(9/30/2013 update: The American Association of Individual Investors tested the performance of the magic formula described in this book. The test results are published in the AAII.com stock screens web site. 4/5/2016 update: A ‘revisit’ is added to General Comments)
about the author
Joel Greenblatt is a celebrity among formula investors for devising the “magic formula” to screen stocks. Greenblatt received his bachelors and MBA degrees from the Wharton School at the University of Pennsylvania in 1979 and 1980. He is the founder and managing partner at Gotham Capital, a hedge fund, and is the author of several books on investing. He is an adjunct professor at the Columbia University Graduate School of Business.
For the benefit of the reader, Greenblatt attempts to explain to his young son a method for earning profits by investing in a portfolio of 20-30 stocks. His method depends on using a magic formula to select ‘good’, ‘cheap’ stocks for purchase and annual replacement. Greenblatt’s method is designed for ordinary investors who commit to the plan at least 3-5 years. It solves the perennial problem of deciding when and which stocks to trade. As of this year, 2013, Greenblatt provides free access to an updated list of screened stocks on his website. Shortcomings of the method and book are described at the end of this review.
Revisited in Apri, 2016: Greenblatt’s book reminds us that buying stocks on pure speculation is likely headed for a loss. Instead, good buying decisions need research and measurements. His method is to condense the company’s financial statements to 2 measurements in the belief that earning cash from customers is the key element of a successful business: 1) “Earnings yield” is a measurement of market valuation that shows how highly the earned cash is valued by investors in the stock market; higher is better. 2) “Return on invested capital” is a measurement of management efficiency that shows how much earned cash is derived from the company’s assets; higher is better. Greenblatt claims that a new basket, every year, of high-scoring stocks will collectively beat the stock market after 5 years. About 50-60% of the purchased stocks will outperform the remainder of 20-30 stocks in his baskets. Greenblatt’s method is not designed for dividend reinvestment plans and other long term strategies for buying smaller baskets of stocks. I’m inclined to believe that more than 2 measurements are needed for making small-basket, multiyear investments.
What is a good business?
Jason was an 11 year old business man who sold sticks of gum at school for a huge profit. Suppose Jason opened a chain of gum stores after graduation from high school and achieved success. Now he wants to sell half the business for $6 million. He plans to split the ownership into 1 million equal pieces, called shares, and sell ½ million shares at $12/share (Jason will keep ½ million shares for himself). Is that a good price for the investor? According to Jason’s income statement from last year:
|Gum sales from 10 stores||$10 million|
|Cost of gum||$6 million|
|Other expenses (rent, salaries, etc.)||$2 million|
|Profit before taxes||$2 million|
|Taxes (40% tax rate)||$0.8 million|
|Net profit||$1.2 million ($1.20/share)|
One share costing $12 today earned $1.20 last year. That earning, called an earnings yield, is 10% of share price ($1.20/$12.00 = 10%). The 10% yield is better than a risk-free return of 6%, so the share price seems to be acceptable. Will Jason’s earnings grow? That depends on how well he operates the business. Here’s Jason’s return on capital:
|Cost of property and equipment (capital)||$4 million|
|Profit before taxes (return)||$2 million|
|Yearly return on capital||50%|
Jason’s 50% return on capital is better than if he invested $4 million in U.S. government bonds for a risk-free return of 6%. He has a very good business. Good businesses attract competition that may eventually reduce profits. Until then, a high return on capital for one year shows temporary success and reflects a competitive advantage. Warren Buffet, a stock market master, buys stocks of good businesses at bargain prices that show signs of growth in value over time.
Stock Market Master
The stock market master earns higher returns than otherwise earned from risk-free U.S. government bonds (assume the minimum U.S. government bond rate is 6%). The classic method is to buy stocks of good companies at bargain prices. Benjamin Graham was a stock market master who invested with a “margin of safety” by paying less than the company was worth. Graham, who knew that market prices fluctuate according to moods of pessimism and optimism, sold his holdings when an optimistic market was paying more than the company was worth. The success of Graham’s method depended on the availability of many bargains during the era of the Great Depression. Today, very few stocks fit Graham’s requirements.
