Greenblatt's Magic Formula: Quite Simple, But Far From Easy

by: John P. Reese


Joel Greenblatt's "Magic Formula" is one of the most elegant, simple investing approaches you'll find, using just two variables.

But the trick with the Greenblatt approach is staying disciplined when the strategy underperforms -- that's the hard part.

If you stick with it, the results show you can net some big gains.

"Investing is simple, but it's not easy."

-- Warren Buffett,, 2009

Simple and easy: We often use those two words interchangeably, but they are far from the same. Running a marathon, for example, is simple. Start running several times a week, build up your endurance, and then go to the race and just follow the crowd. Not a lot of steps or complexity in that process.

Of course, if you think that means running a marathon is easy, you're nuts -- you have to have tremendous discipline and great time management, and you have to stay healthy and avoid any of a number of injuries that sideline many runners.

In investing, a great example of the simple-but-not-easy concept is hedge fund guru Joel Greenblatt. Back in 2005, Greenblatt published The Little Book that Beats the Market, a small, concise book that shows how investors can produce market-beating returns using a formula that has two -- and only two -- variables.

In an investing world of seemingly limitless data points, that may sound improbable. But it's not. Greenblatt's "magic formula," as he called it, produced back-tested returns of 30.8% per year from 1988 through 2004, more than doubling the S&P 500's 12.4% return during that time. What's more, a 10-stock portfolio picked using my Greenblatt-inspired Guru Strategy computer model has averaged an annual return of 10.7% in the four years since its inception -- while the S&P 500 has gained 5.3% per year. Last year alone, the portfolio was up 51.4%; this year it's up 10.7% vs. 6.4% for the S&P (through July 11).

How does the Greenblatt approach work? On a broad level, it's based on a very simple, sensible, Buffett-esque notion of Greenblatt's: "Buying good companies at bargain prices makes sense."

To identify "good companies," Greenblatt uses the first variable of his "magic formula": return on capital. Essentially, ROC is a way to see how much money a company is making by using its assets. The higher the ROC, the better job the company is doing in terms of making profits.

Return on capital is similar, but not identical, to the return on assets rate that Buffett and other gurus like Peter Lynch use. Rather than using a company's reported earnings, as is done when calculating ROA, however, Greenblatt (and the model I base on his writings) uses earnings before interest and taxes (EBIT), so that debt payments and taxes don't obscure how well the firm's actual operating business is doing. And instead of dividing that by total assets, as ROA does, he divides it by "tangible capital employed," which is equal to net working capital plus net fixed assets. "The idea here," he writes, "was to figure out how much capital is actually needed to conduct the company's business."

The second part of the Greenblatt approach is finding those good stocks when they are selling at "bargain prices." To do so, Greenblatt (and my model) uses earnings yield. Typically, earnings yield is calculated by dividing a company's trailing 12-month earnings per share by its current price per share -- essentially the inverse of the price/earnings ratio. But Greenblatt also makes some slight adjustments here, so my model does the same. Rather than earnings, EBIT is used, and rather than price, "enterprise value" is used. Enterprise value includes not only the price of the company's shares, but also the amount of debt it uses to generate earnings.

My Greenblatt-inspired model ranks all stocks in earnings yield and return on total capital, and then adds the rankings together to get the stock's final ranking. The ten stocks with the best combined rankings make it into my Greenblatt-based portfolio.

Sounds easy, right? Not really -- remember what Buffett says about "easy" and "simple" being two different things.

The difficulty of the Greenblatt approach comes not in the logistics or specifics, but instead with mindset. That's because while the strategy has been proven to work very well over the long term, it doesn't work all the time. In fact, the magic formula has had periods of two or even three years when it has lagged the market, Greenblatt notes -- not unlike just about any good strategy. When that happens, he says, most investors bail, jumping on the latest "hot" stocks or strategies -- which usually lands them overpriced duds.

Their abandonment of the magic formula approach is, however, what allows you to buy at bargain prices the strong stocks that the strategy targets -- if, that is, you have the intestinal fortitude to stick with the strategy through the short-term pain. You also have to have the stomach to buy the types of beaten down value stocks it targets -- quite often it keys on companies making negative headlines because of short term problems or industry fears. But if the company has strong financials and fundamentals, which magic formula stocks do, the fears created by the headlines are usually overblown, letting you get shares of good companies on the cheap.

If you stay disciplined, you should reap the rewards when Wall Street realizes it's overlooked these strong companies. Knowing all of this -- and in particular knowing that you can't predict when those down periods and bounce-backs will come -- Greenblatt says it's absolutely critical to stick with the strategy through the rough times. In the end, his approach, like Buffett's, is really based on common sense and discipline -- not magic.

Right now, my Greenblatt-based approach is finding a number of attractive bargains. Here are five that currently rank high on its list.

Ebix, Inc. (NASDAQ:EBIX): Atlanta-based Ebix ($480 million market cap) supplies software and e-commerce solutions to the insurance industry. Shares have struggled over the past year as growth has slowed, but my Greenblatt strategy thinks that has made it a great bargain. It has a 106% ROC and 15.7% earnings yield.

Nu Skin Enterprises, Inc. (NYSE:NUS): Multi-level marketers like this Utah-based firm ($4.4 billion market cap), which sells personal care, nutrition, and technology products, have come under much scrutiny recently, and Nu Skin was the subject of a Chinese investigation of its business practices that led to a small fine. The Greenblatt-based model sees all that as opportunity. It likes the firm's 15.4% earnings yield and 67% return on capital.

C.R. Bard (NYSE:BCR): New Jersey-based Bard is a multinational manufacturer of medical technologies, focusing on the fields of vascular, urology, oncology and surgical specialty products. Bard ($11 billion market cap) has a 12.8% earnings yield and a 70% return on capital.

Performant Financial Corporation (NASDAQ:PFMT): Performant provides technology-enabled recovery and related analytics services in the United States. The company's services help identify and recover delinquent or defaulted assets and improper payments for both government and private clients in a broad range of markets. Performant gets strong interest from my Greenblatt model thanks to its 14.1% earnings yield and 88% return on capital.

GameStop Corp. (NYSE:GME): Shares of this video game retailer have struggled because of fears that the rise of online gaming will hurt its stores, but the business is hanging in there. The Greenblatt model likes its 14.8% earnings yield and 86% return on capital.

Disclosure: The author is long NUS, GME, PFMT, EBIX, BCR. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.