Use “Magic Formula Investing” to Beat The Market
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In his book, The Little Book That Beats the Market, Joel Greenblatt explains how investors may outperform market averages by following his “Magic Formula” - simple process of investing in good companies (ones which return high returns on capital) at bargain prices (priced to give high earnings yield).
When tested against Standard & Poor's Compustat “Point in Time” database on a portfolio of approx. 30 stocks, Greenblatt’s formula actually beats the S&P 500 in 96 % of all cases, achieving an average annual return of 30.8 % over the last 17 years, turning $11,000 into over $1,000,000 over 17 years. Pretty impressive! Greenblatt’s “magic formula” is a purely quantitative, long-term stock investing strategy that works particularly well for small cap stocks (<1 billion) but also works for large-cap stocks (> 1 billion). Essentially, no matter what stocks we invest in, we want a strategy that ensures we can earn much more than we could get from purchasing say a “risk-free” 10 year U.S. government bond generating approx. 6%. Greenblatt’s “magic formula” method of stock investing is one strategy that achieves this.
Steps
- Use value investing. The central premise in Greenblatt's stock investing strategy is that of ‘value investing’. Fundamentally, value investing involves buying stocks that are undervalued, fallen out-of -favor in the Market due to investor irrationality. Greenblatt’s formula for value investing you could say is an updated version of Benjamin Graham’s ‘value investing’ approach.
- Graham is author of the classic bestseller The Intelligent Investor and widely acclaimed to be the father of value investing. Value investing follows the principles of determining the intrinsic value of a company and buying shares of a company at a large discount to their true value allowing a margin of safety to ride out the ups and downs of the share price over the short term but safeguard consistent profitable returns over the long-term. The hallmark of Graham's value investing approach is not so much profit maximization but loss minimization. Any value-investing strategy is very important for investors, as it can provide substantial profits in the long-haul, once the market inevitably re-evaluates the stock and raises its price for a stock to fair value.
- Understand how to work with share prices and wild mood swings. Greenblatt’s “Magic Formula” investing is designed to #1. beat the market and #2. withstand any short-term peaks and troughs in share price. Benjamin Graham, described investing in stocks as like being a partner in the ownership of a business with a crazy guy called Mr. Market subject to wild mood swings.
- Why do share prices move around so much when it seems clear that the value of the underlying businesses do not! Well, here’s how Greenblatt explains it: Who knows and who cares!! All you got to know is that they do. This doesn’t mean that the values of the underlying companies have changed. And that’s what Greenblatt’s “magic formula” takes advantage of once you stick with over the medium-to-long haul.
- Screen stocks to beat the market. Greenblatt’s “Magic Formula” uses two simple criteria to screen stocks for investing:
- Earnings Yield - First, stocks are screened by Earnings Yield i.e. how cheap they are relative to their earnings. The standard definition of Earnings Yield is Earnings/Price i.e. Earnings Per Share. Greenblatt has a slightly different definition of Earnings Yield and calculates it as follows:
- Earnings Yield = EBIT/Enterprise Value - EBIT (Earnings before Interest and Taxes) is used in the formula rather than Earnings as companies operate with different levels of debt and differing tax rates. And Enterprise Value (Market Cap plus Debt, Minority Interest and Preferred Shares - Total Cash and Cash Equivalents) is used in the calculation rather than the more commonly used P/E ratio. This is because Enterprise Value takes into account not only the price paid for an equity stake but also any debt financing used by the company to generate earnings.
- Return on Capital - Next, Greenblatt’s “magic formula” screens companies based upon the quality of their underlying business as measured by how much profit they are making from their invested capital. Return on Capital is defined as:
- Return On Capital = EBIT/(Net Working Capital + Net Fixed Assets)
- Net Working Capital is simply capital (cash) required for operating the business and Fixed Assets are buildings etc.
- Greenblatt's “Magic Formula” simply looks for the companies that have the best combination of these two factors and voila….more or less. I think it could be worthwhile to look under the bonnet of any companies that satisfy these 2 criteria. For instance, you might want to consider how sustainable is the company’s competitive advantage i.e. how long can a company sustain its superior Return on Capital invested. Also, when applying earnings yield, make sure you are using normalized earnings (rather than overstated or super-normal earnings)?
- Do it for yourself. So now that you understand the 2 basic criteria by which Greenblatt's “Magic Formula” screens stocks, how do you go about actually doing this for yourself? Pick “Magic Formula” Stocks as follows in the next steps, which are a step-by-step breakdown of how to pick “magic formula” stocks.
- Screen for stocks with a minimum market capitalization (usually greater than $100 million).
- Exclude any utility and financial stocks. This is because of the difference in their business model and how they make money and the oddities of their financial statements.
- Exclude foreign, non US companies (American Depository Receipts).
- Determine the company's Earnings Yield = EBIT / Enterprise Value.
- Determine the company's Return on Capital = EBIT / (Net Working Capital & Net Fixed Assets).
- Rank all companies above the chosen market capitalization by highest Earnings Yield and highest Return on Capital.
- Invest in 20-30 of the highest ranked companies, by acquiring 5 to 7 stocks every 2-3 months over a 12-month period i.e. dollar-cost-averaging.
- Re-balance portfolio once per year. For tax purposes, sell losers one week before the year-end and winners one week after the year-end.
- Repeat.
Tips
- When it comes down to it, Greenblatt’s “magic formula” is relatively simple to understand compared to some of the other convoluted qualitative stock-picking methods out there. So, the toughest part about using the Magic Formula isn’t the specifics of the two variables; but actually having discipline and the mental toughness to stick with the strategy, even during bad periods i.e. periods of low-returns.
- If the formula worked all the time, everyone would use it, which would eventually cause the stocks it picks to become overpriced and the formula would fail as there would be no bargains to be had. But because the strategy fails over short periods of time, many investors bail, allowing those who stick with it to get the good stocks at bargain prices. In essence, the strategy works because it doesn’t always work — a notion that is true for any good investment strategy. So, in summary, if you’re looking to build wealth and become rich and are not a hurry to do so than this “magic formula” stock market investing strategy just might be a really good starting point for you.
- Greenblatt explains that his strategy will work even after everyone knows about it. Why? Most investors and money managers seek short-term results. Their investment time horizon is short; hence they typically bail after a one or two year period of performing worse than the market average. Remember, this is a long-term strategy. On average, in 5 months out of each year the magic formula performs worse than the overall market. But over a period of 17 years it was shown to generate an average annual return of 30.8 %.
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