing, although for individuals who want completely passive exposure to stocks, value weighting certainly makes much more sense to me than market weighting (because market weighting systematically buys more of a stock as it goes up, thus forcing you to buy more of a stock as it becomes more overvalued, and less of a stock as it becomes undervalued… equal weighting makes these errors random, and value weighting essentially reverses the errors, thus allowing you to own more of a stock as it becomes cheaper, and less of it as it becomes more expensive).

Anyhow, it’s an interesting concept that Greenblatt has been discussing for a few years and it is the topic of a book he recently wrote called the Big Secret for the Small Investor.

It’s a good book, but indexing is not what we do here, so it’s less interesting to me than his previous work on bottom up stock picking.

Cheap is Good, Cheap and Good is Better

But in this short interview, he made some interesting remarks on specific metrics he wants… first, he recapped the same basic things he likes to look for in stocks. Greenblatt likes stocks that are “cheap and good” as he often puts it. This means he likes stocks that are cheap relative to earnings in the Ben Graham tradition, but he strives to own stocks that are not just cheap, but also good.

The “good” part comes from what Warren Buffett talked about in his shareholder letter in 1992… basically he wanted businesses that could invest large amounts of incremental capital at very high rates of return. Good businesses earn high returns on capital, great businesses can reinvest large amounts of capital at similarly high rates. Greenblatt uses historical financial statements as a guidepost for identifying businesses that could potentially meet this critiera.

So Greenblatt attempts to combine Graham and Buffett… he wants stocks cheap (low price to earnings) and good (high returns on capital).

The Importance of Return on Capital

Now, for some inside baseball stuff… To determine valuation, Greenblatt doesn’t use P/E, but rather EV/EBIT, which is a better measure that removes the effect of leverage and tax rates which makes for easier apples to apples comparisons across capital structures and across time. For quality, he uses return on capital.

I might do a more detailed post on return on capital at some point, as it seems each investor calculates it slightly differently.

Return on Capital is a general concept that is extremely important for investors to understand. Some investors prefer to buy cheap assets (Graham bargains, net-nets, etc…), but even in these businesses, return on capital is important to understand as it will impact your margin of safety, i.e. the window of time you have to sell those cheap assets before their intrinsic value begins to decline over time (as inevitably occurs with poor earning assets). Cheap assets and special situation investments can work out wonderfully over time, and they can be very simple investments, but ideally we’d prefer owning businesses that produce high returns on assets at those same cheap prices. That’s what Greenblatt endeavors to do with his magic formula. He wants to have his cake and eat it too…

This broad measure is usually referred to as “return on capital”, “return on capital employed”, “return on invested capital”, among other terms, and they can have slightly varying definitions, but the main objective—regardless of how it’s labeled or the nuances involved in calculating it—is to determine how good a business is at using its capital to generate earnings.

As investors (part business owners), we are interested to know—among other things—these basic things when it comes to Return on Capital:

  • How much capital has the business invested?
  • What kind of rates of return has it historically earned on that investment?
  • How much capital will it need to invest going forward (or better yet, how much can it invest going forward?) and what can we expect to earn on that future investment?

The first two things we can determine by looking at the financial statements. The invested capital is listed on the balance sheet. The third thing is really what we want to find out (how much money can we earn going forward, and what kind of capital will we need to invest to achieve those earnings?). Ideally, we want a business that can produce high returns on capital and can also invest large amounts of additional capital at similar rates of return in the future. There are methods to approximate returns on the incremental capital that a business employs, which we can discuss a different time, but we’ll discuss Greenblatt’s method now…

Greenblatt’s Definition of Return on Capital

Greenblatt defines “capital employed” as net working capital plus net fixed assets (PP&E) less excess cash. In other words, he uses total assets less non-interest bearing current liabilities (a more common calculation), but then he subtracts goodwill and intangibles as well as excess cash.

His objective is to determine the tangible capital that a business needs to operate. A business needs to lay out money to stock shelves with inventory, equipment to produce goods, buildings to house employees and products, etc… but it doesn’t have to lay out money for goodwill, intangibles, or accounts payable (which are essentially an interest free short term loan reducing the amount of required capital). Also, the excess cash is not needed to operate the business either, so that gets subtracted from the total assets as well.

He also uses EBIT in the numerator as opposed to net income, which allows for a better apples to apples comparison of earning power as it allows us to compare earnings across capital structures and across time (varying tax rates).

So the two main components of value that he uses for his “magic formula” are:

  • Valuation: EV/EBIT
  • Return on Capital: EBIT/(Net Working Capital + Net PPE – Excess Cash)

To use an oversimplified example, think of it like this… if you buy a duplex for $100,000 in cash, and it gives you $6,000 per year in net operating income (rent less all expenses before taxes), your duplex provides you with a 6% return on invested capital. Since there is no debt, your return on equity (ROE) is also 6%.

Return on capital accounts for the total capital that your business uses, whether it’s equity (all cash) or equity and debt (cash plus a mortgage). In this example, if you used $20,000 of cash for a downpayment (equity) and took out an $80,000 mortgage at 5% interest (debt), then your Return on Equity changes, but your Return on Capital is still 6%. In this case, you now have a $4,000 interest payment each year, which gets subtracted from the $6,000 net operating income, leaving you with $2,000 pretax income, meaning that your pretax ROE is 10% ($2,000 pretax earnings divided by $20,000 equity). In this case, using debt increased your return on equity, but the business itself (the duplex) didn’t become better. The duplex is the same duplex, and the monthly rent checks didn’t change. The capital structure changed, but the earning power of the duplex didn’t change.

Greenblatt was interested in determining and comparing the raw earning power of each business, and so he didn’t want results skewed due to the effects of leverage and tax rates, which is why he preferred to use pretax operating earnings, or more specifically–Earnings before Interest and Taxes (EBIT).

I introduce these terms here to provide a brief backdrop, but here is what I found interesting in the video. Greenblatt said he prefers companies that produce 50% or better returns on capital, and most of the stocks he owns are businesses that produce 50% returns on capital or better.

