Formula not so magic in UK
Down but not yet out
UK investors must improvise, using affordable data. Of the databases I use, Sharescope does not include the variables required to calculate the magic formula, although it might be possible to create a rough facsimile using alternatives. Sharelockholmes offers a Greenblatt ranking which, on the face of it, uses the correct variables. It ranks companies using:
- Earnings yield (EBIT:EV). This is a measure of value: the return in profit before interest (Earnings Before Interest and Tax) as a percentage of the purchase price of the whole business including its debt (Enterprise Value).
- Return on Capital (ROC). This is a measure of profitability. It is the return, EBIT again, as a percentage of capital employed.
The two variables are intended to identify shares in high quality (highly profitable) businesses at low prices.
But there's a problem. The definition of ROC is defined by Greenblatt in the appendix of 'The Little Book That Still Beats The Market' as:
EBIT/(Net Working Capital + Net Fixed Assets)
Sharelockholmes uses the same definition (see the glossary), but differs in the way it calculates net working capital.
I’m sorry, but there is no way to avoid a certain amount of nerdiness here. I think it's significant.
Sharelockholmes' definition of net working capital is:
Inventory + Receivables + Working Cash - Current Liabilities
Greenblatt doesn't provide an equation, but says:
Net working capital was used because a company has to fund its receivables and inventory (excess cash not needed to conduct the business was excluded from the calculation) but does not have to lay out money for its payables, as these are effectively an interest-free loan (short-term interest-bearing debt was excluded from current liabilities for this calculation).
Both count inventory and receivables (money owed to the company) as capital and exclude excess cash (Sharelockholmes counts only 'working cash').
One area of contention is the calculation of working/excess cash. Greenblatt doesn't say how he calculates it so Sharelockholmes has improvised an arbitrary rule that a company requires enough cash to cover any deficit in its net working capital (as defined by Sharelockholmes) plus 5% of its turnover. (For a discussion about excess cash see this thread on Investment Q & A).
Another is the deduction of current liabilities. Greenblatt does not deduct all current liabilities from the capital the company requires, he just deducts payables (money the company owes to suppliers). Although the company uses this money to fund its operations, there's no cost associated with it so we don't have to count it (according to Greenblatt - I've ignored payables to my cost before, but that's another story). Think of it as the suppliers’ capital.
Money borrowed from the bank (interest bearing short term debt) is part of the company's capital yet, because it's part of current liabilities Sharelockholmes deducts it along with payables. Many sites calculating the magic formula do the same thing including the only other one I know covering UK companies (Magic Formula Investing Europe - you can see how it calculates the magic formula here). I don't think these sites have the fine grained data required to decompose current liabilities.
The difference may be significant, it could make companies with large amounts of short term debt look more profitable, and therefore more desirable. When I discovered the discrepancy, I re-calculated ROC for companies identified by my Nifty Thrifty formula, which incorporates Greenblatt's rankings.
For many companies, those that had little short-term debt in relation to overall net working capital, it made little difference. But other companies may be catapulted up the rankings because Sharelockholmes deducts all current liabilities. Cobham's ROC, for example, was 30% when I deducted payables, but 60% when I deducted all current liabilities. De La Rue returned 47% by the former measure and 86% by the latter. The most extreme case was Ultra Electronics, which produced figures of 99% and 3,411%!
These discoveries have dented my enthusiasm for magic formula investing in the UK, but there is an alternative. Where the magic formula variables are not available, Greenblatt recommends substituting Return on Assets for ROC, "...to best approximate the results of the magic formula".
ROA is a much blunter instrument than ROC. It assumes that all of the assets owned by the company are required to produce a profit including excess cash, and goodwill, which Greenblatt prefers to ignore because it is a historical cost.
Although ROA lacks the finesse of ROC, I feel more comfortable with it, especially since I don’t have the data to screen for high ROC companies according to Greenblatt’s original definition.
Thankfully, Sharelockholmes has implemented ROA, so I can put it to the test (a pretty crude test, admittedly). Expect the results shortly.
I don’t expect the Earnings Yield and ROA formula to perform as well as the authentic magic formula would (and have no way of finding out), but I expect it to beat the market.
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