This World-Class Hedge Fund Manager’s “Magic Formula” Is Spellbindingly Simple

This World-Class Hedge Fund Manager’s “Magic Formula” Is Spellbindingly Simple
Stéphane Renevier, CFA

over 2 years ago4 mins

  • The first step of Joel Greenblatt’s magic formula is to find a good company based on its return on invested capital

  • The second step is to find which of those companies are at a bargain price, based on their earnings yield

  • The third step is to screen out unusable stocks, rank those that are left, and hold the best of them for a year at a time

The first step of Joel Greenblatt’s magic formula is to find a good company based on its return on invested capital

The second step is to find which of those companies are at a bargain price, based on their earnings yield

The third step is to screen out unusable stocks, rank those that are left, and hold the best of them for a year at a time

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Value stocks have been underperforming the market for the last few years, but they’re finally well-placed to deliver big returns. That’s where Joel Greenblatt’s “magic formula” comes in: the world-famous hedge fund manager’s easy-to-replicate strategy could make you serious returns in the long run. And all you have to do to cast its spell is to follow these simple steps...

Step one: Find a good business

Greenblatt uses a single measure to define a “good business”: return on invested capital (ROIC).

In his view, companies that achieve a high ROIC – that is to say, those that use their investors’ money to effectively add value to their businesses – are likely to have a special advantage: the ability to maintain a competitive advantage over competitors. That should, Greenblatt says, allow the business to sustain above average margins and preserve market share, leading to positive and stable earnings growth.

To assess ROIC, Greenbatt uses earnings before interest and taxes (EBIT) as a measure of profits and the tangible capital employed (net working capital plus net fixed assets) as measure of capital. In practice, then, Greenblatt’s finds “a good business” with this calculation: EBIT ÷ (Net Fixed Assets + Working Capital). The higher the ratio, the better the quality of the business.

Step two: Find a good business at a bargain price

Buying a good business isn’t enough. To generate above-average returns, you have to buy it at a bargain price.

Greenblatt’s favorite valuation metric is enterprise value (EV) over earnings before interest and taxes (EBIT). He prefers this ratio to some more traditional ones – like price-to-earnings – because it’s less influenced by changes in debt levels (EV includes both equity and debt) and tax rates. But in his calculations, Greenblatt inverts the ratio to make sure a higher number means a more attractive valuation level. This EBIT/EV ratio is called the “earnings yield”, and it indicates how much a business earns relative to the purchase price of the business.

The calculation for a bargain price is therefore: EBIT ÷ enterprise value.

Step three: Filter your findings and buy the best

So you have your good companies at bargain prices. Now it’s about knowing which ones to invest in, and how.

First, you’ll want to screen out the stocks you can’t use – any with market capitalizations of below $50 million, since they’re too expensive to trade. Lose any financials and utilities stocks too (their business models are too different to make them comparable), along with any foreign companies (ADRs).

Then you’ll want to rank your “good, bargain” companies based on how good and cheap they are. You can use the same metrics as above – return on capital for quality, and earnings yield for value – to prioritize them. And once you’re done, combine the two rankings.

Now that you have your best in show, invest in five to seven of them using 20-33% of the money you intend to invest in the first year, and then repeat every quarter until you’re fully invested and own around 20 companies. Sell a company once you’ve held it for a year, and rinse and repeat for a minimum of three years – regardless of the investment performance.

Does Greenblatt’s magic formula really work?

It does – as long as you have a long-term investing horizon.

Greenblatt’s magic formula is, in essence, a value strategy, and value strategies should beat the market in the long term. Back when Greenblatt published his book on this magic formula, the strategy boasted returns of around 30% a year – twice what the S&P 500 delivered over the same period. But value strategies can also go through long periods of underperformance, and the magic formula is no exception. It’s performed positively in the last decade, sure, but it’s still underperformed the S&P 500.

Now, though, value strategies – and the magic formula – are arguably well-placed to deliver high returns again over the next decade: growth stocks – like those in the tech sector – are at high valuation levels, and value stocks have historically performed very well after long periods of underperformance.

What’s the opportunity here?

There are three ways you could use Greenblatt’s magic formula:

You could follow the formula to the letter, buying the top stocks from the list mechanically every quarter and selling the ones you’ve held for a year. Greenblatt updates his list regularly, and he always shares the list of stocks recommended by the formula. You can find the screener and the list of stocks here.

You could use Greenblatt’s list of stocks for idea generation, screening for promising opportunities before digging deeper into their business models. If you have the patience and ability to perform in-depth qualitative due diligence, you could either build a more concentrated portfolio of your highest conviction 5-10 ideas, or avoid companies of his you think will perform badly.

You could use the magic formula as a starting point, and develop your very own, completely unrelated stock screener. If you’re interested in learning more about other potential criteria, I’d recommend the book Quantitative Value by Wesley Gray. Testing different parameters and comparing the results to Greenblatt’s magic formula may provide some valuable insights. And who knows? You might be able to make an even more magic formula…

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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