Joel Greenblatt’s Magic Formula of Investing

Had there been a magic formula for stock market investment, the entire scenario would have been different. Is that what you just now thought to yourself? Well, the magic solution might make your investment tank simpler. That’s why this post brings up a significant topic of discussion. 

Let’s understand more about Joel Greenblatt’s magic formula. Before understanding Greenblatt’s formula, an investor should conduct a study on the person. So, who was Joel Greenblatt? Find it from the following subhead.

Magic Formula of investing by Joel Greenblatt – Who is the man, and what’s his magic formula?

Besides being an erudite professor at Columbia University, Greenblatt was a successful American investor. The world knows him for his valuable investment insights and, of course, his potential for managing hedge funds. Currently, he owns an asset management establishment (Gotham Funds) with Robert Goldstein as his co-partner.

There’s another reason why the world praises Greenblatt’s capabilities. After all, he’s the creator of the magic formula for investment. He gifted the investment world with a thoughtfully crafted book referred to as – The Little Book That Beats The Market.

After undergoing numerous academic pieces, Greenblatt implemented investing strategies and compiled them in the form of a book. In this book, you can find in-depth investment tactics. Reading this book helps you get better insight into selecting stocks from where you can get higher returns. 

An overview of Joel Greenblatt’s magic formula 

Evidently, Joel Greenblatt’s magic formula for investing works on two prime principles. Firstly, it is based on the current price of stocks. Secondly, it focuses on the net operational expenses of the parent company. The stock selection formula suggests every trader invest in stocks of firms with ROCE or return on capital employed or improved earnings yield. 

Notably, you may calculate a company’s ROCE by dividing the EBIT or earnings before interest & taxes by tangible capital. That’s the sum of net fixed assets and adjusted net working capital. The formula for ROCE is mentioned in the following:

So, ROCE is equal to EBIT divided by the (Net Working Capital added to the Net Fixed Assets)

Things to consider before using the magic formula investing

Notably, an investor who wishes to use the magic formula must conduct an understanding of variables used. The following points describe each aspect in brief:

Return on Capital

It’s the measure of an establishment’s EBIT. Note that it’s a ratio of tangible capital (i.e., net-working and net fixed). ROC happens to be a common ratio and helps you understand the firm’s financial potential compared to others in the market. It eliminates the falsehood arising from tax or interest payments. So, it offers an impartial result. Notably, the value of ROC reflects the ability of the firm to convert investments into profits.

Earning Yields

The earning yields of the firm are the earnings for each share against the EBIT (or enterprise value) or current price of the stock. So, it reflects the earnings of investors for each share. Suppose the earning yield of the company is 8%. So, it means the investor might get ₹8 for ₹100 shares.

Ideally, investors may apply the earnings-yield ratio to compare shares and investment instruments. That’s how they can make better decisions when it comes to investments. It evaluates when the firm shares overvalued or undervalued when comparing the earning yield of the company with other firms. 

Note that investors can better enlist the stocks depending on their performance by combining these ratios. 

Steps to use a magic formula for investing

Investors can list various stocks to invest in with the help of the magic formula rather than using fundamental analysis. Notably, Greenblatt’s formula assists investors in purchasing rewarding company shares at affordable prices. The investor can make the decision in a more straightforward manner. 

Understandably, investors can sell loss-making shares before a year. They may use the loss to offset the gain and receive the tax benefit. They might retain the winning stocks to balance impacts of long-term gain taxes. The magic formula lets them recognise the winning and shares associated with any loss.

As a matter of fact, investors can create individual lists of stocks depending on the return on capital as well as earnings yields. Then, they can add companies depending on the values derived from the list. The following are the steps for investors to use the magic formula in their investment strategy:

Strategies

• First things first, you need to decide on a particular amount for investment. Then, you can spread it among stocks in the portfolio. As far as Greenblatt’s suggestions are concerned, it is better to create a portfolio of twenty or thirty stocks.
• Then, you need to choose companies for the portfolio from the larger companies.
• The third step is to calculate the earnings yield of each company
• Now, you need to assess the return on capital or ROC
• After this, you need to rank companies based on the highest earnings yield as well as ROC
• You may now purchase two or three every year and create your portfolio
• Notably, you may keep track of the portfolio performance of the shares that may result in loss after 51 weeks of buying 
• You may repeat this same procedure for five or ten years. That’s how you can generate a better return

When Greenblatt offered the formula somewhere in the 80s, various fund management firms could drive a potential return. 

So, you may use the parameters to seamlessly compare various stocks from various companies. You can differentiate one stock from the other depending on the analysis. That way, you can create two lists of stocks depending on earnings yield and ROCE and choose one accordingly.

While proposing Greenblatt’s magic formula, he discovered that it was less effective on the stocks that belonged to the utility or financial sector (or even foreign companies). Thus, you may filter out these stocks accordingly.

Closing Words

While describing magic formula investing, Greenblatt’s statement is very clear –

It’s a long-term investment tactic designed to assist investors in purchasing above-average companies. However, it’s true only when these stocks are discovered at an affordable (or below-average) price. 

So, the magic formula is a successful strategy and improves the potential for outpacing the market over time. 

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