How Joel Greenblatt’s magic formula can help your investing

Joel Greenblatt is worth listening to. After setting up Gotham Capital in 1985, his fund returned 40% a year for the next 20 years. And unlike some investors, Greenblatt who is also a professor at Columbia Business School -is very generous with his views on how to invest successfully.

He is the author of two excellent books - You Can Be a Stock Market Genius and The Little Book That Beats The Market. The books are jargon free, easy to read, and full of good advice for the private investor.

At the heart of the latter book is a simple but powerful formula that Greenblatt believes investors can use to generate market-beating returns. How can they do this? Put simply, by buying good companies cheaply.

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But how do you find these companies?

How to spot good companies

According to Greenblatt, good companies are ones that generate high returns on capital employed (ROCE).

Effectively, this ratio looks at companies in the same way as you would a savings account. What you want is a company that offers you a high rate of return. ROCE is preferred to return on equity (ROE ). Different companies have different tax rates and different levels of debt, which means that comparing ROEs can be misleading.

Here's an example of how this works. Two entrepreneurs, Andy and Bob, both sell ice creams. They have identical sales and operating profits, and each has invested £500 in his business. Andy has funded his business with all his own money or equity. Bob has used some of his own money but has also taken out a bank loan.

If you were to look just at ROE, you might come to the conclusion that Bob's Cones is a better business than Andy's Ices - but that would be wrong.

By looking at ROCE, you are looking at the returns to all the providers of finance in a business not just equity. By doing this, you can see that there are no differences between the returns of the two companies (20%). They are just financed differently.

How to spot cheap companies

The price/earnings (p/e) ratio remains popular with investors due to its simplicity. However, Greenblatt advises a different approach. As with ROE, the p/e can be distorted by different tax and financing structures and has the potential to mislead investors.

Greenblatt says investors should identify cheap companies by looking at the earnings yield. He defines this as operating profits divided by enterprise value (market cap + net debt). Cheap companies have high earnings yields.

The rationale for this is to use a whole business approach when investing. When you buy a business you are buying all its assets that are financed by either equity or debt or both.

Enterprise value is the price you pay for these assets. Operating profits are the returns to the providers of equity and debt. This version of earnings yield is therefore a cleaner and more appropriate valuation measure than a P/E ratio. Let's return to our two companies.

As you can see, the lower P/E ratio suggests that Bob's Cones is cheaper than Andy's Ices. This doesn't make sense given the identical operating performance of the two companies. The earnings yield spots this and gives both companies identical valuations.

Putting the magic formula to work

Having established the theory behind the magic formula how do you use it? You take a selection of companies maybe the whole market and you calculate return on capital and the earnings yield for each.

Every company is then given a ranking based on both measures the highest ROCE and earnings yields are given the number 1 and so on. The rankings are then added together, with the companies having the lowest combined scores being the most attractive investments.

Here I've taken the FTSE 100 retail sector as an example.

This process is quite time consuming. We have taken our data from Bloomberg analyst forecasts for the next reporting period. Next is seen as the most attractive magic formula stock, with Sainsbury's the least attractive.

What to remember

Studies suggest that this formula-based approach has worked quite well over time. Greenblatt himself has used it to beat the market handsomely in some of his funds indeed, he has a useful site applying the formula to US stocks (www.magicformulainvesting.com).

We think that the ROCE and earnings yield approach suggested by Greenblatt represents an excellent way to find good stocks. It steers investors away from the problems of tax and debt that cause problems when using P/E ratios.

However, we do still think that investors should do a little more homework before buying the stocks suggested by the formula. For one thing, the formula doesn't work well with utility and financial stocks given their financing structures.

Also, when applying this formula to the whole market, it can suggest very strange portfolios. Theten most attractive stocks in the FTSE All-Share might turn out to be mining companies. Is it sensible to have a portfolio full of mining stocks? We don't think so.

Still, no magic formula' for investing is foolproof and in all, Greenblatt's approach is a very useful one to add to your investing toolkit.