Buy The Little Book That Beats the Market (Little Books. Big Profits)

Joel Greenblatt, a reputedly successful value investor, recommends that you run a screen off his website based on value criteria which he explains in his book. Based on this screen you buy the stocks without performing any further due diligence. Ok so I ran his screen yesterday May 4th, 2010 and these are a few of the stocks that came up. Would you buy these stocks?

BDSI, PE 2.2, is a tiny biopharmaceutical which showed up in yesterday's screen. Just reviewing the news releases on it I learned it received a going concern qualification from its auditors which means there is substantial doubt on the part of its auditors (CPAs) that it will survive the next twelve to fifteen months. To his credit he says you "may" want to eliminate any stocks with PEs under 5 as that may be due to unusual results in the prior year.

Another company TRMS with a of PE 4.35 is yet another tiny little biopharmaceutical company whose revenues have plummeted from $47 million in 07 to $15.18 million in 09. It looks like most of its 09 income came from a $12 million reverse termination fee paid to for a termination agreement with Arigene Co, Ltd. Otherwise it would have had earned close to $0 net income for 2009! Yes, this has a PE of less than 4 but Greenblatt made eliminating these optional.

USMO is another company that came up in yesterday's screen. Its revenues have dropped from $618MM in 05 to $289MM in 09. It's still selling at nearly 2X book value. I calculated the ROC as Greenblatt describes and yes for the past five years its generated 30% plus return on capital but that's partly because it has very little equity and till 09 had no retained earnings. I was actually puzzled by this so I dug into its 10K. In 07 and 08 it declared a net loss but rather than reporting a retained deficit, they reclassified the net loss through the statement of stock holders' equity against APIC, which partly explains why APIC (the additional equity/capital paid in by investors)has been shrinking, although it's also explained by the share repurchase program, which is a positive. Still you have to wonder about a company that can't generate retained earnings. Finance rather than the Sales and Ops teams seems more responsible for generating the impressive ROCs. The stock has lost half its value since 2005, pretty much in line with its drop in revenue from $618 million to $289 million. It has perennially underperformed the NASDAQ despite the impressive ROCs throughout.

SNTS another company that came up in yesterdays screen is running an accumulated deficit; meaning to date it has only consumed investor's capital, let alone provide any return on it. And what kind of company is this, a biopharmaceutical. The company never had positive operating cash flow till 2009 which was due to one $20 million down mileston payment from it's marketing partner Merk. Last month a court over turned five of it's patents for "obviousness."

SNTA, PE 6.6 (forward PE 55!), came up in the magicformula screen. SNTA is a biopharmaceutical drug development company. It had a loss for Q1 10, and is projecting a loss for all of 2010. In fact it looks like it's only ever had one positive quarter ever and is voraciously chewing up capital through its R&D line. Where is the return on capital? How is this a magicformula stock? Why is this showing up in Greenblatt's screen?

If you just ran this screen and decided to buy all 30 stocks, you would be overweight in biotech which is a very risky sector and which is well known for letting investors down. You are not diversified, even if you own 30 stocks, if a good portion of them are in one sector. Also do your due dilligence; take Greenblatt to his word and check stocks with PEs under 5. You can learn a surprising amount just by reviewing recent news releases. Also don't be intimidated by the 10K. These are easily accessible.

One other problem is that Greenblatt advises buying the top ranked 5 to 7 stocks, except that his screen does not provide their rankings. In addition Greenblatt is pushing visitors to his site towards his forumlainvesting funds. I'm wondering if this was part of his grand design from the beginning. He's a billionaire for reason.

The list of stocks in the May 4th screen (Market caps greater than or equal to $50 million) : OSK SNTS PPD SMED IMMU UIS CEU ONTY TTT UNTD DLX PRSC EME CNU UEPS WTW AMED SOLR LO CHKE VSNT APOL ABC JCOM SVA CBPO
I removed those stocks with PEs less than equal to 5.

5/13/10 Update: So how has the above list of stocks held up through the recent market turmoil. Based on 5/4 opening prices you would down -1.7% versus -1.38% for the S&P500 (cap weighted).Get more detail about The Little Book That Beats the Market (Little Books. Big Profits).