'The Magic Formula' Joel Greenblatt Investing Strategy

20 Oct 2020  Read 378 Views

In the realm of investing, it isn't extraordinary to discover masters that want to disclose their most recent disclosure, an enchantment equation for trading that will make you more extravagant than Warren Buffett; or a trading formula that will allow you to spend the rest of your life on an island.

Tragically, more often than not, the only thing that will change after studying this formula and all the financial statements is the amount in your bank account. Truth be told, 99% of the time you will simply lose time and a ton of cash following the expressions of a quack with no dependable history, that wins cash by selling average items.

If there is a magic formula to make more money than Warren Buffett, then let us talk about the only sensible formula, i.e. 'The magic formula' investing strategy by Joel Greenblatt.

Who is Joel Greenblatt?

Joel Greenblatt, a hedge funds manager and teacher at Columbia University, presented the "magic formula" investing strategy in The Little Book That Beats the Market. 

In 2010, a follow-up book titled, 'The Little Book That Still Beats the Market', was distributed with refreshed insights. Greenblatt additionally kept in touch with 'You Can Be a Stock Market Genius'.

He called the formula "magic" in the light of the fact that, as per his testing, the strategy averaged 24% returns every year between 1988–2009. On the off chance that you invested in an index fund during that period, the return would have been 9.55%. The percent difference turns out to be more observable when placed into dollar terms. 

On the off chance that Rs 10,000 was invested at 24% and Rs 10,000 invested at 9.55% over that time span, the formula would have turned Rs 10,000 into simply over Rs 1 million, while the S&P 500 list would have transformed Rs 10,000 into just shy of Rs 5,000. 

Greater returns matter, particularly over significant stretches, because of the intensity of compounding. Underneath, we take a gander at what the strategy is, the means by which to actualize it, just as whether the strategy satisfies Greenblatt's case.

Understanding the Magic Formula Investing Strategy

The formula depends on two principle measures, the stock price and the organization's cost of capital. It necessitates that you put resources into those organizations that own either an exceptional return on capital or ROC or high earning yield (a stock's earlier year's earnings per share divided by the current share price). The earning yield is the factor that shows whether the stock is selling at a decent price or not.

ROC is the ratio of pretax operating earnings (EBIT) to tangible capital employed (net working capital + net fixed capital). It is calculated; 

ROC = EBIT / (net working capital + net fixed capital).

Enterprise value = Market value of all equity + net interest- debt. 

Earning yield = EBIT/EV

For instance, if an organization's earnings are Rs. 0.50, and the stock is trading at Rs. 4/share, by dividing Rs. 0.50 by Rs. 4 you get an earnings yield of 12.5, which is pretty high. 

At that point, the return on capital shows how well an organization can transform an interest in profit. In this manner, it is fundamentally the profit percentage, so if somebody invests Rs. 50,000 and acquires Rs. 2,500, their ROC would be 5%.

Three steps suggested by Joel Greenblatt:

1. Calculate the Earning yield and ROC of stock.

2. Rank the organizations as per the above two factors and combine them to find the best companies for investment.

3. Have patience and invest for the long term.

How Magic Formula works?

Company Symbol

ROC Rank

EY Rank

Combined Rank

A

1

153

154

B

2

35

37

C

3

37

40

D

4

480

484

E

5

13

18

F

6

127

133

G

7

78

85

H

8

512

520

I

9

120

129

J

10

95

105

Step 1: Establish minimum market cap to get a list of all stocks that meet the criteria.

Step 2: Exclude utility and financial stocks.

Step 3: Exclude foreign companies.

Step 4: Determine the earnings yield of the companies.

Greenblatt uses EY to find how much a business earns relative to the purchase price of the business.

Earning yield = EBIT/EV

Step 5: Calculate ROC. Using EBIT allows investors to compare the operating earnings of different companies without the distortions resulting from differences in tax rates and debt levels. 

ROC = EBIT/ (Net fixed assets + working capital).

Step 6: Rank all the stocks by highest-earning yields and highest ROC.

Step 7: Invest in 20-30 highest ranked companies. Do so by accumulating 2-3 positions per month over a 12-month period.

Magic formula investing recommends rebalancing portfolio once per year. Rebalancing sells losers one week before the year mark and winners, one week after. 

The plus point of this strategy is tax efficiency. In actuality, the investors that use this technique will sell losing stocks before they have held them for 1year, and consequently, they will utilize the income tax provision that permits speculators to utilize losses to offer their profits. 

Also, they will close the profitable activities after the one-year point. By doing so, they exploit decreased income tax rates on long term capital additions.

Purchase time and seasonality

The strategy recommends buying 2-3 stocks every month over the course of a year. This spreads out purchases and avoids buying all stock right before a big rise in the market.

Spreading purchases out is fine; however, another thought is to see how stocks will, in general, perform during the year—called seasonality. In view of market inclinations, throughout the most recent 20 years, January is ordinarily a poor month for stocks, and June–September likewise normally observes stocks decrease. All things considered, for that month.

Those who want to accumulate more stocks at once may wish to make more stock purchases toward the end of January or early February or June through the end of September, taking advantage of depressed prices.

Conclusion

To start with, it is instinctive. Investing by the Magic Formula criteria includes selecting outperforming organizations at below-average prices. These investment principles have demonstrated track records from proven investors, including Graham and Buffet.

Secondly, various discoveries and backtest information confirm that the investment strategy works amazingly. These findings exhibit that the Magic formula produces returns that are approximately double market returns.

In closing, let us hope this article gave advice and insight about the Magic Formula investment strategy.

Investors looking to maximize their returns should have exposure to this type of strategy that can provide returns that outperform the market.

About the Author: Ishita Jha | 21 Post(s)

Ishita Jha is an MBA Finance student of BIMTECH, now a blogger; trying to survive the pandemic recruitments. She can be found researching, exercising, and binging to balance life. She finds her happy place in writing.

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