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Joel Greenblatt has proposed a stock screen for which he has reported enviable results. He reported an annual 30.8% return for his “Magic Formula” in his book, “The Little Book that Beats the Market.” His results are interesting because his picks are not subjective: they are based on a simple ranking of earnings yield (EBIT/EV) and return on capital. Since publishing his book, his strategy has performed well, though many analysts who have followed the “Magic Formula” have not seen 30.8% annual returns, but have seen outperformance from this strategy.

Though I am not yet a proponent of this investment strategy, I am interested in how it works and how a “Magic Formula” allocation could fit into an investor’s portfolio. Historically, this strategy results in a beta of roughly 1 (1.05) and a blend of value and growth. Since there is no value tilt, a portfolio based on the “Magic Formula” could have the potential to be an investor’s core holding.

In order to kick the tires, I queried Greenblatt’s website for stocks that fit this screen. Of the 50 stocks returned on August 22, 2011, here are the 12 largest cap stocks:

Company

Ticker

Market Cap ($ Millions)

P/E (ttm)

EBIT/EV

Microsoft Corp

MSFT

200,856

9.19

0.169

Dell Inc

DELL

26,624

7.49

0.251

Northrop Grumman Corp

NOC

13,907

7.66

0.216

Forest Laboratories Inc

FRX

9,002

8.11

0.223

SanDisk Corp

SNDK

7,744

6.48

0.227

Apollo Group Inc

APOL

6,188

15.44

0.257

KLA-Tencor Corp

KLAC

5,652

7.62

0.267

Block (H&R) Inc.

HRB

4,092

11.01

0.184

Dolby Laboratories Inc

DLB

3,554

12.46

0.156

Teradyne Inc.

TER

2,029

6.66

0.316

ITT Educational Services Inc

ESI

1,883

6.01

0.339

Oshkosh Corp

OSK

1,476

4.21

0.304

I was able to validate seven picks using the Yahoo! stock screener to verify them. The Magic Formula Investing website might be using different (better) data, and it does use a slightly different screen from the one I was using (P/E and EBIT/EV*). I’ve highlighted the picks I confirmed independently.

This list is remarkable because it identifies many household names as stock picks based on fundamental analysis. Recently, many value analysts have commented on the cheap valuations of quality, large-cap companies.

It should be noted that this screen does not allow for extreme-value stock picks. Most academic studies use the P/B ratio for value investing. This is prudent since earnings are volatile, not to mention managed and manipulating by the omission of other comprehensive income from net income. Longer averages of earnings, like Robert Shiller’s trailing 10-year earnings, attempt to smooth out earnings volatility. These metrics allow for investment in companies with temporarily negative earnings.

*EBIT/EV was calculated from the Yahoo! stock screener by

EBIT/EV = (EBIT/Sales)/(EV/Sales) = Operating Margin / (EV/Revenues)

Source: Top Stocks From Greenblatt's Magic Formula