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Hendrik Oude Nijhuis
Hendrik Oude Nijhuis
Articles 

Joel Greenblatt: How to Outperform The Magic Formula – Part 1

March 29, 2007

In my first article about Joel Greenblatt I showed the incredible returns of Greenblatt’s magic formula investment system. Then, we focussed on ‘relative goodness’, an essential concept for determining how good companies are in allocating capital. Last month I wrote about ‘relative cheapness’, which gives an idea of the relative valuation of companies.

In this article I want to introduce two ideas that may help you to outperform the returns of portfolios based on automatically generated picks from Greenblatt’s magic formula investment system. In general, I think it is a good idea for inexperienced investors to select top ranked stocks (with high Returns on Capital en high Earning Yields) randomly for their own portfolio (as suggested by Greenblatt). More seasoned and knowledgeable investors may generate additional returns by giving attention to e.g. the following two ideas:

Do not invest in companies that are wrongfully selected

With his focus on Return on (Invested) Capital (ROIC), Greenblatt tries to automatically select companies with durable competitive advantages. The problem is that not all companies with high ROIC ratios have durable competitive advantages and, as a consequence, the ability of these companies to generate high ROIC numbers for years to come should be questioned.

Sometimes a high ROIC is related to external factors or specific ways in which a company is being managed and not to durable competitive advantages. Think of companies that simply profit from high commodity prices or management teams that make use of (legal) bookkeeping and tax tricks or that sell specific company assets. Another explanation for high ROIC numbers can be found in one-time windfalls or an occasionally, and not structural, very profitable year. The expected long-term ROIC figures for such companies lie at the market average.

By not investing in these ‘wrongfully selected companies’ you may outperform the average return of the top-ranked stocks selected by the automatic system.

Give special attention to companies with durable competitive advantages

Groups of stocks with high ROIC ratios are, on average, better than average. This is because companies with durable competitive advantages are included in selections of stocks with high ROIC numbers.

We already saw that companies with durable competitive advantages are also the companies Joel Greenblatt is looking for, as he screens for companies that have shown a high ROIC ratio. It is very important to note that a high Return on Capital ratio at a specific moment can be an indication of a (durable) competitive advantage, but is absolutely no guarantee for it!

Only when a company has (one or more) durable competitive advantages it is possible to create value on a longer term basis. In other words, only then can a company consistently generate higher Returns on Capital than its Costs of Capital.

As we are looking for companies with such durable competitive advantages, we have to look at the quality of their business models. By doing this, you can get an indication of the existence and strength of their competitive advantages and therefore also of their capacity to generate above average ROIC ratios in the long-term.

In my next article, I will bring up two additional ideas that also may help you to outperform randomly selected Magic Formula portfolios over time!

 

About the author:

Hendrik Oude Nijhuis
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 2.9/5 (19 votes)

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