Unraveling the Magic Formula investing Strategy by Investing Ace Joel Greenblatt: Have you ever wondered if you would get an indestructible investment strategy if you combine the strategies of investment gurus in a perfect mix?  The magic formula of Investing by Joel Greenblatt does exactly this. It combines the strategies of Warren Buffets value investing and Benjamin Grahams Deep value approach in order to create the winning ‘Magic Formula’.

In this article, we are going to cover this ‘The Magic Formula’ Investing Strategy by Joel Greenblatt. Here, we’ll discuss the exact magic formula approach and how it can be applied to your stock-picking technique and portfolios.

Who is Joel Greenblatt?

Joel Greenblatt is a hedge fund manager and professor at Columbia University. He runs Gotham Funds with his partner, Robert Goldstein. Joel is considered a genius by other fund managers at wall street. Such was his acumen, that post the release of his book ‘You Can Be A Stock Market Genius’, many hedge funds claimed they were following his approach.

The Magic Formula which we are about to discuss today is from his second book, ‘The Little Book That Beats the Market’. This book was specifically written by him in order to assist small investors with a simple strategy. According to Joel Greenblatt, The Magic Formula when tested by him offered 24% returns from 1988-2009.

What is Magic Formula Investing?

In the book “The Little Book that Still Beats The Market”, Joel Greenblatt focuses on his magic formula investing strategy that is based on two financial ratios- Return on capital and Earnings Yield. Let’s discuss each of these ratios.

1. Return on capital (ROC)

ROC is the ratio of the pre-tax operating earnings (EBIT) to tangible capital employed (Net working capital + Net fixed capital). It can be calculated by using the following formula: ROC = EBIT/ (Net working capital + Net Fixed capital).

Joel Greenblatt described why he used ROC in place of the commonly used financial ratios like ROE (Return on equity) or ROA (Return on assets). This is because, first of all, EBIT avoids the distortions arising from the differences in tax rates for different companies while comparing. Second, the net working capital plus net fixed capital is used in place of fixed assets as it actually tells how much capital is needed to conduct the working of the company’s business.

Overall, Return on capital tells how efficient the company is in turning your investments into profits.

2. Earnings Yield

Enterprise value is the market value of equity (including preferred shares) + net interest – bearing debt. Earning Yield can be calculated as: Earning yield = EBIT / Enterprise value.

This ratio tells how much money you can expect to make per year for each rupee you invest in the share.

In short, from the above two discussed financial rations, ROC tells how good is the company, and Earning yield tells how good is the price.

Next, here are the three steps suggested by the author Joel Greenblatt in his book ‘The little book that beats the market’ to find companies for investment:

1. Find the earning yields and return on capitals of the stock to evaluate stocks.
2. Rank the companies according to the above two factors and combine them to find the best companies for investment.
3. Have patience and remain invested for the long term. Lack of patience is why people fail to implement the magic formula.

How to use magic formula using the above ratios?

1. Find the Return on capital (ROC) and Earning yield (EY) for all the companies.
2. Sort all the companies in ranks by ROC.
3. Sort all the companies in ranks by EY.
4. Invest in the top 30 companies based on the combined factors.

Now, we try to find the companies with the lowest combined factor rank.

For example, for company A, although it ranks 1 for the Return on capital. However, its earning yield rank is quite low and that’s why it’s combined rank is quite high. On the other hand, for company E, both ROC and EY rank are decent and hence its combined rank is good for investment.

Also read: Peter Lynch’s Investment Strategy and Success Tips!

How to use the Magic Formula Investing Strategy efficiently?

The Magic Formula is based on the simple principle that if you buy good companies at cheap prices you are going to do well. In a note of caution, Greenblatt emphasizes that for the formula to work its magic it must be applied for a period of 5 years. The following are the steps to be followed in order to implement this strategy.

1. The very first step involves deciding the total amount that you want to invest along with the number of stocks. Greenblatt suggests creating a portfolio of 20-30 stocks.

2. The next step includes setting up an investment pattern for the period when you would buy the stocks. Greenblatt expects the investments to be bought in batches spread out through the year. I.e. if you plan on investing in 20 stocks you can plan of buying stocks in batches of 5 every 3 months. Or if you plan on investing in 21 stocks you can plan of buying stocks in batches of 7 every 4 months.

3. The next step is to try and allocate the predetermined total investment amount equally among the number of stocks selected. This means that if you have decided to invest in 20 stocks with a capital of $200,000,  then $10,000 must be spent on each stock.

4. Now we sort the companies in order to only include companies with a market capitalization of over $50 million, $100 million, or $200 million. This will depend on the risk an investor can stomach. On whether he would prefer to invest in stocks that have greater growth prospects in the lower Mcap or ones that are stable with higher Mcap.

5. Determine the company’s earnings yield, which is EBIT/EV.

6. Determine the company’s return on capital, which is EBIT/(net fixed assets + working capital).\

7. Based on the last two steps, rank the stocks according to earnings yield and return on capital. Once ranking them individually is on the 2 parameters is done, rank them based on the combined ranks of the two-parameter. This can be done by adding the ranks of stock in the 2 parameters.

8. Invest in the highest-ranked companies calculated whenever the predetermined dates to invest in the batches arrive.

9. Rebalance the portfolio once per year, selling losers 51 weeks after purchase and selling winners 53 weeks after purchase. This is for tax purposes, as losses can be considered for the same year, and stocks that gain are to be held for longer in order to benefit from the reduced Long term Capital Gain tax rate.

The two parameters used above i.e help us identify stocks that are of high value(earnings yield) and at the same time are below the average price(ROC).

Closing Thoughts

The Magic formula is a relatively simple investment strategy that is easy to understand. Its implementation, however, may take some toll. In order to ensure that it does not cause much of a hindrance, it is best that investors continuously keep recording.

This involves the plan and activity performed along with the appropriate dates. By doing so investors will avoid any confusion. These may arise regarding when they have to buy stocks and when they have to rebalance their portfolios. Happy Investing!

Aron Almeida

Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.