Never Run Out Of Investment Ideas with "The Magic Formula"!

By Puah Soon Lim

Joel Greenblatt made his name running Gotham Capital and he made a lot of money doing it with annualized returns reported at 50% annually. He also wrote a very popular book “The Little Book that Beats the Market” which he shared in some of the public talks. He has the intention of teaching his children about investing and also to let them gain some insights into what a hedge fund manager does for a living. He wrote: “If you can’t explain the concept to a three-year-old, then you really do not understand it”. That is why I enjoy his book so much, and I have been recommending “ The Little Book that Still Beats The Market” in a lot of my talks. Greenblatt has a knack for explaining a complicated concept and distill them down to easy to understand snippets.

The central theme of the book is  “The Magic Formula” which is essentially a ranking system that he developed based on two criteria; Quality and Bargain. According to the Greenblatt:

"... if you stick to buying good companies ... and to buying those companies only at bargain prices ... you can end up systematically buying many of the good companies that crazy Mr Market has decided to literally give away.”

-- The Little Book That Beats The Market (p. 45)

This translate into two ratios: a high Return on Capital (ROC) and a high Earnings Yield (EY). 

Return on Capital - measures how effective the company is at making a profit from its assets – this is used as a proxy for how ‘good’ the company is.

Earnings Yield - takes a company’s operating profit and divides it by its enterprise value – the higher the earnings yield the ‘cheaper’ the stock.

The approach is to rank the market from high to low for each indicator and adding the two ranks together to give a Magic Formula score for all the eligible companies in the market. So a company that is ranked 101st best in terms of ROC and 53rd highest in EY would have a Magic Formula ranking of 154th, whereas a company that is ranked 1st in ROIC but only 699th best in EY would have a score of 700.

Once the ranking has been developed, Greenblatt suggests building a portfolio by buying the top-ranked five to seven stocks every three months over a one-year period. After a one year holding period, each stock should be sold. After that just repeat the steps to reinvest the proceeds of securities sold. This approach should be continued over a long-term (3-5+ year) period.

The advantage I see from such a system is that you never run out of investment idea, unlike some other value investing strategy.

Joel Greenblatt was asked whether he was worried about too many people using his “Magic Formula”. He answered “no” because he recognized that there would likely be only a few people able to hang on to depressed stocks for a long time.

So much for patience – or, more precisely, the lack of it.