We'd all love to find a foolproof investing method that makes money in both good times and bad. Sadly, it doesn't exist. But some methods make more sense and have a better track record than others. One such method is Joel Greenblatt's so-called magic formula: buying good-quality businesses at cheap prices.
How does it work?
The Little Book That Beats The Market
The best businesses are the ones that earn the highest rates of interest on the money they invest. You work this out by calculating a firm's return on capital its trading profits (earnings before interest and tax, or EBIT) divided by its tangible capital invested (this is stock inventory, plus money owed by debtors, less money owed to trade creditors, plus fixed assets).
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In terms of the price you pay, you look for the companies with the highest earnings yield what the business earns compared with the purchase price of the business. This is defined as a company's trading profits divided by the market value of the business (its market capitalisation plus net financial debt).
Greenblatt focuses on EBIT so that he can look at the profits the whole business is making. This means he can easily compare companies without worrying about the distortions caused by debt levels and different tax rates that show up in measures such as earnings per share (EPS) and price/earnings (p/e) ratios.
There are no forecasts in this formula. All selections are made based on current profits and prices.
That's all well and good, but how do you go about finding great companies at cheap prices? It takes a long time to do this with a newspaper and a notepad; you ideally need the help of a decent stock-screening product. Here's what to do:
Select a universe of stocks with a minimum market capitalisation of, say, £50m each. This ensures that the shares are liquid enough to buy and sell easily.
Set a minimum return on assets or return on investment of 25%; rank them in order, with the company with the highest returns having a rank of one.
Instead of earnings yield (not many screeners will have this), look for companies with low p/e ratios and rank them, with the lowest p/e ranked one.
Eliminate all utilities and financial stocks.
Then add the rankings together to get a combined score.
Buy the five to seven top companies. Repeat every two to three months until you have a portfolio of 20-30 stocks.
Sell each stock after you have held it for a year and replace it with a new magic formula stock.
Continue this process for at least three to five years or for as long as you can.
Does the formula work?
It had some stellar years with returns of more than 70% in 1991 and 2001 and over 80% in 2003. However, it had a bad year in 2008, losing nearly 40%, which was worse than the S&P 500.
Its recent performance is not as stellar. In November 2010, Greenblatt's firm, Gotham Capital, set up the Formula Investing US Value Select Fund based on the magic formula principles. Since then it has returned 53.3%, marginally beating the SPDR S&P 500 ETF (49.5%).
Things to look out for
The return on capital calculation also ignores intangible assets and fails to adjust for companies that rent rather than own assets, or have big pension fund shortfalls. This could lead to companies looking good when they are in poor shape.
Watch out for trading costs as well. Buying and selling up to 30 companies a year will cost a lot in dealing commissions that reduce portfolio returns, particularly on smaller amounts of money invested.
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Phil spent 13 years as an investment analyst for both stockbroking and fund management companies.
After graduating with a MSc in International Banking, Economics & Finance from Liverpool Business School in 1996, Phil went to work for BWD Rensburg, a Liverpool based investment manager. In 2001, he joined ABN AMRO as a transport analyst. After a brief spell as a food retail analyst, he spent five years with ABN's very successful UK Smaller Companies team where he covered engineering, transport and support services stocks.
In 2007, Phil joined Halbis Capital Management as a European equities analyst. He began writing for MoneyWeek in 2010.
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