Is there a magic formula for making money from investing?

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?

Greenblatt sets out his formula in his classic The Little Book That Beats The Market, a short, well-written book that is a must for any investor’s bookshelf. His approach is very simple – it’s all about looking at a company’s returns as if they were interest rates.

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).

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?

Greenblatt’s book sets out an impressive market-beating track record. Between 1988 and 2009 a magic-formula portfolio delivered average annual returns of 23.8% per year compared with9.6% for the S&P 500 index.

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

No strategy works all the time. Blindly investing to a formula takes a lot of emotion out of investing, but is not always a good idea. The magic formula may lead you to hold lots of shares that are heavily concentrated in a particular industry, making for a risky, unbalanced portfolio.

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.

What’s it telling you to buy now?

Some stock-screening websites, such as Stockopedia, have Greenblatt’s screen set up and ready to use. A look at some bigger companies came up with the shares listed in the table to the left.

Company Ticker Market value (£m) ROCE (%) Earnings yield (%)
Reed Elsevier REL 6,373 56.3 10.9
Royal Mail RMG 5,890 41.9 24
Dragon Oil DGO 2,956 46 26.3
Carillion CLLN 1,488 46.6 11.7
SOCO SIA 1,468 52.9 23.3
CSR CSR 1,130 73.8 10.6
Unisys USY 874 31.3 22.0
Interserve IRV 749 72.2 24.3
Centamin CEY 520 22.3 30.6
Xchanging XCH 447 48.0 13.5