There’s Magic in Joel Greenblatt’s 'Magic Formula'

|
 |  Includes: AYI, BJS, CALM, CEB, COH, MPS, PPD, RAI, XOM
by: John P. Reese

I’ve added a new investment model to my arsenal. It’s based on the “Magic Formula” strategy that Joel Greenblatt outlined in The Little Book that Beats The Market. Some of what you’ll find below is a recap of a post I did last week, but in this post I’ve also included the ten stocks that are currently in my Greenblatt-based portfolio.

The beauty, and attractiveness, of Greenblatt’s “Magic Formula” lays in its perceived simplicity. The purely quantitative approach has just two variables: return on capital and earnings yield. Greenblatt’s back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8 percent return from 1988 through 2004, more than doubling the S&P 500’s 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.

The table below shows Validea’s 10-stock monthly rebalanced Greenblatt portfolio since we began tracking it in December of 2005. The strategy slightly underperformed in ‘05 (though keep in mind that because of its December inception, the ‘05 numbers only include the final month of that year), but since 2006 it has beaten the market each year.

As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices — something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did. The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task — buying those good companies’ stocks on the cheap. (The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.)

While the Greenblatt stock-picking approach is purely quantitative, Greenblatt stresses the mental aspect of using the “Magic Formula”. To Greenblatt, the hardest part about using the formula is having the mental toughness to stick with the strategy, even during bad periods. If the formula worked all the time, everyone would use it, which would eventually cause the stocks it picks to become overpriced and the formula to fail. But because the strategy fails once in a while, many investors bail, allowing those who stick with it to get good stocks at bargain prices. In essence, the strategy works because it doesn’t always work — a notion that is true for any good strategy.

Below you will find the Greenblatt-based model’s Current Portfolio, which represents the highest scoring stocks as of the Jan. 28 close.

Disclosure: At the time of publication, John Reese and his private clients of Validea Capital Management were long XOM, MPS, BJS, NTRI, COH, and PPD.