Joel Greenblatt’s Magic Formula attempts to identify winning stocks by using a dual ranking system: one based on value and one based on profitability. The strategy was described in his best-selling book, “The Little Book That Beats the Market” (John Wiley & Sons, 2005). A new study claims to improve on Greenblatt’s formula by using a different measure of profitability.

The Magic Formula uses earnings before interest and taxes (EBIT) to determine profitability. EBIT can simply be calculated by taking pretax income and adding back interest expense. (Both can be found on a company’s income statement.) Two professors at Fordham University, citing work by Rochester University professor Robert Novy-Marx, replaced EBIT with gross profits. Since gross profits appear higher on the income statement, they are less effected by management decisions over expenses and accounting.

Douglas Blackburn and Nusret Cakici call their strategy the Improved Magic Formula. The formula consists of two parts. The profitability component is gross profits divided by tangible capital. (Tangible capital is the sum of net working capital and fixed assets.) The value component is gross profit divided by enterprise value. (Enterprise value is common and preferred shareholder equity plus interest-bearing debt.) Stocks are ranked separately on the profitability and the value components with the two ranks combined to create a composite score.

The Improved Magic Formula bested the Magic Formula in all four geographic regions tested. In North America (the U.S. and Canada), an equal-weighted portfolio composed of the top 20% of stocks as ranked by their composite scores realized average monthly returns of 1.97% for the period of 1991–2016. In comparison, the comparable group for Greenblatt’s strategy realized an average monthly return of 1.50%. More notably, the monthly return differential between the best and worst scoring stocks for the new strategy was positive (0.79%), whereas it was negative for the older strategy (–0.36%).

A few caveats should be noted. Greenblatt’s strategy called for buying the 30 stocks with the best composite score each month and holding them for a full year. The Fordham professors grouped stocks into quintiles, with each group containing 700 stocks. Furthermore, they rebalanced the portfolios monthly instead of annually. The Fordham professors acknowledge that this more frequent rebalancing may not have not given the value stocks identified by Greenblatt’s strategy enough time to realize higher returns.

Source: “The Magic Formula: Value, Profitability, and the Cross Section of Global Stock Returns,” Douglas Blackburn and Nusret Cakici, SSRN, May 2017.

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