The big secret behind better returns

Joel Greenblatt author and founder of Gotham Capital, a partnership that claims a 40% annualised return over 20 years from 1985 likes to keep investing simple. In his latest book, The Big Secret for the Small Investor, he says the key to successful investing is "to figure out the value of something and then pay a lot less". In other words, buy low, sell high.But how do you do it? And can you find a fund that will do it for you?

Bottom-up valuation

What is the value of a business? To Greenblatt and other value investors the answer is "how much that business can earn over its entire lifetime". But that's much easier to say than to calculate. First, you need to forecast the annual cash flows a business will generate "for the next 30 years plus". Obviously, this means making assumptions about both costs and the rate of sales growth (since profit and by extension, cash flow is ultimately just the difference between sales and costs).

Next, work out what those future annual cash flows are worth in today's terms. A pound of profit generated in ten years' time is worth less than £1 received now. If inflation is 5%, £1 made in a year's time is only worth 1/1.05, or about 95p. After five years it's just 78p. By reducing each year of future cash flow by the appropriate "discount factor", you are comparing "apples with apples". Then you add all the future cash flows up to get a valuation. If the market is offering the firm at less than your valuation, it's a buy.

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One tough part is knowing whether 5% is the right discount rate. After all, if UK government bonds (gilts) are yielding 6% over ten years without risk, you'd presumably want a much better return for investing in a small business. In short, you'd pay less for it. The appropriate discount to apply to its cash flows might be 12%, 15% or even 20%. The higher the rate, the lower your valuation.

If this sounds like a lot of effort, it is. So some investors try other approaches. You could simply list the assets a business holds and try to value them one by one on a sum-of-the-parts basis and then compare to the market's current valuation for the whole firm. But that's only really useful if you intend to break up and sell a business rather than invest in it. Besides, how do you value something like a brand separately from the business? Not easy. Luckily there is a quicker alternative to either method relative valuation.

Peer group valuation

Ratios are a quicker way to work out whether or not a share is cheap or expensive. A ratio gives a snapshot of what a business is worth relative to its peers. Say you know that a firm can generate annual profits of £100m after tax. You also know that four similar listed firms have price/earnings (p/e) ratios (their market capitalisations divided by annual earnings) of eight. In theory you should be able to take the sector average p/e and multiply this by annual earnings for your target investment. That gives a valuation of 8 x £100m, or £800m. So if a firm (with an equally solid brand, decent management, high barriers to entry and so on as its peers) is trading on a lower p/e of 6, say, it might be a bargain.

This approach seems simple. But it too has challenges. For starters you need to pick the right ratio a p/e is no good if your aim is to get an income. For that you want to use something like a dividend yield ratio. It also doesn't help you to value a loss-making firm (although my advice with loss makers is to steer clear). And if you are comparing asset-heavy shares such as in the investment trust sector, you'd be better off looking at price-to-book ratios (for more on all these, see www.moneyweek.com/tutorials). Besides, single ratios can be dangerous and subject to short-term distortion. You might have to use several together, some of which (say, EV/Ebitda, or free cash-flow yield) are less straightforward to calculate.

Value funds the ultimate solution?

But why worry, says Greenblatt a new breed of fund will do the hard work for you. Better still, they are exchange-traded funds (ETFs), with lower management fees than unit trusts. The best of the bunch take a "value-weighted approach". That means the fund not only looks for high-quality, cheap stocks, but also automatically buys more of the ones it likes when they are available "at bargain prices". With more conventional tracker funds (which are often "market capitalisation weighted", so buy and sell purely on price) "if a stock is overpriced, you own too much of it and if a stock is underpriced you own too little".

Sounds great. And a value-weighted approach back-tested (and ignoring fees) would have returned 16.1% per year over the last 20 years versus just 9.1% for the S&P, according to www.valueweightedindex.com. What about actual performance? The US-listed Vanguard Small Cap ETF (NYSE: VBR) tracks the MSCI US Small Cap Value index. It has returned 3.92% a year on an annual fee of 0.12%, versus 2.84% for an ordinary S&P 500 index tracker (NYSE: SPY) with an annual fee of 0.1%. Another Greenblatt favourite the Powershares FTSE RAFI US 1,000 (NYSE: PRF) returned 4.72% over the last five years with an expense ratio of 0.39%. Not bad.

So what's not to like? Over the last five years, value funds that track large-cap stocks have done less well. A bias towards financials hurt them during the 2007/8 credit crunch. Some "active" ETFs can also be expensive. And, of course, the US funds trade in dollars not ideal for a UK investor. Sterling investors could offset some of these concerns with the Invesco Powershares FTSE RAFI 100 ETF (LSE: PSRU). It uses four measures companies' cash flow, dividends, sales and book value to determine the weight of FTSE 100 stocks in its index. RAFI says it beats cap-weighted rivals by more than 2% a year in most markets over the long term. That makes a huge difference potentially. If you're looking for a FTSE 100 tracker, it's worth a look as an alternative. The total expense ratio is 0.5%.