Thirty great UK value stocks, according to Joel Greenblatt

Like many star investors, Greenblatt’s career began with a bang. After founding the hedge fund Gotham Capital in 1985, he and his business partner Robert Goldstein racked up average annual returns of 50 per cent before fees over a decade. Content with their achievements, and preferring instead to manage their own account, the partners returned money to their investors.

Soon after, Greenblatt branched out into the field for which he is now best known. First with You Can Be a Stock Market Genius and then in The Little Book That Beats The Market, he sought to unpack the secrets of his investment success in an accessible format. While intended for a mass market, the books’ fans within the hedge fund world shows that the simplicity and effectiveness of his methods and stockpicking process aren’t simply a mass marketing gimmick.

The process has various starting points, depending on your point of reference in the Greenblatt canon. As described by William Green in Richer, Wiser, Happier, it has much in common with the classic value investing analyses as pioneered by Benjamin Graham: beginning with a discounted cash flow analysis, Greenblatt then goes on to assess value versus other businesses, against what an acquirer might expect to pay, and what a liquidator might expect to uncover.

If this can be reduced to a single figure, then it is 6 per cent. That relates to a stock’s minimum average earnings yield in order to clear the risk-free rate, though as Greenblatt described to us last year (transcript), “that doesn’t mean a company has to have a 6 per cent earnings yield right now”. If earnings are growing, and a 6 per cent earnings rate is eminently achievable in the next couple of years, then a stock can still be said to offer value.

In The Little Book That Beats The Market Greenblatt takes this standard approach to valuation and throws in his theory on market psychology. The result is his famed ‘magic formula’, on which our Greenblatt screens are based. It is principally interested in finding stocks with high earnings yields (as a proxy for cheapness) and high returns on capital (as a proxy for good businesses), which it does by ranking all stocks in each screening universe against each of these fundamentals (which are detailed in full below), and then combining the two scores.

The best combined scores form a ready-made portfolio of 30 stocks, which Greenblatt suggests holding for a year. As a generalist, he isn’t interested in which sectors or parts of the market are in or out of fashion. Rather than take a thematic view of stocks, Greenblatt is more interested in markets’ propensity toward irrationality and emotion, and the mispricing that routinely follows.

Since we started applying the formula to the FTSE All-Share index in 2011, we have followed four varying-sized versions of the screen. On balance, higher scoring stocks have tended to do better, though this record flipped over the past year, as the 2023 30-name portfolio’s 6.6 per cent total return eclipsed the 1.2 per cent from the top 10 and 1.9 per cent from the index.

Still, on a headline basis, the 10-stock portfolio has been a solid performer, boasting a compound annual total return of 14.4 per cent since inception. The 30-stock version’s 10.5 per cent all-time annual total return, while more modest, is slightly ahead of the FTSE All-Share outperformance, even after factoring in a very conservative 1.5 per cent hypothetical annual dealing charge (see table).

From a screening perspective, two aspects of Greenblatt’s approach are especially neat. The first is that instead of pretending to understand the reasons for a company’s valuation or market price, the formula uses past insight into what works in stockpicking and turns it into a broad aggregate bet on stocks with a good chance of defying market expectations.

Second, by setting clear rules – for what stocks qualify, and how often the screen should be run – it tries to cut through the emotions that all too often cloud investors’ judgement. Indeed, in trying to encourage retail investors to adopt his method, Greenblatt has found that individuals armed with market-beating screening prompts tend to underperform an approach that automates buying and selling.

In short, getting past our emotions and preconceptions is very hard. This may be especially true of an investing process that places simplicity above all – which is true of Greenblatt’s formula. His tests for value and quality are as follows.

Value

Greenblatt uses an earnings yield in his magic formula. This is equivalent to a PE ratio with the numerator and denominator inverted and expressed as a percentage. Greenblatt’s earnings yield looks at a whole-company valuation by factoring in the value of a company’s net debt or cash as well as the value of its shares (its market capitalisation). The formula’s earnings yield compares its latest earnings before interest and tax (Ebit) with enterprise value (EV). In its simple form, EV subtracts a company’s cash and adds its borrowings onto its market capitalisation.

Quality

To measure quality, Greenblatt looks at how much Ebit is generated relative to a company’s ‘tangible assets’. Tangible assets consist of net working capital added to net fixed assets. The idea is that tangible assets represent the assets that are actually being used in a company’s operations to generate profits.

This year’s batch sees the return of 11 stocks that appeared in 2023. Though that seems like a high ratio, it also chimes with Greenblatt’s view that markets can take two to three years to recognise value – a trend supported by those stocks’ continued underperformance. The top 30 ranked stocks for the next 12 months are detailed in table and downloadable formats below.