Magic Formula Investing (Joel Greenblatt)
Joel Greenblatt recommends buying a portfolio of 20-30 Magic Formula stocks, holding for one year, and then re-running the process annually. Check out the Internet-site provided by Joel Greenblatt (s. screenshot/picture below).
It’s hard to take something called a “Magic Formula” seriously. But you should. It’s beaten the market by a wide margin over the past two decades and with less volatility (Status by the year 2013!).
The Magic Formula - a stock screener designed by hedge fund guru Joel Greenblatt - ranks stocks by two factors:
♦ Profitability (based on Greenblatt’s chosen metric, Return on Capital)
♦ Earnings yield (the inverse of the P/E ratio, defined here by Greenblatt as EBIT / Enterprise Value)
Buying good, profitable companies at cheap prices is not exactly a revolutionary idea; this is what Warren Buffett has successfully done for decades. But Greenblatt has created a systematic way to do it, and most of the heavily lifting of number crunching is done by the screener.
By Greenblatt’s analysis, the Magic Formula generates annual returns in excess of 30% per year. Independent back tests have generally come up with smaller returns, though the general consensus is that the Magic Formula does indeed beat the market, even after taxes and transactions costs are taken into effect.
Another final remark: Greenblatt explains that his strategy will work even after everyone knows about it. Why? Most investors and money managers seek short-term results. Their investment time horizon is short; hence they typically bail after a one or two year period of performing worse than the market average. Remember, this is a long-term strategy. On average, in 5 months out of each year the magic formula performs worse than the overall market. But over a period of 17 years it was shown to generate an average annual return of 30.8 %. But dont't forget: This is just theory from the past - nobody CAN know, if this theory will turn out into profitable investments in the future (again)...