Greenblatt claims that a revision of Graham’s method will beat today’s market, and future markets, with low risk to the investor. His revision, called the magic formula, is to buy stocks of profitable companies when they are trading at low prices.
All businesses need working capital and fixed assets for successful operation. So, why not rank businesses on the effective use of those assets? The magic formula ranks stocks according to two criteria: return on capital and earnings yield –Greenblatt defines the earnings yield and return on capital differently from the generally used inverse of the price-to-earnings ratio (E/P) and the return on assets (ROA)–.
Good companies have high returns on capital; the higher, the better. The return on capital should exceed the return from a risk-free investment; otherwise, the company is better off investing in the risk-free U.S. government bond. Stocks with high earnings yields offer bargain prices, and higher yields are better bargains. The earnings yield should also exceed the return from the risk-free U.S. government bond.
A stock market index measures the average price of the average stock, but the magic formula selects the above average stock at a below average price. Therefore, it’s a good bet that a basket of magic formula stocks will beat the market. To test this bet, Greenblatt created a portfolio of 30 top-ranking stocks among 3,500 U.S. stocks screened by the magic formula. He used a 3-step screening process: First, all stocks were ranked from 1 (highest return on capital) to 3,500 (lowest return on capital). Second, the same stocks were ranked from highest to lowest earnings yield. Third, the combination of scores were ranked from best to worst (e.g., a ranking of 385 (232 + 153) was better than a ranking of 1,151 (1,150 + 1)). The test portfolio was replaced with a new set of top-ranked stocks every year during the 17 year period of 1988-2004. The market value of the test portfolio grew by 30.8% per year compared to the 12.4% annualized growth of the S&P 500 index. Greenblatt created other test portfolios derived from 2,500 U.S. stocks with market caps above $200 million and 1,000 U.S. stocks with market caps above $1 billion. Both test portfolios grew by 23.7% or 22.9% per year depending on the stock universe.
Did the magic formula make a few lucky picks? Greenblatt opined that a few lucky picks could not bias the outcome.
Will bargain stocks eventually disappear? Greenblatt divided the universe of 2,500 U.S. stocks into 10 subgroups of 250 stocks according to the magic formula’s rankings (i.e., the first subgroup had the highest rankings and the last subgroup had the lowest rankings). The first 6 subgroups of highest ranking stocks (a total of 1,500 new stocks each year) outperformed the S&P 500 during the 17 year test period, indicating a plentiful supply of bargain stocks.
Did subgroup returns correlate with subgroup rankings? It seems so since the returns from subgroup 1 beat the returns from subgroup 2, and so on; however, Greenblatt did not report the correlation.
What if everyone uses the magic formula? Greenblatt opined that they won’t. New participants eventually quit at the first sign of short-term bad news (most investors want to own the most popular stocks, but the magic formula finds less popular stocks!).
What is the risk of losing money over the long term? The good news is that the plan doesn’t lose money and always beats the market during rolling 3-year periods (rolling refers to the calculation of a previous time period every month).
The magic formula offers high returns at low risk based on the simple logic of screening stocks based on the earnings yield and return on capital. The earnings yield helps to sort the universe of stocks for companies that earned a lot last year compared to today’s stock market price. The return on capital is used to identify companies that earned a lot last year compared to the cost of operating the business. The advantage of using the magic formula is to screen for a number of undervalued stocks on a regular basis.
The disadvantage of the magic formula portfolio is the demand for frequent, long-term attention. There are repetitive screenings, many trades, and numerous tax records. The portfolios described by Greenblatt have a 100% turnover that incur 2 trading fees per stock per year. Since the book does not discuss the potential impact of trading fees on investment return, I estimated the effect of trading fees (see chart) on one of Greenblatt’s test portfolios. Don’t expect high returns unless you invest at least $15,000 in the portfolio.
Click on the following links for additional book reviews: 1. A listing of returns from this and other formula investing plans. 2. Why You Should Take Joel Greenblatt’s ‘Magic Formula’ Stocks Seriously. 3. video, What’s Joel Greenblatt’s Magical Investing Formula?