Stéphane Renevier

3 months ago12 mins

This Hedge Fund Guru Has A "Magic Formula" For Buying Stocks

This Hedge Fund Guru Has A "Magic Formula" For Buying Stocks

Stéphane Renevier

3 months ago12 mins

This Hedge Fund Guru Has A "Magic Formula" For Buying Stocks
  • Greenblatt’s doesn’t just want to buy good businesses. Or cheap stocks. He wants to buy good businesses at a cheap price. He uses return on capital and earnings yield to find them.

  • It’s not just about identifying the right stocks. You have to slowly buy a group of them, hold them for a year, and repeat. It’s as much about maintaining the strategy as it is starting it.

  • If you use the magic formula, make sure you understand the rationale (buying good companies at bargain prices makes sense) and the limitations (you have to apply the rules to the letter, be patient, have a long time horizon, and be willing to handle long stretches of underperformance).

Greenblatt’s doesn’t just want to buy good businesses. Or cheap stocks. He wants to buy good businesses at a cheap price. He uses return on capital and earnings yield to find them.

It’s not just about identifying the right stocks. You have to slowly buy a group of them, hold them for a year, and repeat. It’s as much about maintaining the strategy as it is starting it.

If you use the magic formula, make sure you understand the rationale (buying good companies at bargain prices makes sense) and the limitations (you have to apply the rules to the letter, be patient, have a long time horizon, and be willing to handle long stretches of underperformance).

Joel Greenblatt’s got a magic formula for investing. It’s how he manages to always be buying good stocks at cheap prices – and it’s what has made him one of the most successful fund managers of all time. Fortunately, Greenblatt’s not keeping this formula a secret. I’m going to tell you how it works, so you can replicate his success.

OK, so what’s this magic formula?

Not to oversimplify here, but it involves buying stocks that are both “good” and “cheap”, using a couple of straightforward equations to ensure you’re getting both.

A “good” business will generate a high return on capital invested. That’s because more profits per dollar invested will fill shareholders’ pockets faster, sure, but it’s also because these kinds of companies tend to have something that makes them special. Maybe it’s a competitive advantage, for example, that allows the company to preserve its profits while growing its market share. And a high return on capital tends to stick with a firm, and then leads to high future earnings growth. Put more simply, a business with a high return on capital isn’t simply one that’s good today: it’s one that’s likely to remain good in the future.

But it’s not enough just to buy a good business. You also want to buy it “cheap”. Look, there’s still plenty of uncertainty with a business – even a high-quality one – and you have to make sure you’ve got some margin of safety in case things don’t go as well as you hope.

For Greenblatt, that means buying a business that earns more, relative to the price you're paying. And an easy way to calculate that is to look at its earnings yield – how much earnings before interest and taxes (EBIT) you can expect relative to the total value of the company, or its enterprise value. The higher the yield, the more “value” you get.

So Greenblatt’s approach is a combination of value investing and quality investing. It’s all about buying a high-quality company at an attractive price. Or, viewed another way, it’s about buying a cheap company that isn’t rubbish. Yes, you’re looking for the best of both worlds (it’s not called “magic” for nothing).

So, how do you use the formula?

First, identify the best 30 to 50 stocks.

1. Select your universe.

You’ll want to include regions where you can get reliable data (so, avoid off-the-beaten-path emerging market countries), and you’ll also want to include small-cap stocks (they’re more likely to be mispriced). In his screen, Greenblatt includes the biggest 3,500 companies available for trading on the major US stock indexes.

You might want to remove stocks that are so small they could be illiquid (ruling out anything with less than a $50 million market cap), stocks in the utilities and financial sectors (because their different capital structures make them harder to compare), foreign companies (they’re also harder to compare), and companies that have recently reported earnings (to minimize the chances of incorrect or untimely data).

2. Calculate the business’s return on capital invested.

To assess how good a business is, calculate its return on capital, using the following formula:

return on capital = earnings before interest and taxes / (net working capital + net fixed assets).

