Years back, I was amazed at the claim made by Joel Greenblatt’s book The Little Book That Still Beats the Market

[Emphasis Mine]

Can you spare three hours to learn how to beat the market? As unlikely as it may seem, hedge fund manager and professor Joel Greenblatt, whose investment firm has averaged 40% annual returns for over twenty years, can teach you how. You can achieve investment returns that beat the pants off even the best investment professionals and the top academics. In fact, you can learn how it’s possible to more than double the annual returns of the stock market averages.

But there’s more. You can do it all by yourself. You can do it with low risk. You can do it without making any predictions, and you can do it by following, step by step, a time-tested, proven “magic formula” that uses only common sense and two simple concepts. Best of all, once you are convinced that it really works you can choose to do it for the rest of your life.

 

Obviously I bought the book, who doesn’t want to become a stock market genius in three hours, The book made everything easy to understand. Magic Formula – the concept and explanation is simple, but most important of all, the execution for investors is simple enough to do on their own.

The book was a living proof that solely quant based investing could beat markets, Greenblatt presents some impressive numbers illustrating the back-tested historical results of his approach.

Numbers / Screens / Quantitative analysis can be a great starting point and often help you reject potential investment candidates fast if things don’t add up. In this post we will see how quantitative analysis enables us to ask better question while evaluating potential investing candidates.

In today’s post, I will show how our real time online valuation tool (developed on Google spreadsheet) (update 03/02 – No Longer Sold) enables us to proceed in right direction while evaluating potential investing candidates.

If you run this tool for La Opala RG Ltd – This is what you will get as output on dashboard

What will be our first reaction ?

Market price is INR 548 and valuations as per each of parameter is far less than market price so let’s move on to the next company.

Pause for a moment and think

Why is market paying such a hefty premium on this small cap (M- cap is INR 3000 Crores) ? Is this irrational ?

Can numbers help us figure out why?

One thing is clear that market is expecting growth as valuation based on forward looking view is higher than backward looking measures

Let put our focus on forward looking measures

The tool defaults FCF growth to 15% and 11.25% for first 5 and second 5 years, But for La Opala

FCF has gone 4X in last 3 years and even in last fiscal FCF grew 60% so clearly 15% is a lower number and needs to be revised

I played around 20% and 25% growth for first 5 years and then 15% and 18.75% for next 5 years. Results are below

Now turning my attention to sustainable growth rate valuation

The company’s ROE is 25% and pay-out is 9% extending this out of next 5 years and then discounting back gives a fair value of INR 207 / share

These estimates seemed appropriate as ROE has been hovering around 25-30% mark for last 3-4 years.

The other thing that caught my attention was ROE analysis

See how NPM has crept up from 10% to 19% in last 5 years – This signals better operating leverage or pricing power or tighter cost management

What really animated me was Asset turnover ?

Oh! but it has gone down in current year, why that’s fascinating ? Look up sales growth for last 5 years, Sales have grown almost 3X from 2010 levels in 2015

What does that mean ?

Asset turnover has not gone down due to slip in sales, it has gone down as Fixed asset have been added (read capacity expansion), This means that there is a huge lever available to company as it can again increase asset turnover from 1.19 if the sales growth continues.

This would mean ROE would expand and so would be fair value based on sustainable growth.

The other huge insight was how ROE has been maintained with reducing debt levels (the equity multiplier component is reducing)

Market is expecting

• Continued growth in FCF
• Continued improvement in ROE

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That’s why the company is trading at astronomical valuations.

Therefore we saw how numbers can give a great starting point to start  our investment analysis.

However as Einstein said,

Not everything that counts can be counted, and not everything that can be counted counts.

 Numbers alone can’t do the job, once has to elucidate the qualitative measures like

• Does businesses have a sustainable advantage?
• Does it have pricing power?
• Is it run by ethical managers ?

An investment checklist helps us round up and complete our analysis.

Finally remember what Buffet said,

“In the business world, the rearview mirror is always clearer than the windshield.”

Numbers provide us a good rear view but in stock markets you are paid for foresight.

“If past history was all that is needed to play the game of money, the richest people would be librarians.”

***

You can get similar analysis like one above on LaOpala for 2000+ companies by using “Magic” tool (update 03/02 – No Longer Sold)

Now download this post as PDF here