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Working Wonders with the Magic Formula

June 11, 2014 | About:

In The Little Book that Still Beats the Market, Joel Greenblatt (Trades, Portfolio) teaches us about his Magic Formula for investing in stocks. This book is a great read and I highly recommend you pick up a copy. I will start off by defining the formula strategy, explaining why I think it works more often than not, and then discuss how you can work wonders with the Magic Formula.

What is the Magic Formula?

Magic Formula investing is a term referring to an investment technique outlined uses the principles of value investing by ranking companies based on two factors 1) Return on Capital (ROC) and 2) Earnings Yield. The following is Wikipedia.com’s summary of Greenblatt’s Methodology and Formula:

Methodology

Greenblatt suggests purchasing 30 "good companies": cheap stocks with a high earnings yield and a high return on capital. He touts the success of his magic formula in his book The Little Book that Beats the Market ', Joel Greenblatt (Trades, Portfolio) ISBN 0-471-73306-7 citing that it does in fact beat the S&P 500 96% of the time, and has averaged a 17-year annual return of 30.8%.

Formula

  1. Establish a minimum market capitalization (usually greater than $50 million).
  2. Exclude utility and financial stocks
  3. Exclude foreign companies (American Depositary Receipts)
  4. Determine company's earnings yield = EBIT / enterprise value.
  5. Determine company's return on capital = EBIT / (net fixed assets + working capital)
  6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
  7. Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
  8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
  9. Continue over a long-term (3–5+ year) period.

Why does it work?

The Magic Formula works because it looks for quality companies that are relatively undervalued. There are two major factors: 1) good companies that earn a high Return on Capital (ROC) and 2) priced relatively below the current market conditions based on Earnings Yield. By screening for companies that generate high ROC, one finds companies that are generally making economic profit (earning more money than it costs to generate accounting profits).

Two Factors

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

  • EBIT is used because companies operate with different levels of debt and differing tax rates.
    • Compares the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels.
  • Net Working Capital + Net Fixed Assets (or tangible capital employed) was used in place of total assets (used in ROA) or equity (used in a ROE).
    • Figures out how much capital is actually needed to conduct the company’s business.
    • Net Working Capital is used because a company has to fund receivables and inventory.
    • Net Fixed Asset is used because a company has to fund the purchase of fixed assets to conduct business (i.e. real estate, plant and equipment).

Earnings Yield: EBIT / Enterprise Value

  • Figures out how much a company earns relative to the purchase price of the business.
  • Enterprise Value = market value of equity (including preferred equity) + net interest-bearing debt.
    • This is used instead of just the price of equity because it takes into account both the price paid for the equity in the business and the debt financing used by the company.
  • This allows investors to compare companies with different levels of debt and different tax rates on an equal footing.
  • In the book (pages 171-172) there is an example showing why it is a better measure than PE ratios.
    • Consider Company A and Company B, which has the same sales, the same earnings, the same everything EXCEPT Company A has no debt and Company B has $50 in debt (at a 10% interest rate).
 

Company A

Company B

Sales

$100

$100

EBIT

10

10

Interest Expense

0

5

Pretax Income

10

5

Taxes (at 40%)

4

2

Net Income

6

3

     

Price per Share

$60

$10

PE

10.00

3.33

     

Enterprise Value

60 + 0 = $60

10 + 50 = $60

EBIT

10

10

Earnings Yield

16.67%

16.67%

By choosing companies that are generating the highest ROC and have a fair relative price, you end up with a screen of quality businesses that are generally undervalued.

How you can work wonders with the Magic Formula?

If you are in search of quality companies that are fairly undervalued, you should start off by utilizing the Magic Formula screen of 30 potentially promising companies. After this initial step, you should then perform Fundamental Analysis of the businesses’ financial statements. If the company appears sound, you should then value the company by one of the following methods: 1) Dividend Discount Model, 2) Free Cash Flow Model, 3) Residual Income Model, or 4) Relative Valuation Models.

Finally, another application I found for the Magic Formula is for ranking companies on my potential buy list. Sometimes you struggle with the decision of which company to buy from your watch list. If you apply the ranking strategy based on ROC and Earnings Yield, you end up with list in order of both Quality and Relatively Undervalued.

For Backtested Results and More: Checkout www.portfolio123.com’s blog posting entitled “The Greenblatt Strategy: K-I-S-S, Or Not”:

https://www.portfolio123.com/blog.jsp?postid=153&topic=working

About the author:

Nelson Nguyen
Experienced professional with expertise in financial statement analysis, value investing, and financial modeling. Past employment with the government (Internal Revenue Service), banking, insurance, and accounting service sectors. Licensed CPA with individual and corporate tax compliance experience and a 2015 Level III Candidate in the CFA Program.

Visit Nelson Nguyen's Website


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