Using the Magic Formula for Investing

Learning to successfully invest in the stock market is simple, according to Joel Greenblatt’s “The Little Book That Beats the Market” (Wiley, 2005). Greenblatt is the founder and a managing partner of Gotham Capital, a private investment partnership. He is an adjunct professor at the Columbia University Graduate School of Business, and holds a B.S. and an MBA from the Wharton School.

Greenblatt wanted to write an investing book his children could read and learn from. The main point Greenblatt makes is that investors should buy good companies at bargain prices—businesses with high return on investment that are trading for less than they are worth.

Finding Bargain Prices

To those familiar with the value investing style of Benjamin Graham, the latter point is fairly obvious: buy stocks at a lower price than their actual value. This assumes you are able to somewhat accurately estimate a company’s actual value based on future earnings potential.

Greenblatt says that stock prices of a firm can experience “wild” swings even as the value of the company does not change, or changes very little. He views these price fluctuations as opportunities to buy low and sell high.

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He follows Graham’s “margin of safety” philosophy to allow some room for estimation errors. Graham said that if you think a company is worth $70 and it is selling for $40, buy it. If you are wrong and the fair value is closer to $60 or even $50, you will still be purchasing the stock at a discount.

Finding Good Companies

Greenblatt believes that a company with the ability to invest in its business and receive a good return on that investment is usually a “good” company. He uses the example of a company that can spend $400,000 on a new store and earn $200,000 in the next year. The return on investment will be 50%. He compares this to another company that also spends $400,000 on a new store, but makes only $10,000 in the next year. Its return on the investment is only 2.5%. He would expect you to pick the company with the higher expected return on investment.

Companies that can earn a high return on capital (the return a company makes after investing in the business) over time generally have a special advantage that keeps competition from destroying it. This could be name recognition, a new product that is hard to duplicate or even a unique business model.

Magic Formula Basics

EBIT to Enterprise Value

Greenblatt compares a company’s ratio of EBIT (earnings before interest and taxes) to enterprise value against the risk-free rate. Enterprise value is a measure of company value that takes into consideration the firm’s capital structure (debt versus equity). You could do a simple earnings yield calculation by dividing net earnings by the market value of the company’s stock, but Greenblatt has a different take. He divides earnings before interest and taxes by a stock’s enterprise value.

A company’s enterprise value represents its economic value, which is the minimum value that would be paid to purchase the company outright. In keeping with value investment strategies, this is similar to book value.

Enterprise value is equal to the market value of equity (including preferred stock) plus interest-bearing debt minus excess cash.

Greenblatt uses enterprise value instead of just the market value of equity because it takes into account both the market price of equity and the debt used to generate earnings.

Companies with debt must pay interest on the debt and eventually pay off the debt. This makes the debt’s true acquisition cost higher. Adding debt to market capitalization lowers the EBIT-to-enterprise-value ratio, making a company less attractive.

Excess cash is subtracted from enterprise value because the un-needed cash reduces the overall cost of acquiring a business. If a company is holding $25 million in cash, the effective acquisition cost is reduced by that amount. Excess cash raises the EBIT-to-enterprise-value ratio, making the company more attractively priced.

The ratio of EBIT to enterprise value helps to measure the earnings potential of a stock versus its value. If the EBIT-to-enterprise-value ratio is greater than the risk-free rate (typically the 10-year U.S. government bond rate), Greenblatt believes you may have a good investment opportunity—and the higher the ratio, the better.

Return on Capital

Return on capital, or return on invested capital (ROIC) is similar to return on equity (the ratio of earnings to outstanding shares) and return on assets (the ratio of earnings to a firm’s assets), but Greenblatt makes a few changes. He calculates return on capital by dividing earnings before interest and taxes EBIT by tangible capital.

Instead of using net income, return on invested capital emphasizes EBIT, also known as pretax operating earnings. Greenblatt uses this number because the focus is on profitability from operations as it relates to the cost of the assets used to produce those profits.

Another difference in Greenblatt’s approach is the use of tangible capital in place of equity or assets. Debt levels and tax rates vary from company to company, which can cause distortions to earnings and muddy cash flows. Greenblatt believes tangible capital better captures the actual operating capital used.

The equity value typically used to calculate return on equity ignores assets financed via debt, and the total assets value used in the return on assets calculation includes intangible assets that may not be tied to the firm’s primary operation.

The higher the return on capital, the better the investment, according to Greenblatt.

Implementing the Magic Formula

Table 1 outlines the primary criteria Greenblatt used in his original study as well as his method for portfolio construction. The search started with a universe of the 3,500 largest exchange-traded stocks, based on market capitalization (shares outstanding multiplied by share price). Greenblatt used a market capitalization floor of $50 million, but advised that, based on your liquidity needs and risk aversion, you can set the minimum as high as $5 billion.

He then ranked the stocks from one to 3,500 based on return on capital (the highest return on capital got a rank of one; the lowest received a rank of 3,500).

Next, he ranked the stocks based on their ratio of EBIT to enterprise value, with the highest ratio assigned a rank of one and the lowest assigned a rank of 3,500. Finally, he combined the rankings (if a company ranked 20 for return on capital and 10 for EBIT to enterprise value, the combined ranking was 30).