He points out that he specifically looks for businesses with these types of returns on capital. I have a few more thoughts on this topic, which I’ll post in a “part 2” in a day or two, as this post is getting lengthy. I also will provide a link to the video (couldn’t find it in my bookmarks at the moment), as well as a link to one of Buffett’s letters where he did a general study of these types of high quality businesses in the 1980’s.

55 thoughts on “Thoughts on Return on Capital and Greenblatt’s Magic Formula Part 1

    1. That’s a great point ValueFactors. I’ve read that report, along with the nice post by Toby that you linked to.

      This thought deserves a post of its own, but briefly… I’ve spent a lot of time considering this, and basically, my short answer/comment is that cheapness is the most important factor over short term time periods (say 1-3 years). It’s by far the most important. However, over 10-15 years, or longer, ROIC is by far the most important. The longer holding period you have, the less valuation matters and the more quality (business returns, or ROC) matters. I haven’t read much research (other than one report that discusses something similar) on this, but I’ve empirically observed this by looking at the best performing stocks over any long term time period (say the last 20 years)… if you notice stocks that have averaged 15-20% annually over that length of time, almost all of them have really strong returns on capital.

      So I agree that ROIC is much less of a factor if you plan to hold stocks for just one year. In fact, if you plan to do that (like a Greenblatt formula), I would just focus on cheapness (low P/E, low EV/EBIT, low P/B, etc…). I think this type of strategy will continue to work well over time. I prefer to pick my own investments manually, and my ideal holding period is longer than just 1 year, so I do emphasize focusing on quality in addition to valuation, but there are lots of methods that can work over time…

      It’s a really interesting discussion.

      1. Had one other quick thought… as I mentioned, I’ve done some rudimentary studies of this ROIC vs Value topic previously… a good way to demonstrate the importance of high returns on capital is to look at long term shareholder returns (over 15, 20 years or more). For example, I just picked up my Value Line and flipped to the steel section, which is known for their low average returns on capital over time. Note: steel is cyclical, which leads to very volatile results. The companies will produce periods of very high returns followed by periods of very low/negative returns. But over the full cycle, they produce very mediocre returns on capital of 4-6% in most cases.

        We could do this exercise on a number of stocks, but take US Steel for example. This company has reorganized once or twice in the past few decades, but pulling up a long term chart we see that the stock (X) traded around $30 per share in the early 1990’s. USX earned around $3 per share in the early 1990’s, followed by a few years of losses, and then a period of excellent profits in the early 2000’s, and then back to losses.

        But just taking a snapshot in time in the early 1990’s… one could have bought the stock at $30 or so at around 10 times earnings. Today, the stock trades at $25. So even if we paid 3 times earnings for X in the early 1990’s, or $9 per share, or returns over the next couple decades would have only amounted to around 5% per year, which equates roughly to the company’s return on capital.

        Of course, we could have paid 3 times earnings and then sold out at a profit a few years later potentially, reaping a nice IRR, but this relies on buying low and selling high in a shorter period of time. So paying low prices to earnings is more important if your holding period is a shorter period of time.

        Flipping through the steel section of Value Line, this example holds true with many other mediocre return on capital steel stocks. Gilbraltar (ROCK) traded at $10 in 1994 (20 years ago), and it trades at $17 now, an annualized return of just 2.6%. ROCK paid dividends in some years, but they weren’t large dividends, and even if we add 2-3% to those returns, they are still mediocre.

        One more example: Ampco-Pittsburgh Corp (AP) traded at $8 in 1994, and it trades at $17 today, a 3.8% annualized return before dividends, which again might add 2% or so to those returns. An interesting note with AP, if we go back even further to 1984 (30 years ago), the stock traded at $22 per share. So 30 years later, our poor long term shareholder has seen his principal reduced by 23%! It is likely that a buyer of AP stock in the mid 1980’s could have paid far less than 1 times earnings for AP, and still be left with very mediocre long term returns.

        Contrast that with one of the best performing stocks of the past quarter century: Fastenal (FAST). FAST sells nuts and bolts, sounds basic enough… but the returns are far from basic. The company averages around 20% returns on capital and produces very consistent results. 25 years ago, the stock traded for a split adjusted $0.32. Today, it trades at $44, or 138x the price in 1989. The stock has averaged 21.8% annualized returns not including dividends. This long term result nearly matches the company’s average return on capital over time.

        Fastenal earned roughly $3 million in 1988, and a buyer of FAST paid somewhere around 25 times earnings for FAST in 1989. But a buyer could have paid 50 times earnings for FAST in 1989 (or roughly $0.65 per share) and the compounded annual return would have only decreased from 21.8% to 18.4%…. a big difference over time, but certainly still a splendid result.

        This is just one simple example, but a similar long term result could be observed with Walmart, Coca Cola, McDonalds, and many other more well known examples of high ROIC companies that have correspondingly high stock CAGR’s over time.

        The idea here is not to attempt to push long term compounders. And this comment will agitate deep value guys (who I consider myself to be friendly with… I love cheap stocks). I certainly am not recommending paying 50x earnings for good businesses. Capitalism is too competitive and the future is too uncertain (at least for me) to be able to accurately pick out the next Fastenal.

        But it does prove that a business that can sustainably produce high returns on capital over long periods of time (a good business) is far more important for long term shareholders than the price they initially pay for that business.

        Again, I cannot emphasize enough that valuation is more important over shorter time periods, quality is more important over long time periods (10-15 years or longer). The longer you hold a stock, the more important the quality of that company is, as your long term returns will approximate the company’s internal returns on capital over time.

        In the shorter term (1-3 years), valuation is key. You can buy a steel company at 3 times earnings and will likely have the chance to sell it at 9 times earnings at some point. Same goes for low P/B stocks, net-nets, etc…

        I guess this might be a post, but it’s an interesting concept to consider. I prefer to look at quality companies, but I won’t sacrifice valuation, as that is the fail safe if you inaccurately analyze the business’ long term prospects.

        1. By the way, I wasn’t trying to pick on the steel industry, it’s just that that industry has historically struggled to earn its cost of capital, and is burdened with miserable economics. The same types of examples could be used in airlines, or other capital intensive, low ROIC industries.

