In this article I present the strategy used by Joel Greenblatt, managing principal and co-chief investment officer of Gotham Asset Management. There are many approaches to selecting and analyzing common stocks floating around the investment community, ranging from simple value techniques to complex strategies combining a wide range of technical and fundamental factors. Many investors are initially attracted to complex techniques, but they discover that basic but solid approaches often outperform and are easier to implement and understand.
with The Little Book That Beats the Market and follow up The little book that still beats the market, Greenblatt’s goal was to write books simple enough for his children to understand that still reflected the core values he used to manage his portfolio. The result is an easy-to-follow process that relies on two simple rules: Look for companies with high returns on invested capital (ROIC) and that can be purchased at a low price that offer a high pretax earnings yield. These two concepts – buying a good business at a cheap price – create the “magic formula”.
Through October 31, 2023, AAII’s Magic Formula screening model projects a year-to-date gain of 12.1%, compared to -3.7% for the S&P SmallCap 600 Index and 1.6% for the S&P MidCap 400 Index over the same period Is.
finding good companies
Greenblatt believes that a company that has the ability to invest in its business and get strong returns on that investment is usually a “good” company. He gives the example of a company that can spend $400,000 on a new store and make $200,000 the next year. The return on investment will be 50%. He compares this to another company that spends $400,000 on a new store but makes only $10,000 the next year. Its return on investment is only 2.5 percent. He would expect you to choose a company with a higher expected return on investment.
Companies that can earn high returns on capital over time generally have a special advantage that prevents competition from destroying them. This could be name recognition, a new product that is hard to imitate or even a unique business model.
return on capital
Greenblatt measures the strength of a business by examining its return on capital, which he defines as operating profit – earnings before interest and taxes (EBIT) – divided by tangible invested capital – net working capital and net fixed assets. Is divided by.
Return on capital, or return on invested capital, is similar to return on equity (ROE, the ratio of earnings to shares outstanding) and return on assets (the ratio of earnings to the firm’s assets), but Greenblatt makes a few changes. He calculates return on capital by dividing EBIT by tangible capital.
Greenblatt uses EBIT to calculate return on capital because his focus is on profitability from operations as it relates to the cost of the assets used to produce those profits.
Another difference is Greenblatt’s use of tangible capital in place of equity or property. Debt levels and tax rates vary from company to company, which can lead to distorted earnings and dirty cash flows. Greenblatt believes that tangible capital better captures the actual operating capital used.
According to Greenblatt, the higher the return on capital, the better the investment.
For our Greenblatt Magic Formula screen, we need more than 25% return on invested capital.
identifying cheap stocks
For those familiar with Benjamin Graham’s value investing style, the point is clear: buy stocks below their true value. This means that you are able to make a somewhat accurate estimate of the true value of a company based on its future earnings prospects.
Greenblatt says that a firm’s stock prices can experience “wild” fluctuations even if the company’s value does not change or changes very little. He sees these price fluctuations as an opportunity to buy at a lower price and sell at a higher price.
He follows Graham’s “margin of safety” philosophy to allow some room for estimating errors. Graham said if you think a company is worth $70 and it’s selling for $40, buy it. If you’re wrong and the fair value is closer to $60 or $50, you’ll still be buying the stock at a discount.
Using EBIT relative to enterprise value to find value
Greenblatt finds stocks to sell at cheap prices by looking for companies with high ratios of EBIT and enterprise value. Enterprise value is equal to the market value of equity (including preferred stock) plus excess cash from interest-bearing debt.
The enterprise value of a company represents its economic value, which is the minimum price that would be paid to purchase the company outright. Considering value investing strategies, this is similar to book value. Greenblatt uses enterprise value rather than just the market value of equity because it takes into account both the market value of equity and the debt used to generate earnings.
EBIT relative to enterprise value helps measure a stock’s earnings potential versus its value. If the EBIT-to-enterprise-value ratio is higher than the risk-free rate – typically the 10-year US government bond rate is used as a benchmark – Greenblatt believes you have a good investment. There may be opportunity, and the higher the ratio, the better.
Stocks that pass the magic formula screen are domestic, exchange-listed stocks with a market capitalization (shares outstanding multiplied by share price) of at least $50 million. Greenblatt also does not include financials and utilities due to their unique financial structures. The 30 companies with the highest levels of EBIT relative to enterprise value make up the AAII screen results.
Applying the Magic Formula
The search started with a universe of the 3,500 largest exchange-listed stocks, based on market cap. Greenblatt used a market-cap floor of $50 million, but advised that, depending on your liquidity needs and risk aversion, you could set a minimum of up to $5 billion.
They then ranked the stocks from one to 3,500 based on return on capital. The highest return on capital received a ranking of one; The lowest received a rating of 3,500.
Next, they ranked the stocks based on the ratio of EBIT to enterprise value, with the highest ratio being given a rank of one and the lowest being given a rank of 3,500. In the end, they combined the rankings. If a company is ranked 20th for return on capital and 10th for EBIT over enterprise value, the combined ranking is 30.
For practical purposes, Greenblatt recommends investing in 20 to 30 stocks by buying five to seven every few months. He recommends a holding period of one year for each stock. He believes this strategy will allow you to make changes to only a few stocks rather than liquidating and repurchasing the entire portfolio at once.
Greenblatt tested his investment strategy over a 17-year period and earned an average annual return of 30.8%. He owned 30 stocks at one time and held each stock for a year.
Greenblatt points out that the strategy is not a “magic bullet” that always works. During their testing period, they found that the market underperformed an average of five out of every 12 months. Looking at the full year period, this approach failed to beat the market once every four years.
Sticking to a strategy that isn’t working in the short term, even if it has a good long-term record, can be difficult, but Greenblatt believes you will be better off doing so. In his opinion, following the latest trends or short-term investment ideas will not yield market-beating results.
Magic Formula Stock Picking
Greenblatt runs a free website with a magic formula screening tool. After registering on the site, you can use the simple screener. The only options you can choose are the minimum market cap (any number between $50 million and $5 billion) and the number of companies you want to look at (30 or 50).
The website does the rest for you. It orders stocks based on the combined rank of EBIT-to-enterprise-value ratio and return on capital and presents the top stocks. The previous day’s closing prices are used.
Interpreting Screens Using a Stock Screening Program
Applying the magic formula to using a stock screening program requires some explanation. First Cut column in the May 2009 issue of AAII Journal Magic formula investment strategy demonstrated. Greenblatt’s criteria were interpreted and updated to work within the parameters of the AAII Fundamental Stock Screening Program, Stock Investor Pro, Click here for a list of screen criteria for use in AAII Stock Investor Pro,
Greenblatt’s main point is that investors should buy good companies at bargain prices – businesses with high returns on investment that are trading at less than their value.
When it comes time to select some stock ideas to follow, you can run the screen to get a new list. Because this simple approach does not depend on additional research, it is important to own a significant number of stocks to allow you to diversify your risk and adopt the general principles of the approach. The magic formula approach is banking on smart money eventually realizing the value of the “good businesses” selected by the approach and driving up stock prices to reward the value investor.
Top 20 Stocks That Passed the Greenblatt Magic Formula Screen (Ranked by EBIT Relative to Enterprise Value)
American Association of Individual Investors
Stocks that meet the outlook’s criteria do not represent “recommended” or “buy” lists. It is important to do due diligence.
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