Joel Greenblatt developed the Magic Formula, which combined earnings yield and ROCE to pick 30 best stocks. We have adapted his style to the Indian context
Joel Greenblatt is a professor at the Columbia University and the founder of Gotham capital, a hedge fund which returned an incredible 40 per cent to investors every year for 20 years. Greenblatt is known for 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'.
Greenblatt is quite open about how he searches for value. He also teaches his techniques. Greenblatt's research on value investing techniques is his most famous claim to fame. His Magic Formula investing technique is his most acclaimed achievement. Magic Formula Investing is a modification of Graham's method to select bargain stocks. In his Magic Formula, Greenblatt combines companies' earnings yield with return on capital to come up with a list of high-quality companies available cheap.
Greenblatt's magic formula
In the Magic Formula, first, earnings yields of the companies under consideration are calculated by dividing EBIT (earnings before interest and taxes, also called operating profit) by enterprise value. They are then ranked; the higher the yield the lower the rank.
Next, returns on capital employed (ROCE) for the companies are calculated. ROCE is derived by dividing EBIT by the capital employed. Again the companies are ranked. The higher the ROCE, the lower the rank number.
Finally, the two ranks are combined. The list is then sorted in the increasing order of the rank number and the top 30 stocks are selected.
Modified filters for Indian markets
1. ROCE consistently more than 20% over the past 5 years
2. Rank the companies on the basis of earnings yield and then on the basis of the latest ROCE
3. Take 30 stocks based on the combined rank
This story appeared in the July 2017 issue of Wealth Insight.