          Of course, not every steel company produces low returns. The low cost producer might be able to sustainably create above average returns on capital over time. But in a business like steel or any other commodity business, it’s tough.

          The exercise is really about any company that produces low ROIC vs any company that produces high ROIC over long periods of time.

          High ROIC always wins in the end, given a long enough time horizon.

          1. It’s useful to remember an old Wall St. adage: “as soon as you figure out the key, they change the lock.”
            With these truly secular high ROIC companies, the ones Buffet likes, you have 2 problems: there is no assurance that their high ROIC will continue into the future, but even if they were to continue, they are rarely attractively valued enough to purchase. It takes big market breaks (e.g. 1974, 2008) for this to occur.

        2. Great insight. I think the main challenge for these high ROIC businesses is to keep finding reinvestment opportunities, so they can continue to compound their returns. That could be hard to predict, especially 10-15 years in advance.

          1. Yes, very difficult to predict. To put the odds in your favor, it helps to have a business with a stable history and a predictable business model. That doesn’t guarantee you’ll be able to predict the future, but it is easier to guess what Walmart’s profits will look like in 10 years than it is to guess what Delta’s profits will look like.

            As I mentioned in another post, I like looking off the beaten paths for these compounders as well. Small companies with clean balance sheets and good business models.

            I like quiet, boring cheap businesses.

        3. John,
          I looked at Value Line to reconcile the X case. Are you using the Individual investor version or the institutional version? I am asking because the latter appears to provide much more historic data that I find appealing.

          1. Hi Roger,
            I’ll have to check that out. I receive Value Line the old fashioned way (the magazine style hard copies). The data goes back about 15 years or so for most companies. For the US Steel example, I just looked up their earnings history dating back to the late 80’s/early 90’s when the firm called itself USX.

      2. Interesting you should mention the yearly portfolio turnover with the Magic Formula. After submitting my comment I did wonder to myself if that was a factor in the high returns when just focusing on the cheapness metric. It would be interesting to see how the two strategies would match up if the holding period was increased from 1 year.
        If ROIC is more important in the long term then I would expect the Magic Formula to win over just EV/EBIT when the holding period is increased.
        Thinking of ‘What works on wall street’, the low decile P/E, P/B, EV/EBITDA etc strategies are also held for one year then reset to the latest best decile. I don’t think longer holding periods are discussed.

        I assume you have read the paper that claims to have ‘solved’ Buffett’s alpha. They interestingly refer to value investing as ‘buying what is cheap regardless of quality’ and the quality strategy as ‘buying quality regardless of price’. They show that high quality companies have a tendency to remain high performers in the future.
        If understand correctly they combine a multitude of quality metrics that cover profitability, ROA, ROE, debt payments, solvency, low beta etc, with no concern to stock price.
        It’s not simple to replicate (for me anyway), but perhaps (hopefully!) ROIC is a simple metric than can capture a large percentage of the ‘qualitiness’ in companies.

        1. One more thought. I think in the buffett alpha paper they still turnover the portfolio once a year. I need to double check that. So I don’t know for how long or sticky the high quality is.

          1. Value, I think I’ve glanced at the paper, but don’t recall taking much from it. Maybe I need to take another look. I’m always skeptical of any academic paper to begin with, as they always seem to report results that far exceed what practitioners are able to achieve. But nevertheless, the results they find are always interesting.

            There was one paper that studied Buffett’s stock investments within Berkshire and discovered his investments made over 20% per year from 1976-2006. That study seemed to provide legitimate evidence of Buffett’s prowess when it comes to stock picking alone (as if someone had to prove it).

            There was another paper that was referenced by a professor in India that I found interesting. I think an investment bank did the study but I’m not sure… basically the study found that the majority of high quality companies remained high quality after a period of time (I think it was 5 years), and the lowest quality companies remained in the lowest quality quadrant the majority of the time. And very few went from low quadrant to high quadrant and vice versa.

            So that paper basically provided evidence that mean reversion is not the norm when it comes to returns on capital, which seems to be what most people believe.

            I like the Tweedy Brown studies and the other value studies. They show that there is a systematic and consistent undervaluation that occurs in certain parts of the market (low P/E, P/B, etc…). And I think these types of ideas will always add a few percentage points to the overall market. Those ponds seem to be good places to fish.

            I think what those papers demonstrate is that the stocks with low P/E ratios tend to generally have pessimistic near term outlooks, and they get systematically underpriced. The market seems to correct itself fairly quickly though, as the 1 year holding strategy seems to continually provide 2-3% better performance than the average over time.

            I think if an investor wants to flip stocks (when I say flip, I’m just talking about buying cheap and selling higher after a year or two), then that type of strategy (pure cheapness) is the one to focus on.

            I don’t really focus on the quant stuff with my own strategy. I understand that valuation provides a slight edge, but my main goal is to good businesses that produce consistent cash flow that I can buy at good earnings yields. Ideally, the business can reinvest those earnings into the business at high rates of return.

            Secondarily, I’ll look for the cheap stuff that might involve some sort of asset play, special corporate situation, real estate, etc…

            Those can work also, as low P/B tends to work over time.

            Interesting discussion…

  1. Hi John,

    This more to do with the timing of cigarette-butt-type investing and turnaround stocks than Greenblatt’s formula, but kind of in-line with your previous posts, I was just wondering your current views on the state of companies semi-distressed stocks like JCP (and retail sector in general, it seems), gold/silver/coal/etc., and education stocks? I know you considered some retail, gold/silver, and Strayer a few months ago — is that thesis still intact? Or, has the dip lower on most of these sectors caused you to reconsider some of these theses? In short, how do you view the process of thesis development/reconsideration?

