ValueExpectations.com emphasizes evaluating a company’s ability to earn a spread above their cost of capital using a very robust measure of corporate performance, Economic Margin. After evaluating a firm’s ability to create wealth VE.com then determines what price we are paying for the company using a modified discounted cash flow model. If we had to simplify performance, a very elementary way to evaluate performance can be Return on Invested Capital ROIC and valuation which can be simplified by using earnings yield. This is the approach Joel Grenblatt uses in his book, "The Little Blue Book that Beats the Market".
In January VE.com highlighted a list of stocks based on Joel Greenblatt’s Magic Formula Investing Strategy from 1998-2004 Greenblatt’s simulated returns were 30.8% a year, relative to a 12.4% annual return for the S&P 500 and was only down in one year in that time-span.
In our article posted on January 9, 2009 we listed our best 30 “Magic Formula” companies which has earned returns comparable to the tests conducted by Mr. Greenblatt. From Jan. 9, 2009 to Dec. 14, 2009 the 30 companies we recommended from our “Magic Screen” have returned a solid 32.06% spread above the S&P 500. Since our last “Magic Formula” portfolio was successful we have decided to run the screen again for a new list of companies to see just how consistent this strategy is.
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A look at Greenblatt’s formula for successful “Magic Formula Investing”:
1. Establish a minimum market capitalization (usually greater than $50 million).
2. Exclude utility and financial stocks
3. Exclude foreign companies (American Depositary Receipts)
4. Determine company's earnings yield = EBIT / enterprise value.
5. Determine company's return on capital = EBIT / (Net fixed assets + working capital)
6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
7. Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over a 12-month period.
8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
9. Continue over long-term (3-5 year) period.
Mr. Greenblatt was a student of both Ben Graham and Warren Buffett and tried to include valuable insights from each investor in his “Magic Formula.” His Magic Formula was a screen that percentile ranked two variables: Return on Invested Capital (quality) and Earnings Yield (valuation). The idea is simple, buy the best companies at the best price and then hold on to them for one year. The Little Blue Book recommends selecting the top 30 firms from the “Magic Formula.” That formula ranks each company by variable and then puts a 50% weight on each.