Joel Greenblatt’s Magic Investment Formula
The father of value investing Benjamin Graham devoted much of his effort to trying to simplify the investment process. Conscious of the impossibility of knowing firsthand all the companies from which shares can be bought to invest, he adopted a quantitative approach to be able to quickly filter all the companies and find the ones that were cheaper.
Since then, and following this tradition, some value investors have developed their own screeners and quantitative methods to try to beat the market with their investments.
One of the best known of the last decades is the Magic Formula Investing Method by Joel Greenblatt.
Who is Joel Greenblatt?
Joel Greenblatt is a fund manager and professor at the Columbia University Graduate School of Business in New York. He began his career as a manager in 1985 creating his own hedge fund Gotham Capital. From 1985 to 2006 it obtained an annualized profitability of 40%.
In 2006, he published his book The Little Book That Beats the Market. In it, Greenblatt presents a “magic formula” that according to its criteria should beat the market over most long periods of time.
How does the magic formula work?
The procedure of investing with the magic formula consists of selecting a portfolio between 20 and 30 shares that meet certain requirements and that, according to Greenblatt, should beat the market in the long term.
To do this, all the companies in the market are ordered according to two criteria:
1.The first criterion of classification is what Greenblatt calls earnings yield, and tries to determine if the company has a profitable business, that is, if the business of the company produces profits. For this, it observes the profit margins that the company produces and relates them to the price of the company. Here the reasoning is simple: if I buy a company for $100 and it produces annual profits of $10, the company is more profitable than another that buys for $100 and produces $5 of annual profits.
The parameters used by Greenblatt to measure this “profitability” of the company are: EBITDA / enterprise value. EBITDA is earnings before interest, taxes, depreciation, and amortization. Enterprise value is defined as the market capitalization of the company plus net debt.
2.The second criterion of classification is what Greenblatt calls return on capital. This parameter attempts to distinguish firms that make good use of their assets from those that do not. For example: we set up a business in which we have to invest $200 in material. This business produces us annual profits of $30. This business is clearly more profitable than another in which we have to invest $300 in material to obtain those same $30 profit.
The parameters used by Greenblatt to measure this efficiency in the use of the company’s own resources are: EBIT / (net fixed assets + working capital). That is, profit before taxes and interest divided by the net fixed assets plus the working capital (also called working capital).
Keep in mind that the magic formula is that it is a ranking system, not filter (exclusive). This means that it selects companies relatively. It does not decide which companies are good or bad, but rather, which of them are the best and which are the worst.
Two classifications of the companies are made according to the criteria we have mentioned. Then a classification number is given to each company (the first is 1, the second is 2, etc…) Subsequently, the two classifications are added and the companies are again ranked by ranking. With this final classification, one invests in the 20 or 30 best companies.
The investments are held for one year and then the selection and investment procedure is repeated.
Not all companies and all markets are advisable for the magic formula.
Although the magic formula uses a relative criterion to select investments, Greenblatt also establishes a series of filters to eliminate companies that are not good candidates to be analyzed by these parameters. First, it excludes all low-capitalization companies (below $50 million). It also excludes companies in the utilities and financial sector, as well as foreign companies.
It is important to note that as in any statistical system of investment, it is appropriate to apply the magic formula to a large and diversified market.
Results of the magic formula
In the book, Greenblatt presents all the statistics with the results obtained by the magic formula, which clearly beats the market. It is interesting to note that not only the results are good, but when dividing them into deciles, the positive correlations are maintained (the first 10% of the companies are the most profitable, followed by the second 10%, which in turn is more profitable Than the third 10%, etc.).
However, Greenblatt stresses that no investment strategy ever beats the market 100% of the time. Greenblatt argues that the fact that it does not always work is one of the guarantees that this strategy will continue to work most of the time in the future.