Here's how Joel Greenblatt makes 'lots of money'

Published Fri, Apr 8 201610:35 AM EDT

Editor's note: This is Pro Strategy, a column on how to use the philosophies of the smartest minds on Wall Street to generate quality investment ideas. Michael Kors , a former growth stock darling, is still down over 40 percent from its 2014 highs. Is the luxury goods maker a has-been or is this decline an opportunity? Using a legendary hedge fund manager's investing framework may give us the answer. Joel Greenblatt is one of the most respected value investors in the industry, generating a stunning long-term investment track record. The firm he founded, Gotham Capital, reportedly had annual returns of 40 percent from 1985 to 2005. CNBC Pro evaluated Michael Kors using the investment strategy Greenblatt teaches in his "Value and Special Situation Investing" class at Columbia Business School. Comments from a leading Wall Street retail analyst and David Einhorn's hedge fund investor letter also shaped this outlook. "Buying good businesses at bargain prices is the secret to making lots of money." — Joel Greenblatt To find such investment opportunities, Greenblatt screens for companies with high earnings yields and high return on invested capital (ROIC), according to class notes and supplemental materials from his business school students. Invest in Good Companies Whose Stocks are Cheap Good companies have high returns on capital (ROIC) - Defined as operating profit (EBIT or EBITDA – MCX (Maintenance Capital Expenditures) divided by working capital plus net fixed assets Cheap stocks have high earnings yields - Defined as pre-tax operating earnings divided by enterprise value Source: Joel Greenblatt Presentation The formulas above are a bit intricate, but the general concept is to find stocks trading at low earnings valuation multiples and having business models that are able to generate strong earnings returns for each incremental investment of capital (debt or equity). With this universe of "cheap and good" stocks, Greenblatt furthers his analysis by generating proprietary earnings projections called "normalized earnings" to find the best investments. The projections are informed by in-depth fundamental research on each company's business and historical trends. He also excelled in special situations investing, such as spinoffs, restructurings and mergers, which tend to be more complicated, therefore less likely to be efficiently valued by the market. "We run a very concentrated portfolio, with five to eight securities making up at least 80 percent of our portfolio" — Greenblatt to Value Investor Insight in October 2006. Greenblatt repeatedly emphasizes to his class that great ideas are rare, so to generate superior long-term returns one must invest a significant amount of capital to just a few of the best opportunities. Let's look at how Michael Kors fits the framework. Read More Pro Strategy: 'Grand Theft Auto' stock is a steal "I care about normalized high returns on capital though I don't care if it's 50 percent pretax ROIC or 80 percent ROIC, but I just say good is good and really good is really good." — Greenblatt. Michael Kors is the third-largest global luxury accessories brand, according to the company, and still generates extremely high profit margins and returns on capital even after a slowdown in growth. Its pretax ROIC in the last four quarters was 62 percent, according to FactSet. Moreover, the company is trading at a 14 percent pretax earnings yield. The combination of ROIC and earnings yield numbers puts Michael Kors in the top 30 of all stocks over $1 billion in market cap, according to Greenblatt's Magic Formula Investing screening site. The site ranks companies based on Greenblatt's ROIC and earnings yields investing framework. Not only does Michael Kors rank well on Greenblatt's method, it appears after a period of decline the company's fundamentals have stabilized and started to turn in the most recent reported quarter. Due to new designs, the company was able to post its first positive same-store sales growth ex-currency in a year during the March 2016 quarter. Some leading retail analysts are taking note. "We continue to like KORS on attractive valuation, easing comparisons, conservative guidance, strong FCF yield, and a continued runway for geographic and category expansion," BB & T Capital Markets' Corinna Freedman wrote in an email. She added, "In the very near-term, we believe stabilization of gross and EBIT margins will continue to support the unwind of last year's overly negative investor sentiment." Read More Pro Strategy: Fitbit may outrun the shorts And the analyst is not alone. Value oriented hedge fund manager David Einhorn said Michael Kors' recent missteps in product and operations are temporary and he's optimistic. "We believe KORS has multiple avenues of continued growth, including its international business and footwear," Einhorn wrote in an investor letter to clients in October. Einhorn's Greenlight Capital owned Michael Kors as of the end of December, according to the last publicly available SEC filing and Einhorn is known to be a long-term investor. So Michael Kors is a good fit with Greenblatt's framework. And other big names on Wall Street seem to like it, too. Note: As of the December SEC filing, Joel Greenblatt's Gotham Asset Management, owned shares in KORS. Greenblatt declined to comment for this article. Michael Kors declined to comment as the company is in a quiet period.

Designer Michael Kors

Editor's note: This is Pro Strategy, a column on how to use the philosophies of the smartest minds on Wall Street to generate quality investment ideas.

Michael Kors, a former growth stock darling, is still down over 40 percent from its 2014 highs. Is the luxury goods maker a has-been or is this decline an opportunity? Using a legendary hedge fund manager's investing framework may give us the answer.

Joel Greenblatt is one of the most respected value investors in the industry, generating a stunning long-term investment track record. The firm he founded, Gotham Capital, reportedly had annual returns of 40 percent from 1985 to 2005.

CNBC Pro evaluated Michael Kors using the investment strategy Greenblatt teaches in his "Value and Special Situation Investing" class at Columbia Business School. Comments from a leading Wall Street retail analyst and David Einhorn's hedge fund investor letter also shaped this outlook.