The Magic Formula
Here's Greenblatt's formula:
1. Compute the stock's earnings yield, which is earning per share divided by price. Rank all stocks from best to worst.
2. Compute the stock's return on investment, which is earnings divided by capital. Rank all stocks from best to worst.
3. For each stock, compute an overall score by averaging the two ranks (both components are equally weighted).
4. Rank all stocks from best to worst based upon this new combined score.
Basically, that's it. Pick the stocks that rank highest.
The catch . . . sort of
Usually if something appears too good to be true it is. The same can sort of be said for the simplicity of the procedure described above.
For earnings yield, we're actually using beefed-up definitions of each item, EBIT instead of EPS and Enterprise Value instead of stock price. For return on capital, we also use EBIT and instead of a standard definition of capital, we use Tangible Capital (all these terms are defined below).
But don't worry. The simplicity isn't really cancelled. Even these variables can be easily constructed on Portfolio123, and those using screeners that can't match the definitions are told in The Little Book That beats The Market how they can revert back to more generic variables if need be.
Magic or Common Sense
Actually, there's nothing truly magical about Greenblatt's formula. It works because it ought to work. It makes sense! It directs you to good-quality companies whose shares are reasonably priced. What more could any investor pursuing any strategy ever want? This is actually the same goal as we see in most other All-Star strategies.
Greenblatt's contribution to stock selection isn't to be found in the substance of the strategy. It's the notion of simplicity. Powerful results achieved by other All-Stars make it clear that the complexity they often bring to the table is not to be casually dismissed. Even Greenblatt has good reasons for defining his variables as he does. But for those who are unwilling or unable to handle complexity, Greenblatt reminds us that it's not mandatory.
The role of simplicity
We have to acknowledge right here that backtested results of our Greenblatt model, while better than the S&P 500 (consistent with Greenblatt's claims), rank last among the other Portfolio123 All-Star strategies.
Why, then, should anybody consider using this strategy?
Backtests necessarily deal with the past. We can never be sure the results we see will be replicated in the future. So test results must always be combined with common sense in choosing to use or not use a particular strategy. And when it comes to common sense, Greenblatt probably tops the list when it comes to obvious merit.
Perhaps the single biggest mistake investors tend to make is failing to truly understand what they are doing and why. That shouldn't happen with Greenblatt. This model is about as understandable as can be.
For investors who want to use a model as an idea-generator rather than to automatically generate buy lists, understandability can have a direct dollars-and-cents impact on a portfolio. Because it's so easy to recognize why an individual stock ranks as it does under the Magic Formula, it's easy for an investor doing in-depth research on an individual idea to identify particular companies that meet the letter of the law but not its spirit (e.g. earnings inflated by factors that are not likely to be sustainable in the future), this being a key reason why an individual stock might not perform as the model suggests.
So regardless of its backtest standing relative to our other All-Star strategies, this one merits a place at the table.
Too much of a good thing?
Having established the benefits of simplicity, it now seems odd to wonder about whether the strategy, as published, is too simple. But we're going to do that, because the issue that catches our attention is one Greenblatt himself found it necessary to address in his book.
For earnings, however they are to be defined, he uses just the latest year's figure. He doesn't make clear whether this is the last reported fiscal year or the trailing 12 months, a distinction that can be huge late in the new year as the last annual figure grows increasingly stale. In all cases, we use the trailing 12 month number.
The bigger question in the context of the book is whether any single 12-month period is really best. Suppose this result reflects factors that might not persist into the future? In Chapter Five, where Greenblatt explains return on capital, he goes back and forth between describing profitability in terms of a single year and a per-year basis without really addressing the difference between the two concepts.
Later on, though, in Chapter 11, Greenblatt shows awareness of the difficulties in using the latest available set of numbers. He addresses it by considering use of estimated future earnings. He acknowledges that use of estimates can be difficult. The next year might also be unrepresentative. So, he says, we might be better off looking three or four years ahead into a presumably normal environment. But that's more difficult. We'd have to make judgments about how confident we are in our analysis and compare this new earnings yield to returns on other types of investments. Then, on page 103 of his book, Greenblatt writes as follows:
Does that sound hard to do. Well, it is. Yet it's not impossible. There are (emphasis in original) people who can do this type of analysis. In fact, this is precisely the way may partners and I use the principles behind the magic formula to make our own investment decisions (emphasis added).
Considering Greenblatt's recognition of the sustainability question and his acknowledgement that he modifies the simple formula when he actually invests, and considering the general approach of the Portfolio123 All-Star models (that they not be passive laundry lists of factors but instead strategies that, while based on All-Star writings, can comfortably stand on their own), we go with our thoughts and add our own single, and we believe, comparably simple and common-sense-supported addition. Before we will apply the Magic Formula, we will filter the investment universe not just by a few Greenblatt factors (size, ADRs, specialized sectors) but also by a requirement that the company's five-year average return on investment exceed the industry average. This is another approach that can help us weed out situations where the latest 12 months may not be representative of what the company is truly about. (When it comes to simplicity, our extra rule might not have been viable twenty years ago, but with modern applications like Portfolio123, this test is now quite easy to implement.)
The Portfolio123 Joel Greenblatt model
As noted, this model reflects the general principles used by Portfolio123 for its All-Star screens. Specifically, our Joel Greenblatt strategy is as follows:
The screen uses the following rules:
Liquidity filter: Universe(foliofn), which means the stock must be tradable in the Folio Investing.com window system; for backtesting purposes, substitute a rule that bars OTC stocks. (Click here for more information)
Eliminate companies classified in the Miscellaneous Financial Services Industry, most of which are investment companies and funds and not the kind of stocks this all-star tended to seek
Market Capitalization at least $50 million
No ADRs, finance stocks or real estate stocks
Three-year Return on Investment is above the industry average
Among the companies that pass the above screen, we select the top 15 based on the Greenblatt ranking system, which uses the following factors:
Return on Capital - 50% of total
Earnings before Income Taxes (and excluding unusuals) divided by Tangible Capital (net plant plus working capital)
Earnings Yield - 50% of total
Earnings before Income Taxes (and excluding unusuals) divided by Enterprise Value (Market Capitalization plus Total Debt minus Cash)
Portfolio123 users who would like to examine the details or copy the models for their own use, may do so:
Click here for the Joel Greenblatt screen
Click here for the Joel Greenblatt ranking system
Figure 1 and Table 1 show the results of a five-year backtest running through 1/12/10 of our Greenblatt strategy. It assumes rebalancing every four weeks and selection of the top 15 stocks as per the screen sorted on the basis of the Joel Greenblatt ranking system.