Joel Greenblatt Loves This Stock & You Should Too
There is a plethora of profitable tactics being used in the financial markets today. From Buffettology to the contrarianism implemented by David Dreman, greenhorn investors have a range of role models to follow if they so choose. To learn how to effectively implement some of these strategies in your portfolio, check out WealthLift’s Hedge Fund Educational Series. Over the past couple decades, one of the most successful strategies put to use has been Joel Greenblatt’s Magic Formula method. With this approach, Greenblatt focuses on picking stocks with the rare combination of a high return on invested capital, and a high EBIT to enterprise value ratio.
While these two terms may sound like financial gibberish, they are actually quite simple. Return on invested capital, or ROIC for short, is a measure of the return that a company achieves from investing in its own business. For example, a company that makes $10,000 from the construction of a new plant worth $50,000 (ROIC of 20%) would be preferable over a company that earns $100,000 from the construction of a new plant worth $1 million (ROIC of 10%). Greenblatt considers companies with high ROICs to have a wider economic moat than their competition, whether in the form of a unique product, brand loyalty, or governmental support.
Likewise, a high EBIT/enterprise value ratio is a similarly desirable indicator of financial success, because it measures the earnings potential of a particular stock. EBIT is an acronym for ‘earnings before interest and taxes’, while enterprise value is a measure of true economic value. For example, if Stock A has an EBIT/enterprise value of 20.0 and Stock B has an EBIT/enterprise value of 10.0, we can say that Stock A has twice the earnings potential as Stock B. Typically, an EBIT/enterprise value ratio in the range of 25 or higher is considered to be most desirable. Below is one stock that is currently in Greenblatt’s portfolio, likely because it sports impressive metrics in both categories.
Apollo Group (NASDAQ: APOL)
As one of the world’s largest for-profit education companies, Apollo has capitalized on the online college boom quite nicely with its University of Phoenix platform. Since 2000, shares of APOL have quintupled, though they have yet to recover from their pre-recession highs north of $90 a share. In 2012, stockholders have seen their holdings wilt by nearly a third in value, as student enrollment have been dropping like a rock, falling from 470,800 to 380,000 in the past year.
In an attempt to alleviate these issues, the company launched a new ‘Phoenix Career Services’ program this past quarter. This, and other restructuring efforts cost the company $7.6 million during this timeframe. Interestingly, Apollo has an extraordinarily high ROIC of 63.1 percent, meaning that it has had a proven history of achieving high returns from investing in its own business development. Even though APOL has seen lower earnings growth (11.9%) than the education industry’s average (23.0%), it has an impressive EBIT/enterprise value of 29.69, which is higher than competitors like Bridgepoint Education (NYSE: BPI), Devry (NYSE: DV), and Strayer Education (NASDAQ: STRA). Moreover, the stock is also trading at Price-to-Earnings ratio of 8.7X, far below its own 3-year historical average of 12.8X. When growth is factored into the equation, APOL looks to be on the borderline of being undervalued, as it trades at a Price-to-Earnings Growth ratio between 0.9 and 1.0. In fact, Apollo’s earnings have historically traded at a 20 percent discount to those of the S&P since the recession. This year, they appear cheaper, trading at a 41 percent discount.
Last week, the company trounced the Street’s earnings expectations, reporting an EPS of $1.20 compared to estimates of $0.96 a share. Going forward, analysts are expecting Apollo to finish 2012 with earnings of $3.52 a share. Now, this is down from the $4.94 it reported in 2011, but it looks as if the markets have over-discounted for this decline, as mentioned in the above analysis. If the stock is able to regain a valuation on line with its post-recession average, it should be able to eclipse $45 by year’s end. APOL currently trades in the $36 range and has popped 12.7 percent in the past week. WealthLift’s Sentiment Index rates Apollo as a strong buy, with the majority of our investment community placing an ‘overperform’ rating on the stock.
It is important to realize that Joel Greenblatt’s Magic Formula approach requires some serious fortitude, as the creator himself notes that 5 out of every 12 months, and 1 out of every four years yield negative results. In the long run, though, there may not be a strategy that is as simple and effective at generating double-digit returns.
Disclosure: The author has no holdings in the stocks mentioned in this article and has no plans to initiate any positions within the next 72 hours. He does, however, have the intention of rating these stocks on WealthLift.com, a social media website where investment ideas are shared openly and free.