    Part of the reason I feel that some retail investors like the idea of indexing and using things like Greenblatt’s formula is that it’s much easier to simply buy an index-type fund or grab stocks from Greenblatt’s list than it is to perform due diligence and really dig into a company and then see your investment theses not met over the course of 6 months or a year. If one owns an index fund and the index goes down, then it’s like “Well, the whole index was down”– so it’s easier to simply blame the market. Or, if Greenblatt’s formula doesn’t work — then, it’s easier to just blame Greenblatt’s formla. Whereas, if one develops a specific thesis, follows that thesis, and then if the thesis doesn’t pan out then there is a lot more personal blame / regret / would’a-could’a-should’a-type thinking that makes one reconsider personal investment principles.

    At any rate, enjoying these recent posts on quant/computers, value/growth and Greenblatt.

    Thanks much,

    1. Hi Ryan, thanks for the comment. I am finding some off the beaten path value, and in the past few weeks a few things got quite a bit cheaper. There are lots of ideas out there currently. I still like everything I’ve written about recently. I’ve found some ideas I like better, and over time, I’ll probably post some thoughts. Some ideas are too small to write about, as I have new clients continually entering my firm and I’d like the stocks to stay cheap to be able to acquire more, but the larger ideas I’ll discuss on the blog. I’ll probably discuss the small ideas after the positions close, which might be a few years. Most ideas are plenty large enough to discuss.

      Weight Watchers is one. I think it’s unduly cheap right now, and I think it’s a great business. Incredible returns on capital, very high margins, consistent free cash flow, and they need virtually no capital to grow. I love their business model. They have a variable cost structure which allows them to shrink or grow their business to adapt to the top line, and it creates an incredibly stable operating margin. Plus, they have a strong brand, market share, and an insider ownership group that intends to return all of the free cash flow to shareholders over time. All for 7 times cash flow.

      There are some retail businesses I like a lot… I know a lot of value guys don’t like retail. It’s sometimes a tough business, but some firms produce really high returns on capital and good free cash flow, and there are a few interesting ideas.

      Some of the banks I like a lot as well, and there are a few other special situations and asset ideas that are interesting.

      That about sums it up. I’m continually finding new ideas to read about… will probably write about a few specific ideas over the next few weeks as I have time.

    1. Hi Postermind… to be brief, I look at each financial statement on its own, and make certain adjustments if necessary. But basically, yeah usually I would consider working capital to be current assets less current liabilities. Basically, the capital available for day to day operations (liquidity).

  2. I love ROIC. Consistently high ROICs are the ultimate quantitative measure of business quality, in my opinion.

    I think the magic formula is a terrific filter. The hard part is calculating all of the ROICs, especially when you have to make balance sheet adjustments to get an accurate number. I’m based in Brazil, where the IFRS has been adopted; as a result, some firms have reevaluated their fixed assets to a “fair value”. I don’t think these reevaluations should be a part of the invested capital calculations, since they are non cash, so I have to go through footnotes to get a good ROIC estimate. Still worth the effort though.

    It’s rare here to find a high ROIC company on the cheap. They usually have low liquidity, a governance problem or some other issue. I’m currently studying one whose ROIC have averaged 31% (post taxes) over the past 5 years trading for 5.0x EV/EBIT. It has a very a small float and some governance issues but the numbers may be too good to pass up.

    1. Very interesting Pedro. Thanks for the comment. I’d love to hear more about your search process in Brazil. I think there are some economic tailwinds that you’ll benefit from over long periods of time, so I wish the best. Great work on finding a cheap compounder at that price.

    2. And by the way, I agree with you regarding IFRS. There are a few adjustments that need to be made. Actually, even with GAAP there are adjustments that need to be made. The magic formula is designed for retail investors to be able to pick from a “preapproved” list of sorts (not every stock is approved, but the idea from Greenblatt was that he could provide a list of stocks that would carry above average odds of success). But even Greenblatt goes through and makes adjustments from company to company based on each individual situation.

  3. Can you explain more about investing based on assets category again? You have invested in cheap banks that produced earnings, gold miners that were cheap based on their balance sheet, and the for profit education sector that is producing high amounts of return on capital.

    Investing in assets and earnings is such a contradictory thing to do at the same time. Most people go with either deep value of Buffett/Greenblatt. How can you do both? Can you clarify?


    1. Sure Yuan… I basically try to simplify it down to this: How much is this business worth and how much do I have to pay for it? It’s really the same regardless of the category of investments you’re interested. Ben Graham had six different subsets of strategies at one point. I have taken aspects of Graham and Schloss, aspects of Buffett, Greenblatt, Klarman and others… but really, value investing concepts are all the same. What’s it worth, and how much do I have to pay. We’re all trying to buy undervalued stocks with a minimum of risk.

      I should write a longer post with some more detailed thoughts, but yes, I look at both compounders and cheap assets. Compounders are the ideal investment because they require much less turnover, less portfolio maintenance, less taxes, etc… Also, people mistake “compounders” with mega cap companies like Coke, McDonalds, Walmart, etc… those are great compounders, but there are also small firms that are steadily and consistently growing intrinsic value over long periods of time. I’ve been looking at one small cap company that is now worth less than $250 million that has compounded its intrinsic value (and its stock price) at more than 20% per year through great capital allocation, shareholder friendly management, high returns on capital, and the tailwind of a great niche. They’ve stayed small through continual buybacks over time, which has continued to create shareholder wealth (Munger’s cannibal type stock).

      There aren’t necessarily many companies with this kind of track record, but there are lots of small firms that have great businesses that most people haven’t heard of. Look off the beaten path to find these ideas. You’re unlikely to make 20% per year owning a basket of mega cap firms like MCD, KO, WMT (although those are great businesses), but there are lots of really undervalued ideas around that are very small… too small to even write about in some cases.

      As for the idea of cheap assets, I love those ideas if I determine that they are safe. I like safe and cheap, and I prefer firms with growing intrinsic values. If it’s cheap enough, I have invested in businesses with questionable economics, but those types of situations are not as ideal because the market has to agree with you sooner rather than later.

      But as the commenter said in a different comment in this post, a stock like X could have been bought and sold many different times with great returns if a shareholder had the wherewithal to buy at really cheap levels and sell out at really high levels.

