Introduction
Value investing has been a cornerstone of wealth creation for decades. Among the prominent figures in this discipline, Joel Greenblatt stands out for his unique and effective approach to investing. Greenblatt’s “Magic Formula Investing” has gained traction as a simple yet powerful method to identify undervalued stocks with high potential. This article will explore Greenblatt’s investment philosophy, the mathematics behind the Magic Formula, real-world applications, historical performance, and comparisons with traditional value investing approaches.
Who Is Joel Greenblatt?
Joel Greenblatt is a hedge fund manager, investor, and author, best known for his book The Little Book That Still Beats the Market. He founded Gotham Capital, an investment firm that generated extraordinary returns. Greenblatt’s Magic Formula Investing strategy emerged from his rigorous quantitative research, aiming to simplify value investing while maintaining its core principles.
The Core of Greenblatt’s Magic Formula
Understanding Value Investing
Value investing, pioneered by Benjamin Graham and later refined by Warren Buffett, focuses on identifying stocks trading for less than their intrinsic value. The goal is to purchase undervalued stocks and hold them until the market recognizes their true worth.
The Two Key Factors
Greenblatt’s Magic Formula selects stocks based on two fundamental metrics:
- Earnings Yield (EY): This measures how much a company earns relative to its price.
Where:
- EBIT = Earnings Before Interest and Taxes
- Enterprise Value (EV) = Market Capitalization + Debt – Cash
Return on Capital (ROC): This assesses how efficiently a company generates profit from its capital.
ROC = \frac{EBIT}{Net\ Working\ Capital + Fixed\ Assets}Where:
- Net Working Capital = Current Assets – Current Liabilities
- Fixed Assets = Property, Plant, and Equipment (PP&E)
Greenblatt ranks stocks based on both these factors, selecting those with the highest combined rankings.
The Mathematical Justification
Greenblatt’s formula is based on the premise that stocks with high EY and ROC outperform the market. A stock with a high EY is likely undervalued, while a high ROC ensures that the company efficiently uses its capital. By combining these factors, Greenblatt creates a ranking system that prioritizes fundamentally strong yet underpriced stocks.
Empirical Evidence
Greenblatt tested his formula over a 17-year period and found that a portfolio following the Magic Formula outperformed the S&P 500 by significant margins. Historical data suggests that investing in a diversified portfolio of top-ranked Magic Formula stocks yields higher returns than traditional index investing.
| Period | S&P 500 Annualized Return | Magic Formula Annualized Return |
|---|---|---|
| 1988-2004 | 12.4% | 30.8% |
How to Apply the Magic Formula
- Screen for Companies: Exclude financial and utility companies and focus on mid-to-large-cap stocks.
- Rank by EY and ROC: Assign numerical rankings to all eligible stocks.
- Invest in Top 20-30 Stocks: Hold for one year, then rebalance annually.
Comparison with Traditional Value Investing
| Aspect | Traditional Value Investing | Magic Formula Investing |
|---|---|---|
| Complexity | Requires in-depth analysis | Uses a simple ranking system |
| Metrics Used | P/E ratio, P/B ratio, DCF models | EY and ROC |
| Time Commitment | High | Low |
| Historical Returns | Varies | Consistently high |
Strengths and Weaknesses
Strengths:
- Systematic and disciplined approach
- Eliminates emotional biases
- Proven historical performance
Weaknesses:
- Ignores qualitative factors (e.g., brand strength, management quality)
- Market conditions can impact performance
Real-World Example with Calculation
Suppose we evaluate two companies, A and B.
| Company | EBIT | Enterprise Value | ROC Formula Components |
|---|---|---|---|
| A | $200M | $1B | $200M / ($500M + $300M) = 25% |
| B | $150M | $700M | $150M / ($400M + $200M) = 20% |
Step 1: Calculate Earnings Yield:
EY_A = \frac{200M}{1B} = 20% EY_B = \frac{150M}{700M} = 21.4%Step 2: Rank Companies Based on Metrics
| Company | EY Rank | ROC Rank | Total Rank (Lower is Better) |
|---|---|---|---|
| A | 2 | 1 | 3 |
| B | 1 | 2 | 3 |
Since both companies have the same total rank, they would both be candidates for investment.
Magic Formula in Bull and Bear Markets
- Bull Markets: The Magic Formula still identifies strong companies but may underperform growth stocks.
- Bear Markets: The strategy often shines as undervalued stocks recover faster than overvalued ones.
Adjustments for Better Performance
- Adding a Momentum Factor: Some investors combine the Magic Formula with momentum metrics to improve returns.
- Sector-Specific Adjustments: Screening out cyclical industries can enhance stability.
- Periodic Rebalancing: Adjusting every 6 months instead of annually can optimize gains.
Conclusion
Joel Greenblatt’s Magic Formula is an effective, systematic approach to value investing. It balances simplicity with strong historical returns, making it accessible to individual investors. While no strategy is foolproof, Greenblatt’s method provides a structured way to identify fundamentally strong and undervalued stocks. By implementing and adjusting the formula based on market conditions, investors can significantly enhance their chances of outperforming the broader market.
