The Little Book that Beats the Market - Joel Greenblatt

Little Book That Beats the Market - Joel Greenblatt - Magic Formula

A margin of safety

Value investing is not about looking for low price-to-book or low price-to-sales ratio. It involves assessing a company’s expected cash flows and buying them at a discount to its worth. However, it is difficult to know whether a stock is trading at bargain prices and whether our assessment of future performance is reasonable. Hence, we should endeavour to buy shares in a company with a wide margin of safety. These are companies with stocks at market prices that is well below our conservative estimate of its intrinsic value. In the Little Book that Beats the Market, Joel Greenblatt outlines his methodology and magic formula to help value investors find good companies at bargain prices. We review a few of his ideas briefly in this post.

Joel Greenblatt and his magic formula

Joel Greenblatt’s magic formula is in the spirit of value investing. It comprises of two primary filters to help investors find above-average companies at below-average prices. Put simply, it involves looking for companies with a high earnings yield and high returns on invested capital; and building a diversified portfolio of stocks with the highest combination of these two filters. We discuss the two filters in brief as follows.

High earnings yield

The earnings yield is the first important measure under Greenblatt’s magic formula. He uses the following ratio to calculate the earnings yield of a stock:

Earnings yield = EBIT / Enterprise Value

Greenblatt’s rationale is simple. It is better and safer to purchase a business that earns more relative to the price we pay. In other words, we prefer stocks with higher earning yields than comparable stocks with lower earning yields. He prefers this measure to the earnings to price ratio because it accounts for both the equity and debt financing required to generate operating earnings.

High return on capital

Return on capital is the second important measure under Greenblatt’s investment framework and magic formula. His rationale is that companies that achieve high returns on capital will have an opportunity to invest future profits at high returns on capital. This can allow for above-average earnings growth.

While the news of good returns tends to attract competition, a company that has achieved high returns on invested capital consistently is more likely to have a durable competitive advantage. Otherwise, the competitors would have already entered to drive both profits and returns on capital back to average or below-average levels.

All things considered, it is preferable to own shares in good companies than in bad companies. Good companies are more likely to invest their free cash flow at higher rates of return. Greenblatt’s magic formula uses return on tangible capital employed for calculation and evaluation of stocks:

Return on tangible capital employed = EBIT / (Net Working Capital + Net Fixed Assets)

Greenblatt has noted that other measures such as return on assets and return on equity can be distorted by the effects of debt levels, tax rates and reported assets. He prefers to use return on tangible capital for these reasons.

Some fine-tuning

If using Greenblatt’s formula, he recommends investors use normalised earnings for calculating our estimates of yield and return on capital. We might otherwise bias our assessments by focusing only on single-year estimates with extraordinary results. Similarly, using EBIT allows us to compare the operating earnings power of companies with different debt and tax rates without distortion. Depreciation and amortisation is also included to help account and proxy for maintenance capital spending requirements.

Greenblatts to exclude intangible assets from our estimates of tangible capital employed because goodwill is a historical cost that does not require replacement. He believes it is less likely to reflect future returns on capital. We argue that this might not necessarily be true for highly acquisitive companies that pay significant premiums for their purchases. Likewise, brand or software intensive companies may have a maintenance spend for their intangibles. Although such expenses are often operating in nature (e.g. R&D, marketing, etc.).

Magic formula simplified

For the part-time investor, Greenblatt’s filter for earnings yield and return on tangible capital employed is not always easy to compute. However, hobby investors can look for companies that achieve return on assets (ROA) at 25% or higher as a substitute for return on tangible capital employed. You can then sort for stocks under this filter with the lowest price to earnings ratio as a substitute for the earnings yield.

However, stocks with very low price to earnings ratio (less than five) may have reporting issues or contain unusual characteristics. These should be excluded or scrutinised with more caution. Additionally, a Greenblatt screen also excludes utilities and financial stocks (e.g. banks, insurance, mutual funds, etc.) from this filter as their financial reporting, key metrics and underlying economics can be very different.

Alternatively, you can visit and sign up with Joel Greenblatt’s Magic Formula Investing website. He provides his screen of US stocks with filters for high earnings yield and return on tangible capital.

Beating the market

Greenblatt has shared the results of historical back testing as evidence for the formula’s potential to outperform the market. We exclude his empirical results here for brevity. However, the formula can underperform the market for several years before achieving attractive results. Investors may have difficulties coping with this if their investment horizon is not long enough. More importantly, past results is not an indicator of future performance.

Greenblatt believes that most professionals and academics are unable to help if you want to beat the market. You will have to do it yourself because the incentives of most professionals and academics are misaligned with yours. This requires you to develop an investment strategy and displined approach. Additionally, it requires you to understand the risk of permanent loss of capital, and risk of under-performance relative to alternative investment strategies.

Doing this well is not easy. However, Greenblatt suggests that if you can research and understand your companies well, owning five to eight at bargain prices and across different industries can be an effective strategy over the long-term. Joel Greenblatt and his magic formula screen may or may not provide a starting point.

The Little Book that Beats the Market – Joel Greenblatt and his magic formula