In his bestseller, The little book that still beats the market, Joel Greenblatt devised a very simple but extremely powerful formula that allows individual and professional investors to implement a systematic value investing approach.
We highly recommend this book to everyone. Greenblatt wrote it for his young children, so it's very easy to understand. While Greenblatt only tested his theory on US stocks, we were the first to test it on European stocks. You can find our conclusions in the research section below.
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:
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.
The formula is calculated based on 2 ratios:
The individual components of this formula are calculated as follows:
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.
This formula doesn't work on all companies, so Greenblatt advises to set the following filters:
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.
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.
The Magic Formula was developed by Joel Greenblatt in his book, ‘The Little Book That Still Beats the Market’. The basic idea behind the rank is to identify good businesses that are selling at attractive prices. This is done through the use of two ratios:
The rank then combines these two ratios to give you a list of companies with good businesses that are trading at an attractive price.
Kindly note that we tested the Magic Formula based on our interpretation of it after reading Joel Greenblatt’s book mentioned above. Neither Mr Greenblatt nor the website (magicformulainvesting.com) have endorsed this study or have had anything to do with it, or recommended any of the companies included in our back tests. We also made use of our own database and did not have access to Mr Greenblatt's
As you can see, the Magic Formula is a strong factor that leads to substantial market outperformance. Q1 performs better than Q5, and the results are completely linear. It is, however, not that consistent - outperforming the market 50% of the time for small companies and 58% of the time for mid and large companies.
With this combination we wanted to determine if the results of the Magic Formula could be improved by adding an additional factor to select companies to invest in. Out of our universe of companies we thus took the 20% of companies with the best MF-ranking and combined them with the second factors we tested.
Across all the second factors we tested the average return was 401.8% (median was 359.3%) over 12 years. On average, this was the eighth best (out of nine) two-factor strategy we tested. The best performing combination would have been to combine the best Magic Formula companies with the companies that had the highest 6-months price index. This would have given you a return of 783.3% over 12 years.
The worst performing strategy would have been to combine the MF-rank with return on invested capital. In this case your returns would have been 121.6%.
I sometimes wonder whether some financial newspapers are really adept at explaining what's really going on in the world. For everyday market updates, journalists are trying hard to second guess why the stock markets go up or down. If you read their newspapers on the web it's not uncommon for a story to be updated in a very short time: Agfa-Gevaert posted fantastic results.. 15 minutes later: Agfa- Gevaert disappoints with lower than expected earnings. The story changes as quickly as the stock price. Also at macro-level, the newspapers always seem to have an explanation for what's going on in the market but to me they don't seem to be very confident.
To fill the remainder of the pages, newspapers often try to tackle items in more detail. They discuss subjects to which they're not very close and by trying to put their own spin on the subject they completely miss the point.
This is exactly what happened in an article published by the Belgian newspaper 'de Tijd' on 6 August 2011. One of their journalists wrote an article on Greenblatt's Magic formula: http://www.tijd.be/nieuws/archief/Een_magische_formule_als_houvast_in_volle_beurscrisis.9091892-1615.art?highlight=greenblatt&ckc=1. I really hope people didn't use this article as a basis for investment decisions, but it does give us a perfect opportunity to explain a few point about the formula and why MFIE's screener is the only commercially available screener that implements the formula correctly for stocks globally.
The author starts by giving a short explanation of the formula. After that it goes horribly wrong.
First of all, he applies the formula to only the stocks on the Belgian stock exchange. He correctly excludes certain companies on which the formula doesn't work, but that brings the total to around 150 companies. Now it doesn't require a brain surgeon to work out the fact that screening a list of 150 companies is very restricted. How on earth can you find cheap stocks if you only look at a set of 150 stock? In our valuescreeners tool we screen 22.000 stocks and looking at the top 30 you won't find a Belgian company in there. In fact the highest ranking Belgian company - Picanol - is only at position 88 in our screeners. The first company reported in the article - Belgacom - ranks at position 327 and Resulix, the article's number 2, ranks at 643.
The author makes another cardinal mistake, this time in the formula. While the Greenblatt magic formula sounds simple, calculating it is slightly more complicated. In the appendix of his book you will find a detailed description of all elements of the formula and it took our team quite some time to get this exactly right. If the author would have understood this section, he would have noticed that Greenblatt really uses pre-tax operating earnings instead of EBIT, excluding non-operating income. So while in the general section Greenblatt always mentions EBIT, he doesn't really use EBIT! Off course this difference will lead to a completely different ranking. In the MFIE screener the companies at the top of the ranking are: Picanol, Omega Pharma, Melexis, Roularta,.. The first 2 don't even appear in the author's list, the last 2 are at position 14 and 19. Instead a company like Belgacom is ranked number 1 in the article's list but as Siddy Jobe at Bank Degroof commented, Belgacom booked a 400 million Euro non-operating income in 2010.
After compiling an incorrect MF-list, the author casually concludes that stock screening takes away a big part of the 'fun' of investing. Isn't this a remarkable statement in the light of the recent stock market drop and the fact that many people lost significant amounts of money by speculating on the prices of glamour stocks? Shouldn't investing be about earning a good profit on your capital by investing in sound businesses and purchasing their stocks at a margin of safety?
There's many articles like this one but I wouldn't conclude that all financial press is always wrong. There are very good journalists who help us make sense of different subjects by summarizing complicated content. But one should always read these articles with a healthy degree of scepticism. There's always a chance that the author didn't take the time necessary to fully understand the subject.
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