It was late last year that Joel Greenblatt’s new book — “The Little Book That Beats The Market” — was published. I recommended it to our members. I also announced that Greenblatt’s Magic Formula list would be our primary screening source to find winning investments. Since then we have been able to identify some very profitable investments using Greenblatt’s formula.
In fact, two-thirds of our current portfolio consists of Magic Formula stocks. Currently, those stocks are up over 60% on average and we’ve only been in them for an average of about five months. So the Magic Formula works.
Now that the publicity over the book has died down in favor of new hot-off-the-press investment books (everybody’s looking for the Holy Grail), I think it would be a good time to review the main points of the book.
What Can You Do With Your Money?
Greenblatt makes the point that you only have a few basic alternatives for what you can do with your money. You could put it under a mattress. But that hasn’t worked very well for the people who have tried it. You could buy U.S. government bonds. At least you’re guaranteed to get your money back with some interest. You could buy corporate bonds and get more interest, but you may not get your money back. Or you can buy partial interest in businesses.
What It Means To Buy a Partial Interest in a Business
When you buy shares of stock you’re buying a partial interest in a business. You own a portion of that business’s future earnings. The worth of the business depends on how much the business will earn in the future. In order for it to make sense to buy a partial interest in a business, your share of the profits must be more than you can get from owning a risk-free U.S. government bond.
The Behavior of Stock Prices
Ben Graham (the father of value investing and Warren Buffett’s mentor) described stock price behavior with his famous “Mr. Market” metaphor. Imagine that you have a business partner named Mr. Market. Mr. Market is kind of a strange guy, subject to wild mood swings. Every day he comes into your office and offers to sell you his interest in the business. His price is different every day and he leaves it up to you whether or not you want to accept his deal. Some days he wants to sell at a price that is too high and some days he wants to sell at a ridiculously low price. It’s completely up to you. He doesn’t even seem to care if you accept his offer. He just keeps coming in every day with a new offer.
Warren Buffett has described it this way. As an investor, you’re like a batter in baseball. You patiently stand at the plate and wait for a good pitch to hit. Except in this game the umpire is not going to call you out on strikes. You can just take pitch after pitch until you get a good one to hit. Eventually the pitcher will make a mistake and serve you a fat pitch right down the middle of the plate. That’s the one you want to hit out of the park. The key is to wait for your pitch.
That’s the way the stock market works. Stock prices move around crazily over the short term, but the value of the business doesn’t change. If you’re patient, you will have an opportunity to buy a partial interest (shares) of a good business at a ridiculously low price.
Buying Shares of Good Businesses at a Bargain Price
You want to buy shares of good businesses when they are selling at a bargain price. In other words, you want to buy when a good business has a high earnings yield. You know if it’s a good business if it can invest its own money at a high rate of return. And that means you want businesses that earn a high return on capital.
So to make money — maybe a lot of money — all you have to do is buy shares of good businesses (high return on capital) when the shares are selling at a bargain price (high earnings yield).
The Magic Formula
Here’s the Magic Formula:
To identify good businesses, use the following Return on Capital formula:
EBIT/ (Net Working Capital + Net Fixed Assets)
“EBIT” stands for earnings before interest and taxes. “Net Working Capital” is working capital minus interest-bearing current liabilities and excess cash. To get working capital subtract current liabilities (less interest-bearing current liabilities) from current assets. Greenblatt doesn’t explain how he computes excess cash. But if you consider any cash that’s on the balance sheet that’s above 5% of annual sales to be excess cash, you’ll be in the ball park.
To identify when good businesses are selling at a bargain price, use the following Earnings Yield formula:
EBIT/Enterprise Value
“Enterprise Value” is the market capitalization of the stock (the price of the stock times the number of shares outstanding) plus total debt minus cash and short term investments.
That’s all there is. According to Greenblatt’s extensively tested research, owning a portfolio of about 30 stocks that have offered the best combination of Return on Capital and Earnings Yield would have returned about 30.8% per year over the 17 year period from 1988-2004.
And you don’t have to do the research yourself. Greenblatt has made it really easy for you. Every day he lists the stocks that have the best combination of Return on Capital and Earnings Yield on the Magic Formula Web site. It doesn’t get much easier than that.
Why the Magic Formula Will Continue To Work After Everybody Knows About It
Here’s the most important thing you need to know about the Magic Formula. The reason the Magic Formula will continue to work after everybody knows about it is that it doesn’t always work. I know that sounds counterintuitive, but I can tell you from my experience of many years of working with people and their money that it’s the absolute truth.
The deal is that the Magic Formula can under perform the market for months and years at a time. And the number of people who have the discipline to stick with a winning system during the periods of underperformance are few and far between. As soon as it starts underperforming, most people will abandon it in favor of something else.
The great trader, Richard Dennis, once said that he could publish his exact system in the Wall Street Journal and it wouldn’t matter because people would not have the discipline to follow it.
So this is wonderful news for people who understand what I’m talking about — the Magic Formula will continue to work precisely because it doesn’t always work.
Conclusion
The above is just a summary. You need to read the book to know how Greenblatt conducted his research and to get all the details. The book can be read in just a couple of hours.
Greenblatt suggests that you buy any 20 or 30 Magic Formula stocks. He suggests holding them for one year before selling (adjusting the holding period by a few days one way or the other for taxable accounts). And then buy more Magic Formula stocks that you will hold for a year. On this site, we don’t do it that way. As Greenblatt says in his book, there will be those who find other profitable ways to use the Magic Formula.
We use the Magic Formula Web site as our primary screening tool. We start with the list of stocks that are on that site and research them from there to find the ones we think will continue to have earnings increases in the future. Also, we choose the ones that are in what we think are the most promising sectors. And we don’t buy 30 stocks as Greenblatt suggests. We buy no more than 10. In addition, there are some other things we do that are different to manage our risk.
However, if you’re inexperienced I suggest you do it exactly as Greenblatt recommends. It’s an important book. Read it. You’ll be glad you did.
Larry Holmes
