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

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.

Comments

[Edward Yee:]

I read his book and in chapter 11, he stated that if you are going to use the magic formula in a mechanical manner, you would want to own 20 to 30 stocks at one time, so that you get the average returns.

I know he suggested that if you still wanted to pick individual stocks, that you generate a list of the top 100 from his magic formula and pick 10 to 30 stocks from that list. If you know something about evaluating businesses, then 10 stocks would be ok, otherwise 30 if you did not.

My concern is that by picking individual stocks so you have a portfolio of 10 stocks, that would not accurately reflect the average return from the magic formula as a mechanical system.

For comparision purposes, maybe have the top 30 to 50 stocks make up another portfolio and see how that compares to the individually selected 10 stock portfolio.

Jan 30 04:12 AM

[John Reese:]

Edward, that is a good point and thanks for the thoughts.

The models I’ve developed on Validea are all 10 and 20 stock portfolios. My reasoning – I want to make the models followable for the everyday, average investor. When you start talking 30, 40 or 50 stocks it becomes difficult for many to follow. The other thing is that I offer monthly, quarterly or annually rebalanced portfolios.

Your right that there will be a difference in the performance say between a 10 and 30 stock portfolio (like Greenblatt outlined), but I think the key thing here is that you are buying a basket of stocks that meet certain investment criteria and by doing this, you are putting the odds in your favor that a certain percentage of those stocks are going to be winners. If you find a strategy that gets 50-60% winning positions over time, that same winning percentage will apply to a 10, 20 or 30 stock portfolio.

Jan 30 09:01 AM

[Stone Fox C...:]

good article. Impressive returns considering the market.

Jan 30 06:34 PM

[donzelion:]

I like several of the picks, but not Coach or Nutrisystem.

Coach is seriously inflated - think "No Fear" circa 1999. Guru strategies should be less reliable means of evaluating value (except for momentum strategies) in fashion design brands, since what makes a fashion design fashionable has little to do with controllable management functions.

Nutrisystem strikes me as yet another Weight Watchers - in a climate where consumer cost controls will likely trump dietary goals. Once upon a time, Weight Watchers and Tupperware were going to take over the world...

Feb 01 09:33 AM

[John DiStan...:]

Great piece! It helped me.


You summarized Greenblatt’s approach in just two paragraphs. And the most important point for me was “the strategy works because it doesn’t always work — a notion that is true for any good strategy.”

Feb 01 12:51 PM

[SMM:]

Just be careful about overthinking it. The stocks picked by Greenblatt's system are all based on the now (the current balance sheet structure) and the recent (last year's earnings). If you try to project your opinions of a stock's future, you are sort of missing the point of this method.

It is typically going to pick stocks that are ugly in some, or many, ways (hence the low price), but it certainly seems to work.


On Feb 01 09:33 AM donzelion wrote:

> I like several of the picks, but not Coach or Nutrisystem.
>
> Coach is seriously inflated - think "No Fear" circa 1999. Guru strategies
> should be less reliable means of evaluating value (except for momentum
> strategies) in fashion design brands, since what makes a fashion
> design fashionable has little to do with controllable management
> functions.
>
> Nutrisystem strikes me as yet another Weight Watchers - in a climate
> where consumer cost controls will likely trump dietary goals. Once
> upon a time, Weight Watchers and Tupperware were going to take over
> the world...

Feb 10 01:26 PM

[John Reese:]

That's a great point, SMM. These types of approaches are trying to put the odds in your favor. They are not trying to get every stock pick right. That may seem counter intuitive for stock selection, but that that is the way these systematic models work. If you can get 50-60% winning positions over time you should do well.

Feb 18 06:15 PM

[campbel:]

I've always thought highly of Greenblatt's formula, and like SMM (comment above), am reluctant to start imposing my own biases on the individual stocks and just let the system do its job. However I think (or at least hope) PPD is an exception. PPD is a pyramid scheme and if the SEC were doing its job, it would have shut it down by now. That said, Greenblatts' formula is predicting the SEC won't do its job, which is consistent with SEC history.

Mar 15 02:08 PM

[nport:]

Prof. Greenblatt at the end of the day is finding good quality companies that have durable competitive advantages at attractive prices. What could be better than that except Warren Buffett managing your money for free.

Jun 04 05:33 PM