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The best small caps as per the magic formula

Sep 20, 2011

Joel Greenblatt. This gentleman may not be all that famous in Indian investing circles. But he is quite a famous investor in the US. A widely respected hedge fund manager, he is believed to have compounded money at a phenomenal rate of 40% annualised between 1985 and 2005. To understand what it means, Rs 1 lakh invested with Greenblatt in 1985 would have multiplied a whopping 836 times by the time the year 2005 arrived! A mind boggling rate of return any which way you look at it.

However, generating stupendous returns is not the only claim to fame of Mr Greenblatt. A few years back, he authored a small book which created quite a flutter in the investment community especially value investors. Titled 'The little book that beats the market', it outlined a ridiculously easy technique to find fundamentally strong companies trading at attractive valuations. A portfolio built using this technique handily outperformed the US benchmark between 1988 and 2004 as per Greenblatt.

So, what is this technique all about? As mentioned earlier, it is a fairly simple yet very effective technique. It involves ranking a universe of stocks based on their return on capital and earnings multiples. The universe could be any universe say for e.g. BSE 200, BSE 500, BSE Mid Cap and BSE Small Cap etc. However, it should have a fairly decent number of stocks.

Once the universe has been fixed, stocks in it are ranked on the basis of return on capital employed with the highest returning stock getting the first rank and the lowest returning the last rank. Now, the same stocks are ranked on the basis of their EV/EBIT multiples (Enterprise Value/Earnings Before Interest and Tax) with the lowest multiple getting the lowest rank and highest multiple the highest rank.

It should be noted that EV/EBIT is nothing but a multiple that is similar to the P/E ratio. The only difference being that while P/E ratio does not include debt and interest payments, the EV/EBIT multiple includes debt in the numerator and the interest payment in the denominator.

However, if the above ratio sounds confusing, it will not make a lot of difference if uses the ROE of the stock in place of ROCE employed and P/E in place of EV/EBIT. It should be noted however that for ensuring that a stock with a high D/E ratio (debt to equity ratio) does not slip in, it will help if the average D/E ratio of the past five years should not exceed 0.5 times. Anything higher than this and the stock should be discarded right away.

With the number rankings in place, the two rankings viz. one as per the return ratio and another as per the valuations are added up for each company. Now, choose 15-20 stocks in such a manner that they have the lowest combined ranking and your portfolio is ready.

What makes this formula such a potent force that it is able to handily beat the index you would ask? Well, while we have not done any study ourselves, we believe that the formula is indeed a powerful one. This is because according to us, the two most important factors for determining a market beating stock are the fundamental strengths of the company and its valuations. And what this formula does is it helps create a list with the most attractive combination of these two factors. Hence, a portfolio of stocks using this formula does seem to have a strong chance of beating the index than the average portfolio out there.

Another important factor to note is the time horizon. As per Greenblatt, one will have to keep churning the portfolio every twelve months. Thus, at the end of a year, all the stocks in the portfolio are discarded and a new portfolio is created using the same formula.

Finally, please bear in mind that the formula is not completely foolproof. As per Greenblatt's own admission, there have been considerably long periods where the formula has failed to outperform the markets and has tested the patience of the investor. However, Greenblatt opines that if persevered long enough, one does have a very good chance of beating the benchmark indices.

We have tried to use the formula under discussion to arrive at the 20 best small caps in the BSE Small Cap index currently. The table is laid out below.

CompanyMost recent ROE (%)Trailing twelve month P/E (X)
National Peroxide Ltd.565.08
Edserv SoftSystems Ltd445.92
Bharat Bijlee Ltd.294.26
AK Capital Services Ltdv.263.30
Apar Industries Ltd.325.70
Bliss GVS Pharma Ltd.274.90
Ashiana Housing Ltd.336.30
Goodricke Group Ltd.447.10
Navin Fluorine Intl. Ltd.233.00
Hindustan Dorr-Oliver Ltd.317.00
Savita Oil Technologies Ltd.317.00
ZF Steering Gear (India) Ltd.276.50
Tata Sponge Iron Ltd.224.80
Sasken Communication Technologies Ltd.213.60
Zensar Technologies Ltd.277.40
Ess Dee Aluminium Ltd.236.20
Aditya Birla Chemicals (India) Ltd204.50
VST Tillers Tractors Ltd.329.40
Globus Spirits Ltd268.30
Balmer Lawrie & Company Ltd.247.60
Source: Ace Equity, Equitymaster Note: Standalone numbers

There is a certain amount of liberty that can be had while choosing the stocks. If one is not comfortable with a certain stock then one should certainly discard it and look at the one immediately below it in terms of ranking. Greenblatt himself usually avoids stock in cyclical sectors, sectors where ROEs are regulated and also banking stocks. However, this exclusions are subjective in nature and hence, changes to the same can certainly be considered.

To conclude, while the list is not without its faults, it definitely is a good starting point to pick stocks that are not only attractively priced but have relatively better fundamentals than their peer companies.


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2 Responses to "The best small caps as per the magic formula"

CLEETUS FERNANDES

Sep 21, 2011

The article is interesting. However, I notice some anomaly. For example, the P/E of Bharat Bijlee quoted in the table above is "4.6x" whereas your own detail stock quotes page reflect a P/E of "11.6X". Which one is correct? I request yoo to ensure no errors are made, as it can have a devastating effect on investors who take decision based on the above table.

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Debashish

Sep 20, 2011

good article

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Equitymaster requests your view! Post a comment on "The best small caps as per the magic formula". Click here!

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