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I’ve been exploring the Magic Formula detailed in Joel Greenblatt’s latest book, The Little Book That Beats the Market. I must admit that I am leery of any formula that mechanically selects stocks, however, the concept of having a list of great companies selling at good values piques my interest.

What is this Magic Formula?

The Magic Formula seeks to identify “good” businesses selling at “bargain” prices. It uses two factors to rank stocks so that you can identify the best businesses selling at bargain prices.

The first factor identifies a good business as one that produces a high return on capital (ROC). Return on capital is calculated by dividing earnings before interest and taxes (EBIT) by the sum of net working capital and net fixed assets.

ROC = EBIT / (Net Working Capital + Net Fixed assets)

The second factor identifies businesses selling at bargain prices by examining earnings yield, which is basically the in inverse of the price earnings ratio (P/E). More specifically, earnings yield is defined as earnings before interest and taxes divided by enterprise value.

EY = EBIT/EV

Shai Dardashti has done a great job discussing Joel Greenblatt and The Little Book that Beats the Market, and he has compiled all his work in a recent post to prepare for a meeting with Joel Greenblatt. In fact, Shai will be publishing his transcript of that meeting shortly.

Looking under the hood

I’ve decided to take a closer look at how the Magic Formula works in the real world. I just went over to the Magic Formula Investing site and registered for free. With the login information in hand, I decided to run the Magic Formula screen.

The first step required me to select the minimum market capitalization that I would allow. I entered 50 for \$50 million market cap minimum, since I heard that is what Joel Greenblatt used in when he developed the formula. Step two requires you to select the number of top ranked stocks that you wish to choose from. I selected 25, and then I did step three, which was to hit go. Here’s the list of stocks that it returned today:

The first thing I noticed was that this list wasn’t ranked by the two factors, but was just an alphabetical list of the top ranked stocks with market caps great than \$25 million. There are quite a few familiar names on that list, but there are several new companies on that list that I know nothing about.

I have decided that I’m going to research each of these companies. But before I do that, I read a comment by Rick on Shai’s blog that got me thinking. The comment by Rick notes:

“Screening by using a “magic formula” is merely the first step. I wouldn’t get caught up in the “formula” per se. It merely screens for businesses that have the highest ROIC and matches them with a valuation tool, earnings yield. This inherently is what all successful value investors of Buffett discipline would ascribe to. Not just a cheap price for a cigar butt investment! The real magic in my opinion comes from the determination of two things: (1) How sustainable is the competitive advantage, i.e. How long can we sustain these superior ROIC? and (2) When we utilize earnings yield, are we using normalized earnings or are we dealing with overstated or super-normal earnings? In this way, the discipline becomes far less formulaic and becomes more analytic and more of an art.”

I totally agree with Rick. I think the Magic Formula provides a great starting point to identify investment candidates. However, I think determining the sustainability of these companies’ competitive advantages is critical. Right off hand I note a few fashion stocks on the list above that may have a very fleeting competitive advantage that could disappear very quickly if consumer tastes change suddenly. In addition, accounting shenanigans could mask whether or not these companies are really selling at bargain prices.

Kicking the tires

I’m going to kick the tires of these companies over the next few weeks. I’ll figure out what they do and how they do it. After a few kicks, I’ll figure out if the above stocks truly have a durable competitive advantage or whether they are going to potentially run out of gas, break down or require lots of maintenance.