Venturing for Value

Joel Greenblatt, of “Magic Formula” fame, gave a rare interview yesterday on CNBC. The interview had Greenblatt talking about the components of his magic formula as well as recapping its phenomenal performance to date. What Greenblatt stressed multiple times in the interview is that the formula selects many stocks that are currently out of favour with the market, and as such it is important to implement the formula in the context of a “basket”. That is, as Greenblatt is not looking into each company on his screen individually, he recommends buying a basket of 25-30 stocks and expects that on average the basket will outperform. The historical outperformance of Greenblatt’s formula can not be disputed, but I truly believe that the diligent value investor can do even better. This is what I try to accomplish through the individual company analysis I conduct on this site.

The two components of Greenblatt’s formula are ‘return on capital’ and ‘earnings yield’, that is the formula screens for stocks that are performing top of class in terms of return on capital but which are trading at a cheap valuation (high earnings yield means low price to earnings). I think this makes perfect sense, as a first step. Conducting such a screen allows the value investor to narrow the thousands of stocks available down to a pre-qualified list of candidates. What I say is, why buy the basket? A diligent investor can look into each potential investment from both quantitative and qualitative points of view in order to arrive at a fair estimate of intrinsic value. The investor will then only buy the shares of companies which are trading at a significant discount to this estimated value. Sure it’s a lot more work than the “set it and forget it” mentality of the formula, but the results should be worth it.

Greenblatt provides access to a simple “magic formula” screener on his website, MagicFormulaInvesting.com. The screener should prove to be a valuable resource as a first step in finding that next great value investment.

Video: Venturing for Value – CNBC.com

Jonathan Goldberg, MBA

http://www.jonathangoldberg.com

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