      I don’t usually prefer to play that game though (not to say it doesn’t work, it’s just difficult). Some assets I’ve purchased have been so cheap that I felt they were below replacement value, or maybe significantly cheaper than the assets they controlled, or maybe you could buy the firm for far less than they could sell their real estate for. In those situations, I’m less worried about the business’ intrinsic value, and more concerned about what the assets could sell for. Sears might be an example there… shareholders might end up doing better if the business continues to suffer, as it will motivate Lampert and management to continue to liquidate and begin realizing real estate values. That’s one well known example, but there are lots of smaller examples in this area too that Schloss specialized in.

      I really break it down into great operating businesses at cheap prices, and special situations (which include asset investments, sum of parts, corporate situations), etc…

      Hope this helps…

  4. Regarding us steel ticker symbol “x” these are not buy and hold investments…But if you buy them in their down cycle cheap enough there is huge gains to be made… In 2003 it sold for just .3 of book about $9 bucks… 5 years latter it was at $180 a share… A whopping 1800% gain in just 5 years…

    So there is all kinds of ways to twist the facts and figures to make one form of investing look better than another etc.

    A cheap asset type investor buys assets when no one wants them, then sells those same assets when people do want them, resulting in some nice gains, now it is not perfect, but it sure worked for guys like Schloss and Graham.

    Very few great companies every come around so that they are cheap, you always have to pay top dollar for them, and if one does get cheap you must load up big time, and if you are wrong and the stock is in a decline well now you paid to much and have to have a hard time sleeping for the next 10 years as your stock continues to sink… Also you might have 25% of your entire fund in that one stock, since you have to load up big since they seldom come around.

    Being able to buy big when a single stock goes down is hard to do, since the very reason of the stocks decline might very well be a valid one. A buffet might be able to do it and figure it out for some companies. But how many of you on this site are world class business and security annalists who can do this?

    For the average investor, a basket of cheap assets is the way to go, and this has been proven for pretty much a 100 years now.

    1. Yeah that’s true Darryl. In fact, a lot of cyclical companies have magnificent runs where their stocks see 10x, 20x or greater returns during a boom cycle. Often during a bust, the stocks return to where they were years prior. But it’s true, buying cyclical commodity companies in the depths of a cyclical bust and just waiting can often result in higher prices. My point was over time, good businesses (businesses that can create returns on capital that far exceed their cost of capital) are the firms that can grow their intrinsic value over time, and can create significant wealth for their owners. It doesn’t necessarily mean that from an investment standpoint, it’s the best strategy to focus on… as you say, there can be a lot of money made buying and selling certain stocks at the right time.

      My overall thoughts on investment philosophy stem mostly from Graham, Schloss, Buffett, and Greenblatt. There sometimes seems to be two main crowds in the value investing community… those in the Graham camp and those in the Buffett camp. I’m not sure they are all that dissimilar to be honest. Graham, although he wanted a “formula” that could be practiced by all, was actually quite diligent in his efforts to identify good stable businesses. He owned a lot of cheap stocks of course, but he still placed an emphasis on the normal earning power of a business. Schloss I think was less concerned with earnings than even Graham, but Schloss (thanks to his son Edwin) also preferred good businesses over poor businesses, it’s just that he refused to pay more than 2x book for anything. Certainly worked out fabulously for him, as he made 20% per year for nearly half a century. We all know about Buffett… and Greenblatt has his own thoughts regarding quality and valuation.

      In the end, we all want the same thing. We want to buy something for far less than what it’s worth, and we don’t want to take on undue risk to do that.

      I personally look for ideas all over. There seems to be this idea that an investor has to specialize in one category of investment at the expense of all others. A commenter above mentioned that its a “contradiction” to buy stocks that fall into cheap assets categories and also buy stocks that are compounders.

      I don’t really think of investing as something that has to fit into a style box. I’m just looking for cheap stocks. Ideally, I want safe, predictable businesses that I can understand, and at a cheap price. Secondarily, I’ll hunt for undervalued special situations which sometimes include cheap assets, restructurings, etc… but I’m really just trying to locate 50 cent dollars, wherever they are.

      Value investors should strive for simplicity. Don’t overthink and overcomplicate things. Don’t worry too much what Buffett does, or what Graham did, or anyone else. Buffett bought Bank of America because he saw “a fairly large gap between price and value, not because he calculated some precise P/E ratio” (his words paraphrased).

      Just hunt for situations that look obviously cheap to you that provide a reasonable probability that they’ll exceed your investment hurdle rate without much risk. That’s all I do. It can be many different types of situations, but they all have one thing in common: I understand the situation to a level that I feel comfortable with and I found there to be to be a large gap between price and my estimate of value.

  5. Hello John,

    First off, I really love your posts. I’ve been following your site since I accidentally came across a post of yours on Seeking Alpha.

    Was wondering your thoughts on WTW. It looks like with the FCF and market cap, it’s about a 8 year return. But I noticed the high debt it has. I remember seeing a comment you posted about WTW and a possible post on the company as well.


    1. Tuna, yeah I will post some thoughts on WTW as I get time. Busy researching a number of ideas currently. WTW is one I like a lot. It has a lot of debt, but the management group operates it like a PE firm. Basically, it’s a publicly traded LBO. The debt certainly adds some risk, but the company has plenty of interest coverage, and the business model (despite the negative headlines) has plenty of safety in my opinion. Some of the FCF will go to reducing debt, but I don’t think the majority group will ever operate this model debt free. I think they see stable free cash flow and the ability to leverage that with debt, and so I think we’ll see cycles of paying down debt, and then releveraging up to buy back stock, and repeat (Basically, they want to maintain a certain ratio of debt to equity, and as too much equity builds, they want to take on new debt and buy back stock, which provides owners with an increased stake in the free cash flow, and also increases returns as the debt to equity goes up). Of course, there is risk in such a model, but the operating margin history is incredible. Despite negative top line trends, the operating margin has been remarkably consistent, around 25-30% with very little variation. The company needs virtually no capital investment, and turns basically all of their earnings into FCF, which will be used to continue buying back stock. Over the past 10 years, a shareholder could have participated in two large tenders alongside Artal (majority owner), and taken out $2 of capital for every $1 that they initially invested.

