Why This $6.7 Billion Hedge Fund Strategy Doesn't Work for Bank Stocks

In the investing world, fund manager Joel Greenblatt is one of the good guys.He knows how to beat the market, and he wants you to do it, too.

Source: Company website

After a long and highly successful career managing hedge funds, Greenblatt wrote aseries of books that reveal exactly how he consistently beat the markets for all those years. Today he applies those techniques in his newest $6.7 billion fund, Gotham Funds, and he still publishes his "magic formula" stock screen for free at MagicFormulaInvesting.com.

There is one caveat, though. His magic formula doesn't work for bank stocks. Here's why.

What is the magic formula, and why does it work?Using sophisticated back testing, Greenblatt found a way to quantitatively identify high-quality companies that trade for cheap.

Using two relatively simple calculations, the earnings yield and return on capital, the magic formula sorts and rates all publicly traded U.S. companies, excluding utilities and financial stocks. Investors simply choose approximately 20 of these stocks, buy them, and hold them for either 51 or 53 weeks. Stocks that have declined should be sold at week 51 to ensure lower taxes, and winners should be sold at week 53 to avoid paying the short-term capital gains tax.

According to Greenblatt's calculations, over a 10-year period this strategy will beat the S&P 500 handily.

The formula works because it can find companies that are both well run and inexpensive. Return on capital is calculated by dividing a company's earnings before interest expenses and taxes by the sum of its net fixed assets and working capital. The higher the return on capital the better because that indicates a company is more efficient in creating profits from its assets than the rest of the market.

Earnings yield is calculated by dividing earnings before interest and taxes into the company's enterprise value. A higher earnings yield indicates the company produces a high profit relative to its market cap and debt -- in other words, it's cheap.

Taxes and interest are excluded in both calculations because they are not related to the actual operation of the business.

Back to bank stocks -- why are they omitted?There are two reasons banks are excluded from the universe of potential stocks in Greenblatt's magic formula screen.

The official reason given is that there are some pretty weird accounting conventions that are unique to the industry. Those irregularities make the screen impossibly difficult and creates an "apples to oranges" comparison with the rest of the investment universe.

Source: Flickr user Frankleleon.

Banks typically have a small level of fixed assets, and those fixed assets are only indirectly related to driving earnings -- a bank branch, for example, is helpful in generating business in a given neighborhood, but it doesn't directly create the type of value that a manufacturing plant would. Banks' working capital is basically just cash and other liquid assets; they generally won't have significant accounts receivable or inventory in the traditional sense.

The critical assets on the bank balance sheet are loans, a unique asset class in the business world. It's not enough that a bank hold a sizable portfolio of loans to drive revenue; those loans must also be well underwritten and paid back in full.

In addition to the accounting challenges, banks are also highly leveraged. The largest expense for most banks is interest, driven by the payments due to depositors for their savings, CDs, and other accounts held at the institution. That expense is absolutely core to the business of banking, and therefore should not be added back like the formula prescribes for other industries.

The key to the magic formula is simplicityGreenblatt's objective in writing his books, creating the magic formula website, and even offering his new fund in a mutual fund structure, is to help everyday retail investors. To successfully do that, Greenblatt recognizes that simplicity is key.

Thinking beyond the actual market returns his system achieves, a second consideration is that his readers -- investors like you and me -- must be able to fully understand and apply the techniques. The ratios must be effective and simple. The process must be straightforward and easily repeatable.

To achieve this objective, the best solution was to simply exclude bank stocks from the screen. But that doesn't mean banks aren't a potentially strong investment.Banks are a unique kind of business, and investing in one just requires a bit more homework than would be needed for a simple manufacturer or retailer.

The article Why This $6.7 Billion Hedge Fund Strategy Doesn't Work for Bank Stocks originally appeared on Fool.com.

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