What it means
Greenblatt's approach combines two classic ideas. The first is value, buying shares that look inexpensive relative to what the business earns.
The second is quality, preferring businesses that earn a high return on the money invested in them. Cheapness is measured by earnings yield, which is operating profit divided by enterprise value.
Enterprise value is the market value of the shares plus debt, minus cash, and it represents the price of buying the whole business. Quality is measured by return on capital, which is operating profit divided by the money tied up in working capital and fixed assets.
Each company in a chosen universe is ranked separately on both measures, and the two ranks are added together. The companies with the lowest combined rank are the best.
An investor then buys a basket of around 20 to 30 of the top-ranked shares and holds them for about a year before repeating the process. Greenblatt has said that financial companies and utilities are usually excluded because their accounts do not suit the measures, and that very small companies can be hard to trade.
Results from back-testing look strong, but real returns depend on the period, the market and the investor's discipline. The method can underperform for several years, which tests patience.
It is best treated as a screening tool and a lesson in investing logic, not as a guarantee. Always check the underlying data for one-off items, and remember that past performance does not promise future results.
In practice
Real-world examples.
Example
A private investor uses a free screening website to rank 1,000 shares on earnings yield and return on capital. She buys the 25 best combined ranks equally and sets a reminder to review the list in twelve months.
Example
A finance student tests the method on historical data as a class project. He finds it did well over long periods but lagged badly in some individual years, and he writes about why discipline matters.
Example
A small asset manager launches a fund that follows a rules-based version of the method. It explains in its brochure that the portfolio will be rebalanced once a year and that short-term performance may differ from the market.
Formula
Calculation
Earnings yield = EBIT / Enterprise value, and Return on capital = EBIT / (Net working capital + Net fixed assets)
Consider three companies. Company A has EBIT (earnings before interest and tax) of $20,000,000, enterprise value of $200,000,000 and capital employed of $100,000,000, giving an earnings yield of 10% and a return on capital of 20%. Company B has EBIT of $15,000,000, enterprise value of $100,000,000 and capital of $150,000,000, giving 15% and 10%. Company C has EBIT of $12,000,000, enterprise value of $150,000,000 and capital of $80,000,000, giving 8% and 15%. Ranking from best to worst, earnings yield is B first, A second, C third, and return on capital is A first, C second, B third. The combined ranks are A = 1 + 2 = 3, B = 3 + 1 = 4 and C = 2 + 3 = 5, so Company A scores best.Case study
Seen in the real world.
Fernhill Investors is an illustrative, fictional club of retired professionals who decided to try the Magic Formula for five years. They ranked a universe of 800 shares each spring, bought the top 30 and sold them a year later. Every member agreed to follow the rules even when it felt uncomfortable.
In the first two years the portfolio trailed the market by several percentage points, and two members wanted to quit. The treasurer reminded them that the method relies on long-term discipline and that value shares often go through periods of neglect. In the third and fourth years, the portfolio beat the market, and the club finished the five years slightly ahead.
The fictional club also noted that transaction costs and taxes cut into returns, which is why they decided to hold the shares for at least a year. The illustrative lesson was that a simple method is only as good as the investor's ability to stick with it.
Watch out
Common mistakes.
- Abandoning the method after a poor year, when it relies on years of consistent application to work.
- Including banks and utilities in the screen, even though the measures do not suit their accounts.
- Relying on unadjusted data, when one-off gains and losses can distort the profit figures used in the rankings.
Questions
People also ask.
Who created the Magic Formula?
Joel Greenblatt, a US hedge fund manager and investment author, set it out in his 2005 book The Little Book That Beats the Market.
What two measures does it use?
It uses earnings yield, a measure of how cheap a company is, and return on capital, a measure of how profitable the business is.
Does it guarantee returns?
No, it is a systematic approach that has done well in back-tests, but it can underperform for long periods and carries the usual risks of share investing.
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