Greenblatt's Magic Formula: Marriage Of Ben Graham's Value And Warren Buffett's Stock Picking Methods

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by: John P. Reese

Summary

The market's valuation looks extended, but Buffett puts it in perspective with earnings yield vs. 10 year analysis.

Greenblatt combines earnings yield (value) and return on capital (quality) in his "magic formula" investment strategy.

Using Validea's screening application, we found 20 of the top-rated stocks using Greenblatt's quantitative model.

"Frothy." "Pricey." "Stretched." These are among the adjectives used to describe the stock market's valuation these days -- and they're not even the most ominous. When you consider the cardinal rule of investing-buy low, sell high­-such descriptors could discourage the most intrepid investor.

Unless you subscribe to the view of one of the greatest investors of all time, that is. Warren Buffett not only believes that the U.S. stock market is a good bet, he declared in a recent CNBC interview, "If there's a game it's very good to be in for the rest of your life, the idea to stay out of it because you think you know when to enter it-is a terrible mistake." Buffett is steadfastly confident in our country's economy and its ability to overcome adversity. "We have not lost the secret sauce," he says. I outlined Buffett's view in more detail in my last Seeking Alpha article, see here.

There are plenty that would argue differently, however. Nobel Laureate Robert Shiller recently told Bloomberg he believes the market is "way over-priced" and that the current elevated CAPE ratio of 29 is a "bad sign." John Hussman, president of the mutual fund Hussan Investment Trust and a Ph.D. in economics from Stanford University, argues that the market may be due for a hefty correction. In Fortune this month, he was quoted as saying that the current market environment is in "the most broadly overvalued moment in market history" and that investors shouldn't expect much in the way of equity returns.

In his characteristically unshakeable manner, Buffett opines on the elevated market with CNBC's Becky Quick: "We're not in a bubble territory or anything of the sort." In fact, he argues, "measured against interest rates, stocks actually are on the cheap side compared to historic valuations."

Buffett's thoughts on the market's earnings yield got me thinking of strategies I run on Validea that utilize earnings yield as one of the input criteria for selecting individual stocks. The model that stands out of all the strategies I run is the one developed by Joel Greenblatt, the founder of Gotham Capital and author of many great investing books.

Greenblatt published the best-selling book, "The Little Book that Beats the Market" in 2005. In the book, he devised a simple quantitative stock-picking model that combined elements of Ben Graham's value investing approach with Buffett's high quality and blue chip style of stock picking. Greenblatt's "magic formula", which combined ranking stocks based on earnings yield (the value component) and return on invested capital (the quality component), was able to generate back-tested returns of 30.8% between 1988 and 2004 -- versus the 12.4% average annual return for the S&P 500 during that period.

The earnings yield calculation in Greenblatt's model is slightly different than how Buffett views it in that it includes a company's debt in order to arrive at a more conservative measurement:

Return-on-capital, the other half of Greenblatt's formula, which is largely influenced by Buffett's ability to find super high quality companies is calculated by dividing EBIT by the sum of net working capital and fixed assets (he preferred using EBIT rather than reported earnings to account for differences in tax rates and debt burdens). By comparing these metrics to those of the market's largest 3,500 companies, Greenblatt would consider purchasing a stock if it ranked among the lowest 20 to 30 stocks - an approach similar to the one we use on Validea although we run ultra-focused 10 stock portfolios and portfolios with 20 holdings.

Since 2006, our Greenblatt-based stock screening model has returned 116.6%, outperforming the market by 30.9% (using its optimal, quarterly rebalancing period and 10-stock portfolio size). But, it's important to note that like most of the value oriented models I run, a highly active portfolio holding these value stocks can (and will) go through periods when it's underperforming the broader market. Those periods of underperformance, and the fact that most investors can't stick with an investment strategy during those periods of below-average returns, are the exact reasons why a strategy such as Greenblatt's has the potential to produce market outperformance over the long term.

Here is the list of the stocks that currently get 100% based on the magic formula screen I run on Validea's Guru Stock Screener. These stocks are ranked based on their combined earning yield and return-on-capital score. The top 20 names in the screen's investable universe get 100%.