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The Creator of the Magic Formula

A professor at the Columbia University, he is also the founder of the hedge fund Gotham Capital, which he set up in 1985. Greenblatt is well known for his two books: You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits and The Little Book that Beats the Market

Joel Greenblatt The Creator of the Magic Formula

Joel Greenblatt set up the hedge fund Gotham Capital in 1985. The reason you should learn about Greenblatt's techniques is because his Gotham Capital returned 40 per cent annually for 20 years!

Buying good, profitable companies at cheap prices is not exactly a revolutionary idea; this is what Warren Buffett has successfully done for decades. But Greenblatt has created a systematic way to do so, and most of the heavy lifting of number crunching is done by his Magic Formula. The Magic Formula is a stock screener which ranks stocks by two factors: profitability based on Greenblatt's chosen metric, return on capital employed (ROCE), and earnings yield (EY), which is the inverse of the P/E ratio, defined here by him as EBIT/enterprise value.

Greenblatt called these inputs 'good' and 'cheap' factors. He looked for companies that were both good and cheap. This formula had, and continues to have, extraordinary outperformance and Greenblatt still feels that a focused approach to investing will yield higher returns, but a formula approach, i.e., buying a more diversified basket of quantitatively undervalued stocks, is an approach he now prefers due to its simplicity and diversification, yet still above-average returns.

Although his philosophy is similar to Graham's, his strategy was much more focused. The Magic Formula is simply a combined ranking of return on invested capital and enterprise value/EBIT (a variation of the more well known P/E ratio). For casual investors, Greenblatt recommends buying a portfolio of 20-30 Magic Formula stocks, holding them for one year, and then re-running the process annually.

Timeless principles
Greenblatt stresses discipline and his research shows that while beating the market is hard, it doesn't have to be complicated. The hard part comes not in developing a complex strategy but instead in finding a proven approach and sticking to it through good times and bad.

Greenblatt's filter
The Magic Formula filter is a modification of Graham's simplest way to select bargain stocks. Greenblatt combines companies with high earnings yield with high return on capital to come up with a list of high-quality companies trading cheap. He made some of his own adjustments to come up with his screen. He eliminated banks, financial institutions and utilities to try the Greenblatt filter and calculated the earnings yield by dividing EBIT by the enterprise value.

  1. The earnings yield compared the profit generated with the market's valuation of the company (EBIT/enterprise value).
  2. The companies were then ranked. The highest EY was ranked no. 1 and so on.
  3. Next came the ROCE, which was derived by dividing EBIT with the sum of net fixed assets and working capital.
  4. Return on capital = EBIT/(Net fixed assets + Working capital). Companies were ranked. The highest ROCE was ranked no. 1 and so on.
  5. The two ranks were combined with the lowest ranks coming first.
  6. The top 30 stocks were selected. After due research into each of them, these stocks should be held for a period of three to five years.