Joel Greenblatt's Magic Formula: Combining Value and Quality

Joel Greenblatt's Magic Formula: Combining Value and Quality

Many people think investing has to be complicated. They think it takes a massive amount of in depth analysis to find attractive stocks. They think you need CFAs and other advanced designations to have any chance. But Joel Greenblatt turned that idea on its head with the publication of his book “The Little Book That Beats the Market”. In the book, Greenblatt outlined a simple investment strategy that used only two criteria to find good companies trading at a discount. We have used that model to construct our Validea Earnings Yield Investor strategy.

Who is Joel Greenblatt?

Joel Greenblatt is the founder and managing partner of Gotham Capital, a hedge fund that consistently outperformed the market since its inception in 1985. Greenblatt’s investment prowess is exemplified by his fund’s remarkable annualized returns of over 40% from 1985 to 2006. He is also the author of several bestselling books on investing, including “The Little Book That Beats the Market” and “You Can Be a Stock Market Genius.”

The Magic Formula Criteria

Greenblatt’s magic formula is based on two key criteria: earnings yield and return on capital. The formula aims to identify companies that are both cheap and profitable, with the belief that these stocks have the highest potential for outsized returns.

  1. Earnings Yield: The earnings yield is calculated by dividing a company’s operating profit by its enterprise value. This ratio helps identify companies that are generating significant profits relative to their market value.
  2. Return on Capital: Return on capital measures a company’s efficiency in allocating its capital to profitable investments. It is calculated by dividing a company’s after-tax operating profit by its invested capital. A high return on capital indicates that a company is effectively using its resources to generate returns.

Performance of the Magic Formula

In his book “The Little Book That Beats the Market,” Greenblatt provides compelling evidence of the magic formula’s effectiveness. He back tested the strategy from 1988 to 2004 and found that a portfolio of the top 30 magic formula stocks, rebalanced annually, would have returned 30.8% per year on average, compared to 12.4% for the S&P 500 over the same period.

Although attempts by researchers to replicate these eye-popping results have largely not been successful, further research has found evidence for long-term outperformance of the strategy.

Validea’s Joel Greenblatt Model

Validea has developed a stock screening model based on Joel Greenblatt’s magic formula. The model assigns scores to stocks based on their adherence to the magic formula criteria, with higher scores indicating a stronger alignment with Greenblatt’s investment philosophy.

Currently, several stocks are receiving perfect scores of 100 according to Validea’s Joel Greenblatt model. Let’s take a closer look at five of these top-scoring companies:

  1. HP Inc. (HPQ): HP is a leading provider of personal computers, printers, and related supplies. The company’s strong earnings yield and high return on capital make it an attractive investment opportunity according to the magic formula criteria.
  2. Altria Group, Inc. (MO): Altria is one of the world’s largest tobacco companies, with a diverse portfolio of brands including Marlboro cigarettes and Ste. Michelle Wine Estates. The company’s consistent profitability and attractive valuation make it a top pick for the Greenblatt model.
  3. AutoNation, Inc. (AN): AutoNation is the largest automotive retailer in the United States, operating a network of dealerships across the country. The company’s strong financial metrics, including high earnings yield and return on capital, contribute to its perfect score on the Greenblatt model.
  4. J.Jill, Inc. (JILL): J.Jill is a leading retailer of women’s apparel, accessories, and footwear. The company’s attractive valuation and solid profitability make it a compelling investment opportunity according to the magic formula criteria.
  5. Mastercraft Boat Holdings, Inc. (MCFT): Mastercraft is a leading manufacturer of premium recreational boats, including ski boats, wakeboard boats, and luxury performance powerboats. The company’s strong financial performance and attractive valuation contribute to its perfect score on the Greenblatt model.

Joel Greenblatt’s magic formula has proven to be a powerful tool for identifying undervalued stocks with strong growth potential. The strategy gets at the essence of investing by focusing on the two main questions investors often ask when looking at potential investments.

  1. Is this a good business?
  2. Am I buying it at an attractive price?

 By combining those two and focusing on companies with high earnings yields and impressive returns on capital, the strategy seeks to combine aspects of both value and quality investing. Like all investment strategies, it will have periods where it struggles and doesn’t work, but its core principles should allow it to identify quality companies over time

Links for Further Research

Top Joel Greenblatt Magic Formula Stocks

Joel Greenblatt Guru Analysis