      I think it’s a great brand with defensible fundamentals, high margins, stable free cash flow, and an ownership group that intends to return that cash flow to shareholders over time… all for 7 times FCF.

      That’s the gist of the thesis. I might post some additional thoughts.

  6. Correct me if I am wrong here.. but according to you if a company is making poor profits – that will be reflected onto your investment returns right? Why is it that the stock’s return is derived from the ROC?

    If I bought a compounder that can compound intrinsic value at 50%. The return on capital is 50% a year and the capital can be re-invested in some opportunities, are you saying that in the long term my return will be 50%?

    Wouldn’t that mean I should just focus on finding the perfect opportunity and invest disregarding valuation? I find a business making 50+% ROC, and buy it without caring about valuation. Wouldn’t that mean my return is higher then 50%? I’m only assuming this based on your US steel example..

    I’ve always thought valuation was extremely important, but it appears that it is important only in the short term. (If I buy a business at 2x earnings and resell at 6x. Then I should care about time horizon..)

    The reason why I said it is a “contradiction,” is because the mindsets are a bit different. Cigar butt investors more impatient because poor returns will eventually reflect into the stock. These investors look for some catalyst (like the one charlie479 proposed with the mutual fund operations.) In contrast people looking for compounders look for the perfect company that can compound their capital at high returns. As Munger/buffett said time is the friend of the investor in the good business and vice versa The investor’s own capital just sit backs and enjoys compounding. This is how I see it.

    With regards to cheap assets.. are you saying that you love them because of the earning protection? I understand that cash burn, and bad decisions can destroy a cheap asset. So it is ultimately because the underlying business is so cheap is that you like asset investments?

    In my eyes it seems you don’t like relying on one approach of higher investing returns, which is a higher valuation by You like having a mixture from your source of returns..

    On an unrelated note – Have you ever had success investing in cyclical companies? As you said you can make tremendous profits from determining normalized earnings and whether if the company is in a boom/bust cycle. I find this particular area interesting as Lynch had great success with his auto investments..

    1. Hi Yuan, yes this is somewhat theoretical because in the real world, capitalism is such a force that very, very few companies can produce high returns on capital in a nice, excel modeled straight line for 30 years or more. But the math is such that a company that can do this (FAST, WMT, KO, and numerous other examples) will have a corresponding CAGR in the stock price.

      If you own a hot dog stand that makes you 15% returns on the capital you invest in the stand, the dogs, the mustard, etc… over time, the intrinsic value of your stand (and your equity) will increase in the business at a rate that roughly equates to that return that your stand produces for you.

      Very few companies can generate 50% returns on their capital over time. And the ones that can produce these returns typically require no capital or very little capital (Moody’s is a good example). So in theory, yes, the owner will experience the same result of his businesses’ returns over time, but in some cases, you have to pay nearly infinite prices for the capital, so you can’t extrapolate realistic returns when you find a company that produces 100% ROIC. WTW produces returns on tangible capital in excess of this number, but I don’t expect to double my money every year.

      But Munger’s concept is correct, that over very long periods of time, a business that produces 18% ROIC will likely yield splendid shareholder returns over time, and a company struggles to produce 6% will doom long term owners to a similar fate.

      Last thing: the math is true that over very long periods of time, this works. If you had to buy and hold one business forever, you’d want one with high returns on capital that, after careful examination, you conclude that the forces of capitalism will not erode that ROIC over time…. i.e. you’d want a moat.

      But in the shorter term, valuation plays a very crucial role. And the more overvalued something is, the longer you have to hold it to get the returns you want. You could have bought Coke in 1998 and had poor returns for a decade or more even though the business continued growing intrinsically at a 10-15% rate. But if you bought Coke in the boom days of 1972, or 1958, or earlier, even paying what appears to be a drastically high multiple would have worked out well because over time, your returns get closer and closer to the long term business results that the business has produced.

      In the end, pay attention to valuation. You need it as it provides a crucial margin of safety. You can’t expect to be able to accurately or consistently predict what the world looks like in 30 years (or at least I can’t), so I can’t risk paying a high price for something that looks wonderful now and will likely be wonderful in the future. I’d rather pay a cheap price for something that if I’m right about the quality, great… if I’m wrong, I didn’t pay that much.

      These are just thoughts off the top, and I know they are rambling. I’ll have a few more posts coming on ROIC.

      Think like a business owner. You want a great hot dog stand on a valuable corner with lots of foot traffic with regulations against setting up new hot dog stands. And you want to be able to buy that hot dog stand at a low price relative to the normal earnings it has produced.

      You want to own good businesses that will grow intrinsically and can produce great returns on the equity that the owner invests and you want to pay a price that will give you a high earnings yield if something unforeseen occurs.

      1. I didn’t answer your other questions… but to quickly summarize. No I don’t try to focus on getting returns from specific categories. I don’t really think like this. Very simply, I want to locate extremely undervalued situations. I love great operating businesses, but I also look at special situations, i.e. I sometimes find businesses that are selling for prices far less than a private buyer would pay (cheap assets), corporate events, spinoffs, etc…

        I’m just looking for simple, understandable, and obvious undervaluation. It needs to be significant, not marginal. I have a very high hurdle rate so I am not interested in a lot of marginally undervalued ideas. There are lots of great companies, there are lots of cheap stocks, but in order to reach the hurdle rate, I need to find ideas that are truly 50 cent dollars or better with a minimum of risk. That’s really all I do. I don’t search out specific categories of investments.

        1. Hello John

          I really enjoy reading your posts. Upon reading them, there are many ”50 cent dollars” appeared in your reply to these comments. Can you please explain that term? Is that meant the estimated intrinsic value is at least 50% or more than the price paid for a stock?

          1. Hi Kye,
            A 50 cent dollar is just a general way of saying that the intrinsic value is twice the price of the stock.

    1. Hi the link seems to work fine currently. Maybe it was just a temporary glitch. All the articles should still be able to be viewed anytime. Let me know if you have further issues.

