On last year’s Value Investing Congress, Joel Greenblatt gave a presentation on his “Magic Formula” for investment success (slides can be found HERE) 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”, 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%
The process for the “Magic Formula” is as follows:
- Establish a minimum market capitalization (usually greater than $50 million).
- Exclude utility and financial stocks
- Exclude foreign companies (American Depositary Receipts)
- Determine company’s earnings yield = EBIT / enterprise value.
- Determine company’s return on capital = EBIT / (Net fixed assets + working capital)
- Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
- Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over a 12-month period.
- Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
- Continue over long-term (3-5 year) period.
