Graham vs. Greenblatt (Part 5): Bringing It All Together

We made it to the final installment of our Graham vs. Greenblatt series (see the first four installments here). Throughout the series, we examined each of the ratios that Joel Greenblatt recommended in his book, The Little Book that Beats the Market. The final posting will look at how Greenblatt draws the ratios together and bring this all back around, so lets get into it.

What Is It?

Greenblatt says (from p. 53-54, The Little Book that Beats the Market):

It then assigns a rank to those companies, from 1 to 3,500, based on their return on capital. The company whose business had the highest return on capital would be assigned a rank of 1, and the company with the lowest return on capital (probably a company actually losing money) would receive a rank of 3,500...

Next, the formula follows the same procedure, but this time, the ranking is done using earnings yield...

Finally, the formula just combines the rankings.

What Does It Tell Us?

Greenblatt creates a simple formula: He takes a value component (Return on Capital) and an investing component (Earnings Yield), ranks all companies best to worst on both these criteria and then sums the two rankings. What this does is essentially value both components equally, ROC and Earnings.

So What Would Graham Think About These Rules?

• The Benjamin Graham we see in The Intelligent Investorwas all about buying value. When the value doesn't exist don't buy, sit on the sidelines. If one follows Greenblatt though you would buy in all conditions. Please note that I am not making a comment about timing markets; merely that in an overpriced market, Greenblatt would buy the cheapest of the expensive stocks while Graham would take the day off.
• Return on Equity treated with equal significance as value measurements? Graham would not have thought too highly of this. Nothing should be as important as finding value.

Summary

We have spent a considerable amount of time looking at Greenblatt from Graham's perspective. To conclude the series, it is worthwhile to highlight some of the major points we raised:

1. Graham believed in finding the true value of companies. Where Greenblatt uses Market Capitalization in his key ratios, Graham would have cringed. Market Capitalization puts a value on the company based on what the market thinks; not what the company is intrinsically worth.
2. Graham wanted to look at companies over the long haul. His ratios pulled 5 and 20 year data to get a picture of the company. Greenblatt, on the other hand, looked at the company today.
3. Graham was happy to sit on his wallet if the time wasn't right. If the value didn't exist, walk away. Greenblatt, on the other hand, was prepared to buy on any given day.

Final Thoughts

Greenblatt has a creative investment system with proven results. There can be no doubt it is a value based system, but he is far less strict than Graham's. Personally, I think there is merit in the way that Greenblatt looks at investment opportunities. Bringing in an understanding of Return on Capital is a welcome addition to the value perspective; to hold it in the same high regard as Greenblatt, however, may be a mistake.

If you missed any of the earlier series please have a look at the earlier parts to the series:

Part 1 Graham vs. Greenblatt (Session 1)
Part 2 Graham vs. Greenblatt (Session 2) Buy America Buy Big
Part 3 Graham vs. Greenblatt (Session 3) Return on Capital
Part 4 Graham vs. Greenblatt (Session 4) Buy some cheap earnings