  7. In one of your posts you mentioned that you divided your investments between these two..

    Compounders (Earnings Based)
    Cheap and Good (Earnings Based)

    What is the difference between a compounder and a cheap+good business. I’m assuming a compounder can compound at high rates of return and cheap+good would be something like Strayer Education, Weight Watchers etc? Can you clarify on the distinction you make?

    1. Gourd,
      I’ve had many email questions relating to this topic. It’s interesting, I think I may have caused more confusion than necessary when I discussed categories. I really don’t focus too much on it. I tried to categorize things to convey some of the ideas I look at, but really, I’m just looking for really undervalued situations. I have recently tried to simplify this… basically, I stopped really trying to categorize the difference between operating businesses.

      I think the way I’ll try to explain this in a future post is as follows… there are operating businesses, and there are special situations. The latter category includes cheap assets (or bargain purchases of stocks selling below the value to a private owner), corporate catalysts, spinoffs, etc… So in this cheap asset category, I might not have a known catalyst, but I know that I’m buying something for less than a private buyer (or another business) would pay. An example would be an average or even slightly below average earning bank for 70% of book value. The median P/B of an acquired bank was around 1.4 times book in 2013, so this is clearly below the value a private buyer would pay (under most circumstances).

      Basically, the easiest way to break down my investments are operating businesses and these special situations (catalysts and no catalyst cheap stocks).

      I tried to initially explain some of the differences within the operating business category, but I think it might complicate things unnecessarily. Basically, I’m looking for good quality companies that can compound their intrinsic value over time at cheap prices. This gives me two layers of safety (valuation and quality).

      Hope this helps…

  8. John –

    How do you reconcile Greenblatt’s ROIIC calculation to compare ROIIC amongst companies (in your post) with Greenwald’s ROIIC calculation to value growth (good article by Mauboussin here – Do you use both calculations depending on your purpose? or do you use one and not the other?

    They both seem to have different theoretical underpinnings. Greenblatt wants to know the return on tangible assets from a business perspective, whereas Greenwald wants to know the return of the business from an accounting perspective.

    Thanks for your educational writings and ideas. I’m learning a lot and hope to contribute to the community as well as you are!!

    1. Undertherockstocks, thanks for the comment and the link. I’ll check it out. As for ROIC, I use my own calculation. There are many different methods to calculate the same basic idea, which is how efficient is a business at turning its capital into profits. Some calculations are better than others, but they all capture the same basic idea (in my opinion). I will use slightly different techniques to analyze companies depending on each circumstance, but the basic logic is really the same, regardless of the calculation. I haven’ read the paper you linked to, but my short answer is to learn about the various ways to analyze returns and don’t lose sight of the forest for the trees. The general idea is how much money a company can produce from the capital it invests, and secondly, what capital requirements or investment opportunities does the business have to deploy capital?

      Hope that helps…

  9. Do you capitalize operating leases in your ROIC calcuations? If I remember correctly, Greenblatt doesn’t, which skews his list in favor of retailers and others whose ROIC is inflated due to the off-balance sheet leverage inherent in operating leases.

    1. PJK, whenever a company is leasing PPE that they will need to replace to operate their business, I think it’s a good idea to account for the value of those leases as capital invested in the business. So I typically like to capitalize leases… just make sure you add the interest from these capitalized leases back into the pretax operating earnings or whatever numerator you’re using (adjust for the rent that you paid that is now interest on these newly “capitalized leases”) along with adding the capitalization of the leases to the denominator. To be precise, there should also be a depreciation charge that gets factored in as well, which when it’s all said and done, tends to lower EBIT and lower returns on capital when comparing operating leases to capitalized leases.

      I think Greenblatt does this method also, although I’m not sure he mentions it in the book. I’m not 100% sure, but I believe he recommended capitalizing the leases in his class at Columbia.

      I’m not sure if he uses them in the formula on his sight or not. I think for simplicity purposes he probably didn’t get into this in the book (I don’t remember him discussing this), but at his firm my guess is he would view most operating leases as financing expenses.

  10. Interesting, I only started investing months ago and I used the same idea unknowingly, although I use more “crude” metrics. The screener I use looks at P/E for cheap, ROE for good, and I also include that it has to pay >0% dividends. I only came up with 3 companies that I was confident to invest in, and all 3 are up over 20% in 2014. I also found a fourth company that does not pay dividends but was extremely heavily discounted as far as P/E goes, and it is also up about 10%. These are my 4 biggest holdings, so I’m quite happy in this short timeframe.

  11. Thanks for the post, John is very interesting.
    Now I was trying to read the second part and I’ve noticed that the link does not work.
    Greetings from Spain.

    1. I’ve had a few comments like that… not sure why people are having trouble with the Part 2 link. It appears to work fine for me.

  12. Hey John,

    I was trying to reply to part 2 but I’m getting an error message when I click the link (

    Anyway, I was thinking about Munger’s comment on investment results matching the business’ internal results (ie ROIC) and how it applies to companies that do not have reinvestment opportunities.

    As an example, I am looking at a company that has a ROIC close to 100% but with no reinvestment opportunities (they dominate a market that does not grow); as a result, they distribute all of their earnings. I believe a company like this can be valued with a very straightforward formula: Normalized Free Cash Flow / (Discount Rate – Long term growth rate)

    I’d love to hear your thoughts on the subject.


    Best regards,
    Pedro Carone

    1. Try it in a different browser Pedro. It seems to work fine on my end.

      Your question is very similar to a comment I just made on a different post: I’ll repeat that comment here:
      the simplest way to think about this is that a firm’s future ability to grow its value intrinsically is simply the product of two factors: the incremental ROIC and the reinvestment rate (how much can it retain from earnings to reinvest at that same ROIC). So a business that produces 20% incremental returns on capital that can reinvest 50% of its earnings at that rate will grow intrinsic value at a rate of 10% annually (50% times 20%). Likewise, a firm that produces 10% ROIC that can reinvest 100% of earnings will grow at 10% annually (100% x 10%). A business that makes 50% ROIC that can only reinvest 30% will grow at 15% annually, etc… Also, the firms with lower reinvestment rates but higher ROIC will likely create more value for shareholders (assuming the same intrinsic value growth rate) because it still has a large portion of its earnings to either buyback stock or make accretive acquisitions (or just pay dividends). Of course, they could destroy value as well…

      So yes, what Munger was talking about is “incremental ROIC”, not the returns on capital that has already been invested… the incremental ROIC is really what drives value going forward, combined with how much it can reinvest.

