The Magic Formula Approach to Stockpicking

There are many approaches to the selection and analysis of common stocks floating around the investment community, from simple value techniques to complex strategies combining a wide array of technical and fundamental factors. Many investors are initially drawn to intricate techniques, only to discover that basic, but sound, approaches often perform better and are easier to implement and understand.

Joel Greenblatt’s latest book, “The Little Book That Beats the Market” (John Wiley & Sons, Inc., 2006), has created a stir within the financial community because of his simple “magic formula” approach and promise of long-term, low-risk, market-beating performance.

Joel Greenblatt is the founder and a managing partner of Gotham Capital, a private investment partnership that has provided 40% annualized returns since its inception in 1985. Greenblatt’s first book, “You Can Be a Stock Market Genius,” published in 1997, explored how to profit from more complex situations—spin-offs, mergers, risk arbitrage, restructurings, rights offerings, bankruptcies, liquidations, and asset sales. The book may have been a hit with hedge fund managers, but it was beyond the level of the typical investor.

Figure 1. Performing the Screen at MagicFormulaInvesting.com CLICK ON IMAGE TO SEE FULL SIZE.

With the “The Little Book That Beats the Market,” Greenblatt’s goal was to write a book simple enough that his children could understand and use the approach, yet have it reflect the core values used by Greenblatt to manage his portfolio. The result is an easy-to-read book that relies on two simple rules: Seek out companies with high return on invested capital, and that can be purchased at a low price that provides a high pretax earnings yield. These two concepts—buying a good business at a bargain price—make up the “magic formula,” and Greenblatt makes it even easier to follow the approach in the book by currently offering a free Web site that screens for stocks passing the Magic Formula (Figure 1).

Identifying Good Businesses

Greenblatt identifies the strength of a business by examining the return on capital. The return on capital measures the operating profit of the tangible investment (capital) used by the company to generate that profit. If a company is able to earn a high return—such as a 50-cent profit for every dollar invested in inventory and property, plant and equipment—it is a desirable business. The high return points to a business profitable enough to justify expansion and provide an opportunity to realize a high rate of earnings growth. The high profitability and growth potential should attract investors who then bid up the stock price.

Of course a high return on capital should also attract competition, which may ultimately lead to lower profitability, but the better companies have something special about their business that supports and sustains an above-average level of profitability. It may be the introduction of new a product that has no effective competition, or a strong brand name that commands a premium, or even some form of patent protection that limits competition. Not every company with a high return on capital will be able to sustain its profitability over the long term, and even a mediocre business may have a good year or two that temporarily inflates the return on capital. However, Greenblatt’s approach relies on building a large portfolio of 20 to 30 stocks. This pushes the odds in your favor of having a portfolio predominately \made up of companies more likely to realize opportunities to reinvest their profits at high rates of return and achieve high earnings growth.

Calculating Return on Capital

While many investors use return on equity (ROE, net income divided by shareowner’s equity) or return on assets (ROA, net income divided by total assets) to judge the profitability of a business, Greenblatt prefers using return on capital. He determines return on capital by dividing earnings before interest and taxes (EBIT) by the tangible capital employed (net working capital plus net fixed assets).

Why use EBIT (also known as pretax operating earnings) and not reported net income? Greenblatt wants to focus the analysis on profitability from operations relative to the cost of the assets used to produce those profits. Debt levels and tax rates vary from company to company and may introduce distortions to earnings that mask operating cash flow.

TABLE 1. Greenblatt's Calculations: An Example CLICK ON IMAGE TO SEE FULL SIZE.

Tangible capital employed is used instead of equity (ROE) or total assets (ROA) to better capture the actual operating capital used by the business. Conceptually, the equity value in the ROE calculation ignores assets financed via debt, while the total assets in the ROA calculation includes intangible assets and other assets that may not be tied to the primary operation of the firm or assets that are financed by suppliers. Tangible capital employed is the sum of net working capital and net fixed assets. Net working capital is generally defined as current assets less current liabilities. Greenblatt refines the calculation to focus on accounts receivable, inventory and cash needed to conduct business less accounts payable. If net working capital is negative, zero is used in the calculation. Net fixed assets are defined as property, plant and equipment less accumulated depreciation. Table 1 presents the financial statements for American Eagle Outfitters and return on capital calculations.

