By
Ben Hobson

11:20, 6 June 2013


|

13:30, 6 June 2013

Joel Greenblatt has long been hailed as a guru in the investment world for his ability to generate profits from the oddities of the stock market – in special situations, spin offs and bankruptcies.

But his fame spread when he conjured a magic formula that he promised could help cut DIY investors loose from underperforming fund managers and improve their returns.

In the latest article in our stock market guru’s series, Ben Hobson of investing strategy website Stockopedia looks at how Greenblatt made a mint from the stock market using this very simple technique.

The magic touch: Joel Greenblatt worked out a 'magic formula' to find 'cheap¿ and ¿good¿ stocks fsp/Photo Courtesy Walt Disney Pictures REUTERS

The magic touch: Joel Greenblatt worked out a ‘magic formula’ to find ‘cheap¿ and ¿good¿ stocks fsp/Photo Courtesy Walt Disney Pictures REUTERS

How a US hedge fund manager beat the market with a magic formula anyone can use

Ten years ago a New York City hedge fund manager called Joel Greenblatt proved that smart thinking and financial commitment could change the lives of kids that would otherwise have failed at school. He worked with the principal of Raymond York Elementary School, in a poor area of the city’s Queens district, to make changes that would boost reading and maths results.

It was a move that required Greenblatt to invest in topping-up the school’s budget over several years, so that it could make long-term, sustainable improvements. Predictably, the project was a huge success and more schools followed.

Greenblatt’s determination to coax a better performance from a struggling environment echoed a philosophy that has made him a hugely respected investor. He recognised that the school needed to make its money work smarter and harder, and at Gotham Capital, the fund firm he set up in 1985, he delivered on that philosophy in spades.

Greenblatt the value investor

Greenblatt rose to prominence in the world of investing largely as a result of producing 50 per cent annualised returns at Gotham Capital over the 10 years to 1995.

That performance earned him guru status among his peers (as well as a lot of money). It also led to a handful of books explaining how he’d managed to achieve such spectacular results – and one in particular remains required investment reading.

In 2006 Greenblatt penned a charming and mercifully straightforward guide for lay investors called The Little Book That Beats the Market. In it, he insisted that anyone who really wanted to beat the market shouldn’t rely on professionals or academics for help and that the best option was to ‘do it yourself’.

 


Hargreaves Isa Guide

His stock-picking approach is cut from
the same cloth as value investing legend Benjamin Graham.

In The Little
Book, he affectionately re-examines Graham’s core principles of
understanding a company’s intrinsic value when deciding whether it is
cheap or not and then buying with a wide margin of safety.

But like
Graham’s one-time student Warren Buffett, Greenblatt took the value
approach further by adding in a focus on finding good quality shares.

To do this in a systematic way, he introduced a so-called ‘Magic Formula’ that investors could use to rank every company in the market.

It brings together the two components of ‘cheap’ and ‘good’ shares by incorporating a pair of simple metrics. Shares are ranked on each metric and then the two ranks are added together to arrive at an overall Magic Formula score – the lower the score, the better.

How to find ‘cheap’ and ‘good’ stocks

Working out at an accurate valuation – or the intrinsic value – of a company has always been a tricky task for investors.

This is partly because trying to predict the future using a company’s past results can be terribly inaccurate, making it difficult to judge whether the market is valuing it correctly or not. Greenblatt’s solution is to study something called the earnings yield.

Earnings yield tells you how much profit a company is making in relation to its underlying value. To take account of varying levels of cash and debt in companies, a widely used way of working it out is to divide what the company earns in operating profit by its total valuation (known as the enterprise value).

You can then apply this earnings yield to every company in the market to see which of them are offering the best value – the higher the yield, the cheaper the company and the more bang you get for your buck.

 


DIY investing

Greenblatt’s second metric focuses on how good a company is at generating a profit from the investment it makes in itself.

Good quality companies are very efficient at delivering high percentage returns from the cash they reinvest to grow.

It might be opening new stores, expanding product lines or buying new plant and equipment.

The percentage improvement in profits relative to that investment is known as return on capital, which is a leading indicator of a good quality company that can grow profitably.

Meet the Magic Formula

Greenblatt’s simple investment process is to buy shares with both high earnings yield and high return on capital.

