Quantitative Value Screening Models: From Graham to Greenblatt
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# Quantitative Value Screening Models: From Graham to Greenblatt
Introduction
Quantitative value screening is a systematic approach to investing that uses a set of predefined criteria to identify undervalued stocks. This approach, which has its roots in the work of Benjamin Graham, the father of value investing, has been refined and popularized by a new generation of quantitative investors, such as Joel Greenblatt. This article provides a survey of classic and modern quantitative value screening methodologies, from the timeless principles of Graham to the "Magic Formula" of Greenblatt.
Benjamin Graham: The Father of Value Investing
Benjamin Graham's approach to value investing was based on the principle of "margin of safety." He believed that investors should only buy stocks that were trading at a significant discount to their intrinsic value. To identify such stocks, Graham developed a set of rigorous screening criteria, which included:
- Size: The company should be of a certain minimum size.
- Financial Strength: The company should have a strong balance sheet, with a low debt-to-equity ratio and a high current ratio.
- Earnings Stability: The company should have a long history of positive earnings.
- Dividend Record: The company should have a long history of paying dividends.
- Earnings Growth: The company should have a record of earnings growth.
- Moderate Price-to-Earnings (P/E) Ratio: The company's P/E ratio should be below a certain level.
- Moderate Price-to-Book (P/B) Ratio: The company's P/B ratio should be below a certain level.
Formula for Graham Number:
Graham Number = Square Root of (22.5 x Earnings Per Share x Book Value Per Share)
The Graham Number is a theoretical intrinsic value for a stock, based on Graham's formula. A stock is considered to be undervalued if its price is below its Graham Number.
Joel Greenblatt: The Magic Formula
Joel Greenblatt, in his book "The Little Book That Beats the Market," introduced a simple yet effective quantitative value screening model that he called the "Magic Formula." The Magic Formula is based on two key metrics:
- Earnings Yield: This measures how much a company is earning in relation to its price. It is calculated as EBIT / Enterprise Value.
- Return on Capital (ROC): This measures how efficiently a company is using its capital to generate profits. It is calculated as EBIT / (Net Working Capital + Net Fixed Assets).
The Magic Formula ranks stocks based on these two metrics and then combines the rankings to create a single "magic" score. The stocks with the highest scores are considered to be the most attractive investment opportunities.
A Comparison of Value Screening Models
| Feature | Benjamin Graham | Joel Greenblatt |
|---|---|---|
| Core Principle | Margin of Safety | Good Companies at a Good Price |
| Key Metrics | P/E Ratio, P/B Ratio, Financial Strength | Earnings Yield, Return on Capital |
| Complexity | More complex, with a larger number of criteria | Simpler, with only two key metrics |
| Focus | Identifying deeply undervalued stocks | Identifying high-quality companies at a fair price |
Conclusion
Quantitative value screening models, from the classic principles of Benjamin Graham to the modern "Magic Formula" of Joel Greenblatt, provide a disciplined and systematic approach to value investing. By focusing on key metrics of value and quality, these models can help investors to identify undervalued stocks and to avoid the emotional biases that can lead to poor investment decisions. While no single model is perfect, a quantitative approach to value investing can be a effective tool for achieving long-term investment success.
References
[1] Graham, B. (1949). The Intelligent Investor. Harper & Brothers.
[2] Greenblatt, J. (2005). The Little Book That Beats the Market. John Wiley & Sons.