Joel Greenblatt is a successful hedge fund manager and adjunct professor at the Columbia University Graduate school. In 2006 he published the bestseller 'The little book that beats the market', a book he supposedly wrote to teach his children how to make money. In this book he encourages people to take control of their own money and invest it themselves. Most people entrust their money to investment professionals but Greenblatt observes that most of them don't beat the market. They make investing sound quite complicated but as Greenblatt explains, it's actually quite simple. He devised a very straightforward model that can be implemented easily by everyone and has proven to beat the market significantly in the past.

According to Greenblatt, you should be interested in 2 things when investing money into a business:

1. Paying a bargain price when you purchase a share in a company. One way to do this is to purchase a business that earns more relative to the price you are paying. In other words, you should buy companies with a relatively high earnings yield.
2. Buying good business rather than bad ones. One way to do this is to purchase a business that can invest its own money at higher rates of return. You should buy companies with a relatively higher ROC.

Combining these 2 points is the secret to make lots of money.

By eliminating companies that earn ordinary or poor returns on capital, the magic formula starts with a group of companies that have a high return on capital. It then tries to buy these above-average companies at below-average prices.

Joel Greenblatt

How do we calculate the magic formula?

The formula is calculated based on 2 ratios:

1. $$\mathrm{Earnings\; Yield}=\frac{\mathrm{EBIT}}{\mathrm{Enterprise\; Value}}$$
2. $$\mathrm{ROIC}=\frac{\mathrm{EBIT}}{(\mathrm{Net\; Fixed\; Assets}+\mathrm{Net\; Working\; Capital})}$$

The individual components of this formula are calculated as follows:

$\mathrm{Enterprise\; Value}=\mathrm{Market\; Cap}+\mathrm{Total\; Debt}+\mathrm{Minority\; Interest}+\mathrm{Preferred\; Stock}-\mathrm{Cash\; \&\; ST\; Investments}$

$\mathrm{Net\; Working\; Capital}=\mathrm{MAX(}\mathrm{Total\; Current\; Assets}-\mathrm{Excess\; Cash}-(\mathrm{Total\; Current\; Liabilities}-(\mathrm{Total\; Debt}-\mathrm{Long\; Term\; Debt}\left)\right)\mathrm{,\; 0})$

$\mathrm{Excess\; Cash}=\mathrm{MAX}(\mathrm{Cash\; \&\; ST\; Equivalents}-\mathrm{20\%}*\mathrm{Net\; Sales\; or\; Revenues},0)$

$\mathrm{Net\; Fixed\; Assets}=\mathrm{Total\; Assets}-\mathrm{Total\; Current\; Assets}-\mathrm{Goodwill}$

Earnings-related numbers are based on the latest 12 months, balance sheet items are based on the latest available balance sheet, and market prices are based on the most recent closing price.

Rank companies based on each of these ratios individually. Make the sum of the results and rank this again.

$$\mathrm{Magic\; Formula}=\mathrm{Rank}\left(\mathrm{Rank}\right(\mathrm{Earnings\; Yield})+(\mathrm{Rank}\left(\mathrm{ROIC}\right))$$

This formula doesn't work on all companies, so Greenblatt advises to set the following filters:

1. Set Market Capitalization to a value greater than 50 million dollars.
2. Exclude utility and financial stocks

Invest in the top 20-30 companies, accumulating 2-3 positions per month over a 12-month period. Re-balance the portfolio once a year. The formula won't beat the market every year, but should do if correctly applied over a period of 3 to 5 year.

Combining the Magic Formula with other value indicators

Studies have shown that combining the Magic Formula with for instance the Piotroski F-Score increases return. If for instance you take the top 20% results of the magic formula and then take the 20% of stocks with the highest 6-month price index, the total return increases from 235% to 784% during the period 1999-2011. You can find more details about this in our latest paper.