Joel Greenblatt's Magic formula is a very powerful screening technique (from "The little book that beats the market")

Hey, this was an insightful read when I read it many years ago and thought I'd share it here.

Here it goes.

One particularly powerful screening technique is Joel Greenblatt’s Magic Formula. In his book, “The Little Book That Beats the Market,” Greenblatt argues that amateur investors can outperform the market by investing in a portfolio of stocks selected using his “Magic Formula”, which ranks companies based on quality and value metrics.

Let’s dive into the process:

The Magic Formula

  1. Define Your Universe of Stocks
    Begin by defining the universe of stocks from which you’ll construct your portfolio. Currently, my universe comprises all US-listed companies, but you can define your own. You may choose to invest only in companies with a minimum market cap or stocks that trade a minimum daily volume, or perhaps you prefer UK-listed companies. The choice is yours.

Below I walk you through a simple example of how the Magic Formula ranking process works using all the constituents of the S&P 500. For each company I have populated the necessary metrics and rank them showing you the top 5 for each step below.

  1. Rank According to Quality Next, rank each business in your universe based on quality. Greenblatt’s formula uses a metric called Return on Capital (ROC), which measures the amount a company earns per dollar it invests. A higher ROC indicates a stronger incentive for the company to reinvest back into the business.

ROC is calculated as follows:

ROC = EBIT / (Fixed Assets + Net Working Capital)

Once you have each company’s ROC, rank them from highest to lowest as per the example below:

| Company        | Ticker | ROC    | Rank - ROC |
|----------------|--------|--------|------------|
| Public Storage | PSA    | >1000% | 1          |
| Verisign       | VRSN   | 486.2% | 2          |
| Mastercard     | MA     | 418.4% | 3          |
| Netflix        | NFLX   | 404.2% | 4          |
| Broadcom       | AVGO   | 222.9% | 5          |

The table above represents the 5 companies in the S&P 500 with the highest ROC. It is for illustrative purposes only, and data should not be relied upon

Measure for Value

Greenblatt advocates using the Earnings Yield as a measure of value. This metric reflects a company’s earnings from an operating perspective and is less prone to manipulation than net income. Think of earnings yield as similar to an interest rate, and is calculated as follows:

Earnings Yield = EBIT / Enterprise Value

Once you have each company’s yield, rank the companies from highest to lowest based on this metric.

| Company        | Ticker | Earning Yield | Rank - Yield |
|----------------|--------|---------------|--------------|
| APA Corporation| APA    | 22.2%         | 1            |
| Valero Energy  | CLU    | 19.7%         | 2            |
| Bunge Global   | BG     | 19.4%         | 3            |
| Fox Corp       | FOX    | 17.4%         | 4            |
| HP Inc.        | HPQ    | 14.6%         | 5            |

The table above represents the 5 companies in the S&P 500 with the highest Earnings Yield. It is for illustrative purposes only, and data should not be relied upon

  1. Building the Portfolio
    Once you have completed the initial rankings, it’s time to construct your portfolio. Combine the ROC and Earnings Yield rankings to create a Total Ranking. Order the Total Ranking from lowest to highest

The next step is to purchase the 20 - 30 companies with the LOWEST Total Ranking and hold them for exactly one year in equal proportions. Based on our example, the portfolio has the following 5 companies:

| Company        | Ticker | Total Rank | Weighting |
|----------------|--------|------------|-----------|
| Omnicom Group  | OMC    | 33         | 3.5%      |
| HP Inc.        | HPQ    | 33         | 3.5%      |
| Altria         | MO     | 40         | 3.5%      |
| Match Group    | MTCH   | 82         | 3.5%      |
| General Mills  | GIS    | 95         | 3.5%      |

The table above represents the 5 companies in the S&P 500 with the highest Total Ranking. It is for illustrative purposes only, and data should not be relied upon

At the end of the year, you repeat the process above and adjust your portfolio accordingly. It’s that simple.

Of course, there will be years of underperformance, but consistency is key. If followed diligently, Greenblatt’s evidence suggests you will outperform the relevant benchmark, e.g., if you are investing in US stocks, you will outperform the S&P 500 over the long term.

If you want a more detailed version you can read it here.

Hope you enjoyed this! Paul