For practical purposes, Greenblatt recommends investing in 20 to 30 stocks by purchasing five to seven with the lowest combined rank every few months. The holding period he advises for each stock is one year. He believes this strategy will allow you to make changes on only a few stocks at a time as opposed to liquidating and repurchasing the entire portfolio at once.

Performance

Greenblatt tested his investing strategy over a 17-year period and earned an average annual return of 30.8%. He held 30 stocks at a time and held each stock for one year.

In the book, Greenblatt devotes an entire chapter to explaining that the strategy is not a “magic bullet” that always works. During his test period, he found that, on average, five of every 12 months underperformed the market. Looking at full-year periods, once every four years the approach failed to beat the market.

Sticking to a strategy that is not working in the short run even if it has a good long-term record can be difficult, Greenblatt says, but he believes you will be better off doing just that. Following the latest fad or short-term investment ideas will not yield market-beating results, in his opinion. Discipline is his key to successful investing.

Choosing Magic Formula Stocks

Magic Formula Web Site

Greenblatt runs a free Web site (www.magicformulainvesting.com) with a Magic Formula screening tool. After you register with the site, you can use the simple screener (Figure 1 shows the screener and the passing company list). The only choices you can make are minimum market capitalization (any number between $50 million and $5 billion) and the number of companies you wish to see (30 or 50).

The Web site does the rest for you. It orders the stocks based on the combined rank of EBIT-to-enterprise-value ratio and return on capital, and presents the top stocks. The prior day’s closing prices are used.

Interpreting the Screen Using a Stock Screening Program

Using a stock screening program to implement the Magic Formula requires some interpretation. The First Cut column in the May 2009 issue of the AAII Journal introduced the Magic Formula investing strategy. Greenblatt’s criteria were interpreted and updated to work within the parameters of AAII’s fundamental stock screening program, Stock Investor Pro. Table 2 presents a summary of the screen criteria. Table 3 lists the screen criteria for use in AAII’s Stock Investor Pro, and Table 4 lists the custom fields used in the screening process. [Stock Investor Pro subscribers: Click here to download a .txt file with the custom fields for copying and pasting into the Custom Field Editor.]

Narrowing the Stock Universe

The first step is to remove all over-the-counter stocks (OTC) and ADRs (shares of foreign companies trading on U.S. exchanges). Greenblatt’s initial database of stocks included only exchange-traded stocks. Next, all stocks in the financial and utility sectors are excluded due to their unique financial structures.

 

Market Capitalization

The screening tool found at MagicFormulaInvesting.com lets you choose a minimum value for market capitalization between $50 million and $5 billion; however, Greenblatt’s original study included stocks with market capitalizations of $50 million or greater.

Return on Invested Capital

Return on capital measures the return a company achieves after investing in the business; the higher the return on capital, the better the investment.

For the AAII First Cut screen, tangible capital was defined as accounts receivable plus inventory plus cash minus accounts payable. This figure is based on the fact that a company needs to fund its receivables and inventory but does not have a cash outlay for accounts payable.

For this screen, we require a return on invested capital of greater than 25%, as specified in Greenblatt’s alternative screening suggestions.

 

EBIT to Enterprise Value

The ratio of EBIT to enterprise value helps to measure the earnings potential of a stock versus its value. To calculate, Greenblatt divides EBIT by enterprise value. For this screen, we use the EBIT-to-enterprise-value ratio to narrow the field to 30 stocks by choosing those with the highest ratio.

“Magic” Stocks

Table 5 lists the 30 companies with the highest EBIT to enterprise value from the Stock Investor Pro database as of July 3, 2009. Trancept Pharmaceuticals TSPT has the highest ratio of EBIT to enterprise value at close to 95%. The company has an enterprise value of 29, mainly due to high levels of excess cash from a recent merger, but also due to minimal debt.

The company with the highest return on capital is Petroleum Development Corp. PETD. Its ROIC of 1,547% can be attributed to a high EBIT and low tangible capital levels.

 

Table 6 compares the median market cap, ratio of EBIT to enterprise value, return on capital and relative strength of the companies passing the Magic Formula screen to all exchange-listed stocks and the stocks in the S&P 500 index. As expected, the Magic Formula stocks have a much higher EBIT-to-enterprise-value ratio (36.2%, versus 8.9% for exchange-listed stocks and 8.4% for S&P 500 stocks). Magic Formula stocks also have a higher return on capital (70.8%, compared to 38.7% for exchange-listed and 51.0% for S&P 500 stocks).

Interestingly, the Magic Formula stocks have a lower relative strength than exchange-listed stocks for both the 13- and 52-week period. This could be for a number of reasons—one being that, as Greenblatt mentions in his book, the Magic Formula doesn’t always beat the market. Another reason could be that these stocks have been underperforming the market and are “on sale.” Perhaps this relative underperformance points to an attractive buying opportunity.

 

Conclusion

Like any stock screening strategy, blindly buying and selling stocks is never a good idea. Developing and implementing disciplined buy, sell and hold strategies is a better option. Greenblatt’s Magic Formula is not revolutionary, but does provide a new twist on the old value investing ideas. While his past record is impressive, it will be interesting to see how the screen holds up during this period of market turmoil and its aftermath.