Greenblatt’s Magic Formula
by John Bajkowski
Long-term success relies on both a sound strategy and the discipline to follow your approach during bull and bear markets. In “The Little Book That Still Beats the Market” (John Wiley & Sons, 2010), Joel Greenblatt shows that his “Magic Formula” approach holds up over the long term, but that you need to be prepared for brief runs when it underperforms the market. The approach seeks out good companies with a high return on invested capital that can be purchased at an attractive pretax earnings yield.
Greenblatt measures the strength of a business by examining its return on capital, which he defines as operating profit (EBIT, earnings before interest and taxes) divided by tangible investment capital (net working capital plus net fixed assets). If you do not have access to this variable, Greenblatt suggests that investors use return on assets (net income divided by assets) or visit his website (www.magicformulainvesting.com), which has a free magic formula screening tool.
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To help value a business, Greenblatt takes the price-earnings ratio, inverts it and tweaks the variables slightly. Greenblatt calculates earnings yield by dividing EBIT by the enterprise value. The enterprise value tries to reflect the minimum value to purchase a company outright. It is calculated by adding market capitalization, preferred stock, and total debt and subtracting excess cash. Greenblatt notes that you can also look for low price-earnings ratios, but warns to avoid firms with extremely low ratios because earnings may be unusual in some way.
Stocks that made this issue’s First Cut are domestic, exchange-listed stocks with a minimum price of $5.00 per share and a market cap of at least $50 million. Greenblatt also excludes financials and utilities because of their unique financial structures. To calculate the magic formula, the rank value of return on capital was combined with the rank value of the return on enterprise value. The 30 stocks with the lowest magic formula total passed the First Cut. Greenblatt suggests building a 20- to 30-stock portfolio by selecting five to seven stocks every two to three months.
—John Bajkowski, President of AAII
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Discussion
Is there anyway to make the spreadsheet user friendly readable on my MAC, without having to print it out? On my MAC I can't drag the corners to have the sheet appear completely. It requires that I use the up/ down and side to side arrows. which causes me to lose the left and irght columns/rows that define the criteria of the company's.
posted about 1 year ago by John from Colorado
Nice summary of Greenblatt's book. I read the book and there is very little to add beyond your article. I think this is a good shortcut to estimating company value. But I would hesitate to follow the investment advice. There are probably several reasons why this could be viewed as inadequate; I shall list two:
1. There is no decision threshold in this process, just the magic number 30. Presumably there are times when no company is a value and it would be prudent to withhold from the market. There may be other times when many companies are selling at a value. A decision threshold or at least a guideline would be useful in making the distinction.
2. In addition to a company being a value, I am concerned about issues of debt (risk of bankruptcy and potential future interest burden) and persistent dividend yield (an additional measure of strength and durability). Adding Greenblatt's formula to a short list of additional criteria seems valuable. Using it as a standalone omits a lot of valuable information.
posted about 1 year ago by Wesley from New Mexico
Thanks a million for providing the info for use in Stock Investor Pro. This is very helpful and greatly appreciated. Please continue to provide this type of assistance.
posted about 1 year ago by David from Alabama
I've been tracking the performance of a portfolio of 30 MFI stocks with a market cap of $50M purchased on the first of each month since August. You can see the holdings and performance of the 5 portfolios here:
http://dark-liquidity.com/MFI.php
posted about 1 year ago by Donald from Michigan
The "Magic Tangible Capital" calculation should include PPE.
posted about 1 year ago by Terry from California
Is there anyway to make the spreadsheet user friendly readable on my Windows PC, without having to print it out? On my PC I can't drag the corners to have the sheet appear completely. It requires that I use the up/ down and side to side arrows. which causes me to lose the left and irght columns/rows that define the criteria of the company's.
posted about 1 year ago by John from Wyoming
I would like to reinforce what John from Colorado said about the worksheet, as well as John from Wyoming. I use Ubuntu Linux and have the same problem.
posted about 1 year ago by Daniel from Arizona
If you are referring to the Magic Formula Stocks table you can download the worksheet here into excel (and other formats):
https://docs.google.com/spreadsheet/ccc?key=0Ar-HKg-x7RcadFdpbGNPbDc2Tk9WMDZGckhKT0VmV1E
posted about 1 year ago by Donald from Michigan
We adjusted the table to appear in a spreadsheet format. If you click on "Full Screen View," you should be able to see the table without scrolling on all PCs. - Charles Rotblut
posted about 1 year ago by Charles from Illinois
On the spreadsheet, the ranks are given in columns C & D. How were these determined and printed. I am aware that the Magic Formula Total is the sum of these to columns. Thanks
posted about 1 year ago by Arnold from Hawaii
I don't know why you've programmed a web site to demand cookies to display a simple spreadsheet.
This is one page I won't be looking at as I'm unwilling to putz around that much to see a simple table.
posted about 1 year ago by William from Florida
can't fine the list of 30 stocks and can't find any spreadsheet.
posted about 1 year ago by Lee from Massachusetts
This is the first AAII article with a screen which was not viewable 'because cookies are not enabled in your browser'. But they are. Please correct.
posted about 1 year ago by David from New York
The cookie issue is because the spreadsheet is hosted on Zoho. To see the spreadsheet using Safari (and possibly FireFox and other browsers) you need to enable "Always Accept Cookies". By default it is safer to only accept cookies from sites you visit. If you trust AAII and Zoho then go ahead and accept setting a cookie from a site you haven't navigated to directly.
posted about 1 year ago by Paul from California
I gather that the ranking of the companies by enterprise value and return on captital is something that is unavailable inside of Stock Investor Pro.
This article was of great interest to me since I had purchased the book not so long ago.
posted about 1 year ago by E b from Florida
The screen criteria and the custom fields for use with SIP are available for SIP subscribers. However, I can get no help on setting up a View Menu to show the "Ratio - Rank" for the EBIT/Enterprise Value or the Return on Capital. Would appreciate help.
posted about 1 year ago by Arnold from Hawaii