Greenblatt uses return on capital rather than return on equity (earnings / equity) or return on assets (earnings / total assets) for two reasons: first, earnings before taxes can make it easier to compare companies with different capital and tax structures, and second, tangible capital employed (i.e. net working capital + net fixed assets) is a better reflection of how much capital is actually required to run the business. By also excluding intangible assets like goodwill and patented tech, you can focus on how much funding is necessary for receivables and inventory (net working capital), as well as the purchase of fixed assets like real estate, factories, and equipment (net fixed assets). If you can’t find return on capital data, however, you can use return on assets as a stand-in.

3. Calculate the stock’s earnings yield.

To assess how cheap the stocks are relative to their earnings, calculate the earnings yield for each company using the following formula:

earnings yield = earnings before interest and taxes / enterprise value.

Enterprise value is calculated as the market value of equity + the net interest-bearing debt. Greenblatt likes this ratio over the narrower price-to-earnings (P/E) ratio as it allows for a better comparison of businesses with different capital and tax structures.

4. Rank companies on both metrics.

The next step is to rank the companies based on their return on capital and earnings yield (separately). You can then add the two ranks together and put them in order, so you’ll have a final ranking of companies that have the best combination of those two factors. This is important: a company that’s good but not great on both scores might be more highly ranked than a company scoring really highly on one but extremely poorly on another. The important thing here is to hunt for stocks that are both good and cheap, rather than one but not the other.

If you find this ranking process overwhelming, you can use the following shortcut using a screener like Finviz: on the “fundamental” tab, start by selecting “return on investment” over +25%. You can then specify a forward P/E higher than five (to avoid stocks that may be impacted by data issues), and a P/E lower than ten, and rank the stocks by their P/E.

Alternatively, you can use the “map” feature to visualize stocks that have both a high return on investment (vertical axis, and, here, the higher the better) and a low P/E (horizontal axis; the lower the better). Stocks in the upper left of the chart will be the most attractive.

Stocks on the top-left are "good companies at bargain prices". Source: Finviz.com
Stocks on the top-left are "good companies at bargain prices". Source: Finviz.com

Now, I’ve shown you all that so you understand how the measure is calculated and so you can see that you can play around with the data yourself.

But there’s also an even simpler and better method if you plan to focus exclusively on US stocks – and that’s by using Greenblatt’s own screen, which he shares here. He’s kindly made it available so anyone can see the magic formula calculated in the right way. And it’s updated in real-time, so make sure to bookmark it.

Then, build and manage your portfolio.

Now that you’ve got a list of the top 30 or 50 companies, you have to put your money to work. Here’s how:

5. Buy five to seven of those companies. To start, invest only 20% to 33% of the money you plan to invest during the first year. That’s called dollar-cost averaging and it’ll smooth your entry price points.

6. Repeat the previous step every two to three months until you have invested all of the money you have chosen to allocate to your magic formula portfolio. After nine or ten months, this should result in a portfolio of 20 to 30 stocks. I’ll explain later why it’s important with this strategy to diversify across so many stocks.

7. Sell each stock after holding it for one year. For taxable accounts, sell stocks with a gain after holding them for a few days more than a year and sell the ones with a loss after holding them for a few days less than a year. Then replace those stocks with the new ones identified by the formula.

8. Continue this process for at least three to five years, regardless of investment performance. It takes time for the magic formula to work, so make sure to give it enough time.

Does it really work?

It does – if you respect the rules and have a long investing horizon.

The magic formula isn’t one of these complicated measures that’s been overengineered to make the backtest look great. It’s grounded in economic intuition and it’s extremely simple – so, since it’s worked in the past, it’s more likely to work in the future.

What’s more, Greenblatt tested the formula diligently, and found that it outperformed the S&P 500, and delivered robust returns that weren’t explained by things like transaction costs, survivorship biases, or quirks in the data. In fact, the magic formula was so successful that it formed the core of the investment approach at Greenblatt’s hedge fund Gotham Asset Management.

That said, Greenblatt tested the formula about a decade ago and it hasn’t been as thoroughly tested since then. And since most value-like strategies have struggled in more recent years, it’s very possible that its performance over the past decade has been less than stellar. In my opinion, that doesn’t really matter: what matters is what the magic formula does next, over the long term.

So, is there still magic in the formula?

