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Investing with the magic formula

26 November 2010

How would you like a magic formula to beat the market? A formula that was simple, easy to use, quick to apply, and almost certain to deliver superior returns over time?

That's exactly what Joel Greenblatt claims to offer in his best-seller, The Little Book that Beats the Market. Just reissued in a new edition called (you guessed it) The Little Book that Still Beats the Market, Greenblatt's book has spawned a hedge fund, a series of structured products and a specialised market index. More importantly, it has inspired thousands of investors to build portfolios based on his simple seven-step process.

So who is Joel Greenblatt? What's his not-so-secret formula? What can we learn from it? And why isn't everybody doing it if it's so successful?

Who is Joel Greenblatt?

Unlike many people spruiking a particular trading philosophy, Greenblatt has an impressive record of success to make investors sit up and listen. In 1985 he founded Gotham Capital, a private investment partnership that delivered annualised returns of more than 50% before being closed to investors in 1994. He is also a professor on the adjunct faculty of Columbia Business School – so he's well grounded in the theory, as well as the practice.

What's the magic formula?

Greenblatt offers a few different versions of his investment process, depending on how hands-on you want to be, but the basic elements are still the same:

1. List the companies in your chosen market in order of their earnings yield, then give them a rank, highest return first. So, on the ASX, the company with the highest earnings yield would be ranked number 1, all the way down to number 1,998.
2. Rank the same companies by their return on capital, highest yield first.
3. Add the two ranks together to give a final score.
4. Decide which companies to exclude. Greenblatt suggests setting a minimum market capitalisation, so you can exclude higher risk low-cap stocks from your investment universe if you prefer to do so. An alternative is to eliminate stocks with a PE of 5 or less, since that may indicate that their recent results were anomalous in some way. He also recommends excluding financial stocks and utilities, since their highly geared balance sheets makes their performance difficult to measure using return on capital, at least as Greenblatt defines it.
5. Choose between 20 and 30 of the highest scoring companies, then buy them in three or four tranches over a 12-month period.
6. Repeat the process and rebalance your portfolio every 12 months. Continue for a minimum of 3–5 years, preferably longer.
7. "Feel free to write and thank me", writes Greenblatt.

Two magic ratios

As you can see, Greenblatt's method is based on just two fundamental ratios: return on capital and earnings yield. Together, they give him an insight into both a company's long-term performance and the value it currently offers investors.

Earnings yield is simply PE turned upside down – earnings per share divided by price per share. This is the value part of the magic formula, revealing which stocks are currently delivering a big share of corporate earnings for a small price.

Return on capital is the performance part of the formula. Like return on equity, it's a measure of the earnings a company generates from a given level of investment. Greenblatt calculates it slightly differently to some others:

On the earnings side, he prefers to use earnings before interest and tax (EBIT), rather than reported earnings, because that removes any distorting effects from the different tax regimes and interest rates companies may be subject to. Meanwhile, his capital calculation is designed to come as close as possible to understanding exactly how much capital the company has had to employ to generate those earnings.

Those are the technicalities, but the key point is this: as an investor, you want to put your money into companies that generate the highest possible return on their capital. After all, some of that capital belongs to you.

What can it teach us?

Now, I'm not suggesting you should blindly follow Greenblatt's method. But it does hold some interesting lessons for investors – especially since there is some evidence that it works. Greenblatt's back-testing suggests that $100,000 invested in the US market in September 1999 using the magic formula would have been worth $388,860 ten years later, a rise of 288%. That compares to 1.5% decline in the S&P500.

So here are my key takeouts from Greenblatt's approach:

• Filter out the noise. Once upon a time, investors had to hunt for information. Now we are overwhelmed with news, views and opinion. But how much of it is truly relevant? Greenblatt's method demonstrates the value of focusing on a few pieces of key data, rather than being distracted by short-term noise.
• Seek out quality, but at the right price. For buy and hold investors, the ability of a company to consistently deliver strong returns is crucial. But that doesn't mean price is no object. Greenblatt uses earnings yield to combine earnings quality with market timing in one simple indicator.
• Diversify – or roll up your sleeves. Greenblatt suggests buying a very sizeable portfolio – up to 30 stocks. That helps to reduce risk for the relatively inexperienced investors who might be expected to simply follow his formula without doing further research. But he also acknowledges that those who are willing and able to undertake further analysis may prefer a more focused portfolio.
• Be in it for the long term. Greenblatt cautions that, while his approach is likely to outperform over a three year period, it can also be expected to underperform as often as one year in every four. That's because it can take time for the market to recognise and price in the superior quality it is designed to seek out. Which means you need to be prepared to stick with your approach, even in the face of short-term losses.
• Curb your enthusiasm. That brings us to the final and most difficult lesson. To succeed as an investor, you need to put emotion aside. The enthusiasm that causes investors to buy when the market is buoyant is as dangerous as the fear that leads them to sell when shares dip. A sound strategy driven by objective indicators can help you avoid the emotional peaks and troughs that so often lead investors astray.

Happy trading!

Julia Lee
Equities Analyst
Bell Direct
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