Identifying Cheap Stocks

Over the last year Intel has seen its price fluctuate from a low of $21.89 to a high of $28.84—a 32% price swing. Home Depot’s stock ranged from a low of $34.56 to a high of $43.98 over the last year—a 27% price swing. Did the worth of these companies really fluctuate that much over the course of a year? No. Stock prices can fluctuate wildly within a short period of time. While the market may correctly price stocks in the long run, short-term overreactions lead to many mispriced stocks. A value investor can take advantage of these short-term price swings to buy good companies at low prices.

While many valuation techniques are used by investors, Greenblatt takes the popular price-earnings ratio, inverts it and tweaks the variables slightly to better reflect the notion of buying a complete business. Greenblatt calculates the earnings yield by dividing earnings before interest and taxes (EBIT) by enterprise value. We have already discussed EBIT, but what is enterprise value?

Enterprise Value

Enterprise value (EV) represents the company’s economic value, or the minimum value that would be paid to purchase a company outright. Enterprise value is equal to the market value of equity (including preferred stock) plus interest-bearing debt less excess cash. Enterprise value is used instead of simply the market value of equity (market capitalization = shares outstanding times price per share) because it takes into account both the market price of equity and the net debt used by a company to help generate operating earnings.

To better understand enterprise value, consider two companies with the same market cap of $100 million. One is debt free, but the other has $50 million in debt outstanding. If you buy the company with debt, you will need to pay interest on the debt and/or pay off the debt, so its true acquisition cost is higher. Adding debt to market cap reduces the earnings yield, making the company less attractive.

Excess cash is also considered in the calculation of enterprise value. If a company is sitting on a pile of cash that is not needed in the normal operation of the business, it reduces the overall cost of acquiring a business. If our $100 million market-cap company has no debt but has $25 million in cash, the net acquisition cost is reduced by the amount of this excess cash. Excess cash reduces the enterprise value, boosting the earnings yield and making the company more attractively priced.

Enterprise value puts companies with different debt and cashan equal footing. Table 1 also shows the earnings yield calculations for American Eagle Outfitters.

Finding Magic Formula Companies

Greenblatt begins his analysis with exchange-listed stocks. He then eliminates foreign companies, which are typically trading as ADRs (American depositary receipts). The financial statements of financial firms (banks, brokerage firms, insurance companies, etc.) and utilities are not directly comparable to industrial and service companies, so they are also excluded from the screen.

It is more costly to trade less liquid, micro-capitalization stocks, so Greenblatt looks at the 3,500 largest companies for his testing and analysis. This size cut-off is roughly equal to a market capitalization minimum of $50 million, still allowing a large segment of small-cap companies to be considered for purchase.

The universe of 3,500 stocks is then ranked from 1 to 3,500, based upon their return on capital. The company with the highest return on capital receives a rank of 1, while the company with the lowest return on capital is ranked 3,500.

The universe of stocks is then ranked separately using the earnings yield, in which the stock with the highest earnings yield is ranked number 1 and 3,500 is assigned to the stock with the lowest yield.

The two rank values for each stock are then combined into a composite figure and the companies with the lowest combined rank are purchased. A company with a return on capital rank of 187 and an earnings yield rank of 431 would have a combined rank of 618.

The Results

Buying the 30 best-ranked companies, holding the portfolio for a year, and then repeating the screening process the next year would have returned 30.8% annually over the last 17 years. By contrast, the S&P 500’s annual return over the same timeframe was only 12.4%.

Limiting the universe to the largest 2,500 companies (market cap above $200 million) would have reduced the annual rate of return to 23.7%, while using just the largest 1,000 companies (market cap above $1 billion) resulted in a 22.9% annual rate of return.

A further study of the Magic Formula system when considering the top 1,000 companies revealed that magic-formula portfolios underperformed the market an average of 25% of the time for any one-year test period (starting with any month during the 17 years). Following the strategy for any consecutive two-year test period (starting with any month during the 17 years), resulted in below-average performance 17% of the time. However, following the annual rebalancing method for any three consecutive years (starting with any month during the 17 years) resulted in the strategy beating the market an average of 95% of the time.