If you’re going to believe in “magic”, you might want to understand why it works.

It works because markets aren’t fully efficient. While the intrinsic value of a business doesn’t materially change on a daily, weekly, or even monthly basis, its price often does. That’s because, as the father of value investing, Benjamin Graham, famously explained, in the short term “Mr. Market” acts like a wildly emotional guy, often willing to buy hyped-up stocks at a hefty premium, but unwilling to buy out-of-favor stocks unless they’re selling at a steep, steep discount. But over the long run, Mr. Market does get it right and the price does converge to the intrinsic value of the business.

If Greenblatt’s magic formula works well, it’s because it’s good at identifying quality businesses that are more likely to trade at a discount to their intrinsic value. These are businesses that might be getting overlooked for various reasons: maybe they operate in out-of-favor industries, have recently received bad press, have a complex business model, or are simply smaller. By focusing not just on whether the stock is cheap relative to its earnings, but also on whether the business is high quality, you can reduce your risk of buying a stock that’s cheap for a reason (i.e. it’s a dud, and it’ll remain a dud). And over time, you’ll profit from the price converging to its higher fair value.

But how can such a simple formula be so good at identifying those businesses? A massively overlooked factor behind the success of the strategy is that you’re not betting on a single company, but on a portfolio of stocks displaying those attributes. Use the formula on a single stock, and it may not work (in fact, there’s a close to 50% chance that any of those stocks will underperform the market). But buy a portfolio of stocks showing those attributes, and you’ll profit from the fact that on average investors are underpaying for them, meaning you’ll profit over time when their prices converge to their intrinsic value. Think of it like running a casino: sure, you’ll have to pay out sometimes, but on average, and over time, you’re likely to make a lot of money.

What are the risks?

Well, if markets do suddenly become more efficient, then this formula might not work as well. But while that’s a real risk in theory, a quick look at what happened to meme stocks in 2021 shows how very unlikely that is. Another risk is that investors might stop prioritizing the value and quality attributes of a company, and prefer to just pile into the stocks with the highest growth potential. That’s certainly possible in the short term, but unlikely over the longer term. Remember, Mr. Market always eventually gets it right. A third risk is that the metrics used aren’t a good reflection of value and quality anymore. But I don’t think it’s a huge risk: this formula is grounded in theory and hasn’t been overengineered. And because you apply the formula to a group of stocks rather than to single ones, it’s got the laws of averages on its side.

For me, the biggest risk here isn’t that the magic formula stops working but that you give up before it has time to work. While the rules are easy, adhering to them can be difficult and could force you out of your comfort zone. You’ll be holding unsexy stocks that could see dismal returns for a long time. You might not understand why you’ve bought a specific company. You might be underperforming the broader market for a long time. And unless you’ve got an iron-clad belief in the underlying philosophy, you could end up abandoning the strategy at the worst possible moment. That’s the main risk you should focus on: how to make sure you can stay the course if it doesn’t go your way.

What stocks should you buy then?

Here are the top 30 companies with a minimum market cap of $50 million from Greenblatt’s official magic formula screen:

Top 30 companies with a minimum market cap of $50 million. Source: www.magicformulainvesting.com
Top 30 companies with a minimum market cap of $50 million. Source: www.magicformulainvesting.com

To bring it to life, I’ve created a list of eight stocks that you can track live in your Finimize app. Rather than pick the ones I’m most bullish on (something that would go against the magic formula), I’ve tried to diversify across different dimensions: smaller and larger stocks, stocks with positive and negative momentum in the past year, and stocks from a wide range of industries (consumer cyclical, tech, energy, healthcare, basic materials, and industrials). They may be good candidates for your first purchase if you want to give the “magic formula” a try.

Eight stocks of different size, sectors, and momentum. Source: Finimize
Eight stocks of different size, sectors, and momentum. Source: Finimize

Remember, there’s no single investment approach that works. But this is better than most. As Greenblatt himself wrote: “Having a disciplined, methodical, long-term investment strategy that makes sense is essential to making it through and being successful in almost any market environment. But it can’t just make sense – it must make sense to you. Having a deep understanding is the only way to stick with a long-term strategy that might not work over shorter time periods.”

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