He does it by ranking the market on a best to worst basis for each metric, with the very best score being 1 for each.

Those scores are then added together to arrive at the Magic Formula score. If a company that was 14th on an earning yield basis and 96th on a return on capital basis, it would have a Magic Formula score of 110.

WHAT NEXT FROM THE GURUS?

In the next article in this series we look at how US fund manager James O’Shaughnessy came up with a way of beating the market by snapping up undervalued shares in large companies paying big dividends.

In Greenblatt’s back-tests over 17 years to 2006, a portfolio of around 30 companies with the best combination of both metrics would have produced a very impressive return of around 30.8 per cent per year.

Ranking the market for high Magic Formula scoring shares requires some robust screening technology and excellent data.

It also needs investors to ‘buy-in’ to the theory with an investment horizon that can be measured in several years. Part of the reason for this, as Greenblatt freely conceded, is that Magic Formula investing does go through some periods when it doesn’t work.

Indeed at Stockopedia our Greenblatt inspired Magic Formula screen has underperformed the FTSE 100 this year.

But during Greenblatt’s 17-year back-test, there were periods ranging from a few months to a few years when the portfolio underperformed the market.

Despite that, it still delivered long-term annual returns of double and occasionally almost triple the returns of the market averages.

The shares that fit the Magic Formula

Among the highest ranking Magic Formula shares in the market is defence and aerospace company Qinetiq, which recently announced a rise in full year profits despite spending cuts in some of its key territories, including the US.

Elsewhere, support services and construction group Interserve ranks just ahead of its peer WS Atkins. Interserve recently reported that it was on course to hit targets in 2013 and was actively looking to invest in growth markets.

Dragon Oil tops the list of high ranking oil and gas companies ahead of SOCO International and Coastal Energy. Dragon raised production levels and completed two new wells in the first quarter of this year and is set to increase the pace of development in the second half of the year.

Few investors would argue with the underlying principles of finding and buying ‘cheap’ and ‘good’ shares and recognising that taking a long-term view with the Magic Formula gives it a great chance of success.

Could it be that the recent underperformance of the Magic Formula in the UK is just a hiccup along the way to resounding success?

Given that it has become one of the most popular strategies amongst investors, there are many betting that it is.

 ABOUT STOCKOPEDIA AND THE GURU INVESTING STRATEGIES

Our investing guru series is being written by Ed Page Croft and the team at Stockopedia. You can read This is Money’s review of Stockopedia by Simon Lambert and more about the site at the links below.

But first a word of warning: The investing guru series seeks to explain the theories behind the great investors’ success and highlight some shares that fit their methods.

We highlight the modelled returns their strategies could achieve based on actual stock market performance, however, never forget that past performance is not indicative of future returns.

It is also vital to consider that these and all other investment articles on This is Money are simply ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.    
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Track the performance of all Stockopedia’s GuruModel strategies
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* No fee for publication is involved between This is Money and Stockopedia for this column.

The comments below have not been moderated.

It sounds like he is selecting Dog shares that have a low PE ratio. The differance between High profit to share price and overall capital worth to profit is subtle. Not too sure how new his ideas are. but once the above critera are met just a little more work will ensure that the company is generally improving

Graham
,

York, United Kingdom,
07/6/2013 09:51

What’s it done from 1st January 2000 to date?

No disrespect buy during major bull markets you can’t fail but to make decent money, it’s during the bear markets that people prove their worth and very few do.

1982-2000 was the greatest bull market of all time, the Dow in 1982 was approx 800 points and in 2000 it was approx 11,000 = 10,200 points growth / 18 = 566 points year average = 1375% growth /18 = 76% growth per on average.
If you had KNOWN that 1982 -2000 was going to be a rampant bull market employing a buy and hold strategy from 1982-2000 would of beaten the fund managers! It can be done, you just have to know when the bull markets start and end.
Less fees the DIY route too!
Point proven

Also the Buy and Hold strategy only works during bull markets, throw in a decent bear market and it wrecks the strategy, so you need 2 Investment strategies one for a bull market and one for a bear market.

The Hovis Trader
,

Halesworth,
06/6/2013 21:13

I imagine that he is now telling you of his secret when in all probability it doesn’t work any more.

royston amphlett
,

bournemouth, United Kingdom,
06/6/2013 20:40

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