Joel Greenblatt’s Original Magic Formula

Joel Greenblatt’s Original Magic Formula

Most investors are familiar with Joel Greenblatt’s Magic Formula, made famous in his book, “The Little Book That Beats the Market”.

The key drivers of the Magic Formula we know today are Earnings Yield (EBIT / Enterprise Value) and Return on Capital (EBIT / (Net Fixed Assets + Working Capital)). Companies are ranked according to these two metrics — highest earnings yield and highest return on capital — then the 20 to 30 companies with the highest ranks are purchased at a rate of two to three positions per month over a 12-month period.

However, before Greenblatt came up with this quality-and-value screen, he built a strategy around Benjamin Graham’s net-nets strategy, which relatively unheard of and has since become known as Greenblatt’s Original Magic Formula.

Greenblatt’s original Magic Formula

Greenblatt developed his Original Magic Formula with Richard Pzena, who currently manages Pzena Investment Management LLC, a value oriented global investment management firm with $28 billion in assets under management, and Bruce L. Newberg. The three money managers published their findings within the The Journal of Portfolio Management Summer issue 1981, Vol. 7, No.4, in an article entitled, “How the Small Investor Can Beat the Market: By Buying Stocks That Are Selling Below Their Liquidation Value

Greenblatt and his co-authors argued within the article that only way the small investor can beat the market, is by looking for undervalued stocks. To do this successfully, the investor has to look outside the realm of Wall Street’s analyst coverage:

“We should recall, however, that Wall Street research houses limit their coverage to fewer than 500 actively traded issues…Meanwhile the NYSE trades 2000 stocks, Amex trades 1000 companies, and the OTC market trades another 7000 issues…Under these circumstances, the individual may in fact be able to locate unrecognised values in the nearly 9000-stock second tier not closely followed by the “experts”.

The figures are different today, but the underlying argument remains the same. Greenblatt built up his deep value strategy from there:

“In an effort to discover whether inefficiently priced, undervalued securities do exist, we turned to the acknowledged father of security analysis, the late Benjamin Graham…decided to update Graham’s studies to see if his simple fundamental approach still provided the returns that could not be explained by an efficient market.”

To start, Greenblatt used Graham’s traditional net-nets formula to screen for bargains:

Current Assets – Current Liabilities – Long Term Liabilities – Preferred Stock / Number of Shares Outstanding = NCAV Per Share

After using this formula to build a rough list of qualifying NCAV stocks, Greenblatt went further, in an attempt to remove any ‘junk’ firms from the list — something that’s been a thorn in the side of the deep value investors ever since the strategy was first conceived. To try and remove the wheat from the chaff as it were, Greenblatt enlisted the help of the P/E ratio.

Separating out the chaff

Benjamin Graham’s last will was a set of ten rules used for stock selection based on Graham/s five decades of stock market experience. The list of ten points, published around the time of Graham’s death, will be familiar to most value investors:

  1. An earnings-to-price yield at least twice the AAA bond rate
  2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
  3. Dividend yield of at least 2/3 the AAA bond yield
  4. Stock price below 2/3 of tangible book value per share
  5. Stock price below 2/3 of Net Current Asset Value
  6. Total debt less than book value
  7. Current ratio greater than 2
  8. Total debt less than 2 times Net Current Asset Value
  9. Earnings growth of prior 10 years at least at a 7% annual compound rate
  10. Stability of growth of earnings in that no more than 2 declines of 5% or more in year-end earnings in the prior ten years are permissible.

There’s no denying that this list of rules is extremely onerous and in most markets the number of stocks that meet all ten criteria is likely to be minimal. (Société Générale publishes a monthly stock screen based on the Graham criteria — the April update can be found here — the bank’s analysts note that in the past two decades, only three companies have passed all ten criteria out of a universe of FTSE World Developed, FTSE 350 stocks and FTSE World Emerging stocks.)

When Joel Greenblatt set out to create his new NCAV strategy he clearly wanted it to be less restrictive than Graham’s criteria. However, Greenblatt also wanted his new deep value strategy to outperform, with less risk than the wider market.

To accomplish these goals, Graham’s list and put together and added the P/E ratio to his NCAV screening criteria. Greenblatt tested four different four portfolios, each with a different P/E screening criteria.

Portfolio one

  • Price below NCAV
  • P/E floating with corporate bond yields
  • No dividends required

Portfolio two

  • Price below 85% of NCAV
  • P/E floating with corporate bond yields
  • No dividends required

Portfolio three

  • Price below NCAV
  • P/E of less than 5
  • No dividends require

Portfolio four

  • Price below 85% of NCAV
  • P/E of less than 5
  • No dividends required

Stocks with a market cap of less than $3 million were discarded from the study. Stocks were sold after a 100% gain or two years had passed, whichever resulted first. The portfolios themselves were equally weighted, so the actual yearly returns of each portfolio were just the average returns of the stocks within each portfolio. The returns of the four portfolios were compared to the Value Line’s own value index.

Greenblatt orignal

The results show that portfolios three and four, which demanded qualifying stocks trade at a P/E of less than five, racked up the best performances of the group.

The average performance of portfolio three was 32.2% p.a. per annum excluding tax and commissions — the high portfolio turnover meant that returns were impacted significantly when including commissions (12.1% p.a. after including taxes and commissions).

Portfolio four returned 42.2% p.a., although this dropped to 29.2% p.a. after excluding taxes and commissions. Interestingly, these two portfolios performed better than Greenblatt’s second Magic Formula, which boasts of 30% p.a. returns.

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