Everything on Joel Greenblatt's Magic Formula

Do you ever wish there was a magical solution to make investment easier? Your wish is granted. You can solve all your investor woes with a magic formula.

We will be discussing the magic formula for investment that makes you a winner every time. It is widely used by investors and hedge fund managers.

Joel Greenblatt is the man who popularized magic formula investing. This combination of strategies used by successful investors such as Warren Buffett and Benjamin Graham creates the perfect balance to help you win the game.

Understanding the Person Behind the Idea

His colleagues call him a genius. Joel Greenblatt, a successful hedge fund manager, is also a professor at Columbia University. Greenblatt's company Gotham Funds, which he runs with Robert Goldstein, has a ten-year average return of 50%. In his second book, "The Little Book that Beats The Market", he described magic formula investing. He combined Warren Buffet's value investing with Benjamin Graham's deep-value strategy to create his winning formula. It has generated him returns of 24 percent between 1988 and 2009. Greenblatt's formula is intended to beat the market.

What is the Magic Formula for Investing?

Magic formula investing is a disciplined rule-based investing strategy that helps investors understand value investing theory. He simplified stock selection by listing stocks according to their return on capital and price. He used two ratios to simplify the process of ranking stocks: the Return on Capital (ROC), and the Earing Yield (EBIT).

Magic formula investing requires a deep understanding of the variables used to describe it.

Return on Capital

It's a measure of earnings before interest and tax (EBIT) of a company as a percentage of tangible capital employed (net work + net fixed). It can be calculated by following a simple formula.

ROC= EBIT/ (net fixed asset + net work capital)

ROC is a common ratio that can be used to compare companies' financial strength with their peers. This ratio is free from distortions due to interest and tax payments and therefore gives a neutral result. The company's ability turn investment into profit is represented by ROC values.

Greenblatt stated that ROC was used to help investors compare stocks.

Earning Yields

The earnings yield of a company measures the earnings per share compared to the stock price or EBIT/enterprise valuation. This, in turn, shows the investor's earnings per shares. If a company's earnings yield equals 8 percent, the investor will get Rs 8 per 100 shares.

To make informed decisions, investors can use the earnings yield ratio to evaluate stocks and other investment options. This ratio shows whether shares of company are undervalued, or overvalued if they compare earnings yields from peer companies.

Combining these two ratios allows investors to list company stocks based upon their performance and then select the best.

Using Magic Formula Of Investing

An investor does not need to do a thorough analysis. Instead, he or she can simply list stocks that he wants to invest by using the magic formula. This is value investing simplified. Greenblatt's formula allows investors to buy shares of good companies at a low price. It is straightforward and non-emotional. To receive a tax advantage, investors sell shares that are losing and use the gain to offset the loss. They would, however, retain winning stocks to offset long-term capital gains tax. They can use the Joel Greenblatt magic formula to screen companies for winning shares and lose-making shares.

Investors often create separate lists of stocks that are based on earnings yield or return on capital. Then, they add companies to a third list based on the relative values from the two first lists.

These are the steps you need to take to implement the magic formula for investment strategy

  • First, decide how much to invest. Then spread it among your stocks in your portfolio. Greenblatt recommends creating a portfolio that includes 20-30 stocks
  • Choose large-cap companies to add to your portfolio
  • Calculate the earnings yield of each company
  • Assess return on capital (ROC).
  • Rank companies based on highest earnings yield and ROC
  • To build a portfolio, buy 2 to 3 positions on the top 20-30 corporations each year. To make the strategy work, you must follow it systematically for a certain period.
  • Monitoring portfolio performance is important. After 51 weeks of buying, you should sell any shares that are losing money.
  • For a market-beating return, repeat the process for five to ten more years

Many fund managers said that they had followed Greenblatt's formula to earn a substantial return when he proposed it in the 1980s. Greenblatt claimed that the formula was capable of generating a 30% return.

General Exclusion

However, magic formula investing doesn't work for all markets. It does not include the following

  • This formula is not intended to be used in every case. It's not a magic formula but it is useful in evaluating large-cap companies.
  • Companies in the financial and banking sectors are not included under the magic formula investing rule.
  • Greenblatt exempted foreign companies from his magic investing formula

The Final Thoughts

Greenblatt described magic formula investing as "a long term investment strategy that helps investors buy a group above-average companies, but only when they're available at below-average price."

Is magic formula investing possible? Magic formula investing has been proven to be a successful strategy that can increase your chances of outperforming other investors over a long period of time. Although magic formula investing may have lost its appeal, it is still a reliable investment strategy that works in controlled environments.


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