  13. John,
    I’m coming back to this topic because I wanted to ask you about ROIC adjustments and I couldn’t find an email address on the site.
    I’m looking at a retail company here in Brazil. A good chunk of their sales are done via credit card. Here in Brazil it is a common practice for consumers to pay for their credit card purchases in monthly installments – in some cases, up to 12 months. There is no credit risk for the retail firm but they take a longer time to turn their sales into cash (the credit card companies pay them according to the amount of installments). The retail company can get the money from the credit card firm upfront, in exchange for a discount. This practice is a huge boost to ROIC as it cleans the company’s balance sheet (no accounts receivable) and it doesn’t affect its EBIT as the discount is considered a financial expense. From an accounting standpoint, it makes sense, but from an operational standpoint I think there’s a risk of overstating ROIC and, consequently, the company’s valuation. So I’m leaning towards considering this discount as an operational expense. I would love to get your thoughts on this.

    Pedro Carone

  14. Thanks John for your blog. I just discovered yesterday when I’m trying to find out how exactly Munger calculate his return on capital, what hurdle rate he uses, 20%? 50%? sth. like that, mostly on technique side.

    Here you mentioned, incremental ROIC, it sounds to me like marginal ROIC? additional/incremental return that can be generated by increasing every one more dollar of Capex?

    1. Hi Nina, yes, generally speaking, when I’m talking about ROIC I’m trying to figure out the rate of return that a business can achieve on the capital it invests going forward. Looking at past ROIC is a guide, but ideally, you want to have an understanding of what the “cash on cash” returns of the business will be going forward. Importantly, you also want to know not only the ROIC, but the percentage of earnings that it can reinvest at that rate. In other words, how much capital can the business reinvest, and what will the rate of return be on the incremental investment? A business’s intrinsic value will grow at approximately the product of two main factors: the percentage of earnings that it can retain and reinvest, and the return it can achieve on that investment. (Earnings retained but not reinvested is a third factor–and that’s where capital allocation (dividends, buybacks, acquisitions, etc…) come into play).

  15. One thing that bugs me and I disagree strongly is that the need to re-balance a portfolio ever year when using magic formula. For me it just doen’t make sense.

  16. Hi John,

    Your site is one of my very favorite, along with Brooklyn Investor (especially when he was in his compounder/Outsiders phase). Thank you very much for all that you do!

    I hope you will see this comment even if it is on an old post.

    My question is about how to think about ROIC with a company that has lots of intangibles and goodwill (strategy is to use its FCF to buy more high-quality, asset-light businesses).

    If I calculate ROIC using Greenblatt’s approach, I get ROIC in the 100%+ range. If I calculate it with another approach, which just uses equity book value + debt book value – cash, I get a ROIC more in the 20-30% range.

    My problem is with interpreting those numbers properly. I know they both tell me something different about the business, but I’m not sure I quite understand what. I was hoping you could help me elucidate…

    On one hand, the intangibles don’t need to be replaced or maintained with cash, so I can understand why they would be excluded. But they have been a real cost to the company through M&A, so I can also understand why they would be included. I tend to think that the long-term performance of the business will be in the 20-30% range and not 100%+, so intuitively it seems like the second approach might be more useful.

    But maybe the Greenblatt approach is still useful when comparing this business to other businesses. Another one that has 20-30% ROIC when taking all the intangibles into account might have a much lower ROIC with Greenblatt’s approach, which might mean that it is overall of lower quality (especially important if the businesses can generate decent organic growth, I think).

    Anyway, I’d love your help to untangle this. Thanks, and keep up the good work!

    1. Hi L, thanks for the comment. And yes, I’ve spent time thinking about this… my short answer is that each business is different, and so I think you need to make adjustments based on the business. For a company like Davita that is growing through acquisitions, I think you’d want to include the intangibles and goodwill, as that capital will need to be replaced (a large part of the business model relies on making acquisitions). I think a company that primarily invests capital to grow organically and has goodwill on the balance sheet related to a one time acquisition could be evaluated excluding the goodwill. But each case is different, and as you said, the company still paid for the acquisition in the past, and that was allocated capital at one time. I think Greenblatt’s point is that as a new shareholder (or if you think of yourself buying the whole business, as a new owner), you’re not paying for that acquisition, it’s already been paid for. So what kind of capital requirements (working capital and plant) will be required going forward? If acquisitions will be required going forward, then you should probably include that.

      It’s not concrete, but hopefully that helps somewhat.

  17. Hi John,

    I’ve been a longtime fan of your blog, especially this series on return on capital.
    I have a question for you. I’ve come across a very attractive company with a set of products that I think will be around for a long time. On a ROIC basis, it looks great when the formula to calculate invested capital is based on Greenblatt’s formula (excluding Goodwill). The thing is, this company has largely grown through acquisitions and I suspect they’ve been paying high multiples because the ROIC (when factoring in goodwill) is materially lower.
    Have you thought about ROIC for companies like this that have grown by M&A?
    Thanks again for your excellent work here.

    1. Hi Iman, Thanks for the comment. I just had a long reply that accidentally got deleted unfortunately, but to quickly summarize… yes, you’re exactly right. Each business needs to be evaluated based on its own business model and capital requirements. A business that is growing through acquisition will presumably be laying out more capital in the future to make these acquistions, and so these should be considered when thinking about the capital requirements and return on investment of the business. Goodwill and intangibles should be factored in to get an idea of what kind of return on capital the business has achieved in the past.

      Remember, the objective when looking at ROIC–what we are really after–is what will the business do in the future. What will the returns on investments be in the future. If a business is going to be required to lay out capital to make acquisitions, then those investments need to be considered in the denominator of that equation (along with the associated intangible assets and goodwill). We want to use the past as a guide, but what we really want to know is what will they earn on their capital investments in the future…

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