- The book circulates around Joel Greenblatt’s Magic Formula, which is constructed around Warren Buffett’s “fantastic companies at a reasonable prices”-philosophy. The ‘reasonable price’-factor is defined based on EBIT/EV. The ‘quality’-aspect is based on return on capital (ROC), which is calculated as follows: ROC = EBIT / (working capital + fixed assets). The formula is described as a guide to “systematically spot above-average businesses at below-average prices.”
- Joel has created a Magic Formula screener, which can be accessed on www.magicformulainvesting.com. If one slavishly followed this screen’s output, you would have achieved an annual return of 30.8% over a 17-year period.
- If you – like yours truly – ventures into selection of stock picks, remember Joel’s warning: “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”
Legendary value investor Joel Greenblatt, who achieved an annual average return of 50% – yes, fifty – in the 10 years he managed Gotham Capital, has written a book that’ll make you wonder: “This is too good to be true!” The Little Book That Beats the Market centers on Joel’s Magic Formula, which reportedly can beat any market index.
The Magic Formula
Joel became fascinated by Warren Buffett’s investment philosophy about acquiring “fantastic businesses at reasonable prices.” Hence, Joel studied Warren’s letters to Berkshire Hathaway shareholders in an attempt to quantify the two variables: 1) “fantastic businesses”, and 2) “reasonable prices”. The result of this study was a two-variable formula: The Magic Formula. The formula ranks stocks based on 1) earnings yield, and 2) return on invested capital (ROC).
The former is calculated by dividing EBIT with a company’s Enterprise Value (EV) (read Deep Value for a walk-through of EV), e.g. 1.20/12 = 10% earnings yield. This variable constitutes the “reasonable price” aspect of Warren’s philosophy. The higher the yield, the better the ranking.
The other variable concerns the quality of the business. Joel quantifies this otherwise subjective question by the ROC metric. This is calculated as such: ROC = EBIT / (working capital + fixed assets). In short, this variable covers to what degree the management is capable of optimizing the earnings relative to the capital that is necessary to operate the business.
The formula is described as a guide to “systematically spot above-average businesses at below-average prices.” Sounds simple, right? “Simple is good, goes the saying, and it appears to be true. A study shows that a portfolio strategy centering on a yearly rebalancing of 30 Magic Formula stocks would have returned 30.8% annually over a 17-year period. Joel proves that the formula works regardless of time period and market segments. For instance, Joel tested the formula in 169 time periods. The worst annual result that the formula returned was +11% relative to the market’s worst of -46%. Hence, capital was never lost with the Magic Formula. In short, you get market beating results with far less risk than e.g. an indexing strategy.
It gets even better..
“That sounds amazing! How can this get any better?”, you ask. Joel has developed a screen on www.magicformulainvesting.com, which outputs the 30 or 50 best stocks within a market cap range. Joel’s algorithm assigns each stock a rank based on aforementioned variables. Say that stock X has the highest earnings yield of the 30 stocks, it would be assigned an earnings yield score of 1. Let’s assume that it’s the 15th highest ranking stock measured on ROC. This would bring the total score to 16. If stock Y ranks 5 and 6, the total score would be 11, which would make this stock preferable over stock X (the lower the score, the better). Note, however, that the stocks are ranked alphabetically on Joel’s screen, not by score. You should just acquire all e.g. 30 stocks from the screen, and you’ll beat the market by a wide margin. That’s the claim.
Don’t be the idiot at the dynamite factory
Joel is well aware that the Magic Formula sounds too good to be true. He knows that there’ll be skeptics (just as yours truly) out there who wish to dig deeper and not ‘just’ accept a screen’s output. If you can nod in agreement herewith, you’ll probably venture into discovering, selecting and analyzing individual stocks. This may be fine and dandy, but just remember Joel’s warning: “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”
Oh, doesn’t it just sound wonderful to merely rebalance your portfolio once a year, and just sit back and watch the cash pour into your back account? Indeed! Why haven’t I just surrendered myself to Joel’s screen then? Perhaps I’m the idiot with the burning match, but 1) I enjoy the hunt for investment ideas, and 2) I’d like to know the businesses I own. However, when push comes to shove, it’s all about making money. Perhaps I’ll look back at this post and think to myself: “Why on earth didn’t you just follow the instructions?!” Well, time will show, but for now I’m more comfortable with a concentrated portfolio of businesses that I’m comfortable with.