Greenblatt’s Magic Formula for Beating the Market

This week, we present the strategy used by Joel Greenblatt, managing principal and co-chief investment officer of Gotham Asset Management. There are many approaches to the selection and analysis of common stocks floating around the investing community, from simple value techniques to complex strategies combining a wide array of technical and fundamental factors. Many investors are initially drawn to intricate techniques, only to discover that basic but sound approaches often perform better 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: Seek out companies with high return on invested capital (ROIC) and those that can be purchased at a low price that provides a high pretax earnings yield. These two concepts — buying a good business at a bargain price — make up the “magic formula.”

As of October 31, 2023, AAII’s Magic Formula screening model has a year-to-date gain of 12.1%, versus –3.7% for the S&P SmallCap 600 index and 1.6% for the S&P MidCap 400 index over the same period.

Finding Good Companies

Greenblatt believes that a company with the ability to invest in its business and receive a strong return on that investment is usually a “good” company. He uses the example of a company that can spend $400,000 on a new store and earn $200,000 in the next year. The return on investment will be 50%. He compares this to another company that also spends $400,000 on a new store but makes only $10,000 in the next year. Its return on the investment is only 2.5%. He would expect you to pick the company with the higher expected return on investment.

Companies that can earn a high return on capital over time generally have a special advantage that keeps competition from destroying them. This could be name recognition, a new product that is hard to duplicate 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 investment capital — net working capital plus net fixed assets.

Return on capital, or return on invested capital, is similar to return on equity (ROE, the ratio of earnings to outstanding shares) and return on assets (the ratio of earnings to a 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 assets. Debt levels and tax rates vary from company to company, which can cause distorted earnings and muddy cash flows. Greenblatt believes tangible capital better captures the actual operating capital used.

The higher the return on capital, the better the investment, according to Greenblatt.

For our Greenblatt Magic Formula screen, we require a return on invested capital greater than 25%.

Identifying Cheap Stocks

To those familiar with the value investing style of Benjamin Graham, the point is fairly obvious: Buy stocks at a lower price than their actual value. This assumes you are able to somewhat accurately estimate a company’s actual value based on future earnings potential.

Greenblatt says that stock prices of a firm can experience “wild” swings, even as the value of the company does not change or changes very little. He views these price fluctuations as opportunities to buy low and sell high.

He follows Graham’s “margin of safety” philosophy to allow some room for estimation errors. Graham said that if you think a company is worth $70 and it is selling for $40, buy it. If you are wrong and the fair value is closer to $60 or even $50, you will still be purchasing the stock at a discount.

Using EBIT Relative to Enterprise Value to Find Value

Greenblatt finds stocks selling at bargain prices by seeking out companies with high ratios of EBIT to enterprise value. Enterprise value is equal to the market value of equity (including preferred stock) plus interest-bearing debt minus excess cash.

A company’s enterprise value represents its economic value, which is the minimum value that would be paid to purchase the company outright. In keeping with value investing strategies, this is similar to book value. Greenblatt uses enterprise value instead of just the market value of equity because it takes into account both the market price of equity and the debt used to generate earnings.

EBIT relative to enterprise value helps to measure the earnings potential of a stock versus its value. If the EBIT-to-enterprise-value ratio is greater than the risk-free rate — typically the 10-year U.S. government bond rate is used as a benchmark — Greenblatt believes you may have a good investment opportunity, and the higher the ratio, the better.

Stocks that passed 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 excludes financials and utilities because of their unique financial structures. The 30 companies with the highest level of EBIT relative to enterprise value make the AAII screen results.

Implementing 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, based on your liquidity needs and risk aversion, you can set the minimum as high as $5 billion.

He then ranked the stocks from one to 3,500 based on return on capital. The highest return on capital got a ranking of one; the lowest received a rating of 3,500.

Next, he ranked the stocks based on their ratio of EBIT to enterprise value, with the highest ratio assigned a rank of one and the lowest assigned a rank of 3,500. Finally, he combined the rankings. If a company ranks 20 for return on capital and 10 for EBIT to enterprise value, the combined ranking is 30.

For practical purposes, Greenblatt recommends investing in 20 to 30 stocks by purchasing five to seven every few months. The holding period he advises for each stock is one year. He believes this strategy will allow you to make changes on only a few stocks at a time as opposed to liquidating and repurchasing the entire portfolio at once.

Performance

Greenblatt tested his investing strategy over a 17-year period and earned an average annual return of 30.8%. He held 30 stocks at a time and held each stock for one year.

Greenblatt explains that the strategy is not a “magic bullet” that always works. During his test period, he found that, on average, five of every 12 months underperformed the market. Looking at full-year periods, the approach failed to beat the market once every four years.

Sticking to a strategy that is not working in the short run, even if it has a good long-term record, can be difficult, but Greenblatt believes you will be better off doing just that. Following the latest fad or short-term investing ideas will not yield market-beating results, in his opinion.

Choosing Magic Formula Stocks

Greenblatt runs a free website with a Magic Formula screening tool. After you register with the site, you can use the simple screener. The only choices you can make are minimum market cap (any number between $50 million and $5 billion) and the number of companies you wish to see (30 or 50).

The website does the rest for you. It orders the stocks based on the combined rank of the EBIT-to-enterprise-value ratio and return on capital and presents the top stocks. The prior day’s closing prices are used.

Interpreting the Screen Using a Stock Screening Program

Using a stock screening program to implement the Magic Formula requires some interpretation. The First Cut column in the May 2009 issue of the AAII Journal featured the Magic Formula investing strategy. Greenblatt’s criteria were interpreted and updated to work within the parameters of AAII’s fundamental stock screening program, Stock Investor Pro. Click here for a list of the screen criteria for use in AAII’s Stock Investor Pro.

Conclusion

The main point Greenblatt makes is that investors should buy good companies at bargain prices — businesses with high returns on investment that are trading for less than they are worth.

When it is time to select some stock ideas to follow, you can run the screen to get a fresh list. Because this simple approach does not rely on additional research, it is important to hold a significant number of stocks to diversify your risk and allow the general principles of the approach to take hold. 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 Passing the Greenblatt Magic Formula Screen (Ranked by EBIT Relative to Enterprise Value)

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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.

If you want an edge throughout this market volatility, become an AAII member.

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American Association of Individual Investors

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