Implementing the Screen

Performing this type of screen is difficult with most stock screening programs, so Joel Greenblatt provides two options. First, Greenblatt has set up a Web site (www.magicformulainvesting.com) that investors can use to perform the screen. Registration and usage of the site is currently free, but there is no guarantee that it will continue to be free in the future. The data on the site is updated daily and is licensed from Standard and Poor’s. The same source was used by Greenblatt to test his Magic Formula strategy.

The site requires you to register and supply a valid E-mail address in order to obtain a code to activate your account. Greenblatt promises not to send spam or resell addresses, only to use E-mail to inform registrants of relevant events.

To run a screen, users specify a minimum market-cap floor and number of best-ranked companies to display (Figure 1). The market-cap minimum can range from a low of $1 million to a high of $2 billion.

The site returns an alphabetical list of top-ranked companies for the combined return on capital and earnings yield rank. The site displays the company name, its ticker, the market cap, the pretax earnings yield and the pretax return on equity. Investors will need to use other resources to do any additional research.

Figure 2. Screen Results with $50 Million Market-Cap Floor CLICK ON IMAGE TO SEE FULL SIZE.

Figure 2 shows the results of the screen when the market-cap floor is $50 million, while Figure 3 lists the results when $2 billion is specified as the market-cap minimum. Both lists contain a diverse range of companies, with only four stocks that managed to pass both filters—American Eagle Outfitters, H&R Block, CBS Corp., and King Pharmaceuticals.

Greenblatt recommends that you build your portfolio slowly over the course of the year by selecting five to seven stocks every two or three months until you have a portfolio of 20 to 30 stocks. When it is time to select some stocks, you would run the screen to get a fresh list. Because this simple approach relies on no additional research, it is important to hold a significant number of stocks to diversify your risk and allow the general principles of the approach to take hold.

Figure 3. Screen Results with $2 Billion Market-Cap Floor CLICK ON IMAGE TO SEE FULL SIZE.

Greenblatt feels that it does not matter statistically which top-ranked companies you choose from a given run of the screen since you are already choosing among the top few percentiles of top-ranked Magic Formula stocks. There is no real benefit to doing further ranking of the top 25 companies.

Once fully invested in a portfolio of 20 to 30 stocks, you would hold a stock until it approaches a one-year holding period. If you are investing through a taxable account it would make sense to sell stocks showing a loss a few days before the one-year holding period and sell stocks with a gain just after the one-year holding period. Stocks held for a year or longer are subject to a much reduced maximum federal capital gains tax of 15%. After selling a stock, you would repeat the initial investment steps to reinvest the proceeds of securities sold and add any additional money to the portfolio. The goal is to always hold 20 to 30 stocks with roughly an equal dollar investment in each holding.

Figure 4. Entering Magic Formula Criteria in AAII's Stock Investor Pro CLICK ON IMAGE TO SEE FULL SIZE.

Greenblatt also provides an alternate method of finding high-return stocks at below-average prices that uses return on assets to identify profitable companies and the price-earnings ratio to determine if they are priced attractively. The alternative screen is provided for those who want to use a general-purpose stock screening system to find stocks. The screen is described in the summary box on page 21; Figure 4 shows how the screening criteria of the alternate screen would look when entered into AAII’s Stock Investor Pro software program. Note that the maximum price-earnings ratio of less than 13 was specified so that only 25 companies would pass all of the filters combined. Figure 5 shows the results of the Stock Investor screen with data as of January 6, 2006. Note that this screen looked for companies with market cap of $50 million or greater and only three companies were common with the authentic Magic Formula screen of $50 million or higher market cap—Aldila, Forward Industries and VAALCO Energy.

Conclusion

Greenblatt warns that you must stick to this system for three to five years to give the Magic Formula a chance to work. As discussed previously, there will be individual years or even multiple years in which the strategy will not work. Most professional money managers do not want to take the risk of underperforming their peers and follow what everyone else is currently doing. Greenblatt feels that the possibility of short-term underperformance will keep many institutional investors away from the strategy and actually help ensure that good values will always be available. People tend to leave a strategy or fund after a few years of underperformance, only to jump into those investments that performed well recently.

Figure 5. Screen Results Using AAII's Stock Investor Pro CLICK ON IMAGE TO SEE FULL SIZE.

The Magic Formula approach is banking on smart money eventually realizing the value of the “good businesses” selected by the approach and driving up stock prices to reward the value investor.