Widely read:
Joel Greenblatt, a hedge fund manager, rose to fame after giving stellar returns (30 per cent annualised net of all fees) to his shareholders during 1985-1994. Born in 1957, Greenblatt graduated from the Wharton School of Pennsylvania and published his paper 'How the Small Investor Can Beat the Market,' which eventually became a mantra for many retail investors. In association with Michael Milken (another famous bond investor), he founded Gotham Capital (not the Batman one!) in 1985. In 1996, he started teaching value investing at Columbia University's Graduate School of Business. His books 'You Can Be a Stock Market Genius' and 'The Little Book that Beats the Market' are bestsellers across the world, inspiring millions of investors.
An ardent follower of value investing, Greenblatt's Magic Formula technique is based on the Graham/Buffett value approach. The formula uses two metrics - return on capital employed (ROCE) and earnings yield. ROCE is calculated by using earnings before interest and tax (EBIT) divided by the capital employed, while earnings yield is calculated by dividing EBIT with the enterprise value. Investors can use the ROCE and earnings yield of, say, 1,500 companies and select the top 30 companies based on the combined ranking of both the metrics. By using this formula, investors will arrive at a list of companies having a great combination of quality and cheap valuation.
Methodology
To arrive at the companies we used Joel Greenblatt magic formula that we discussed above. These are the quantitative filters that were used:
- ROCE consistently more than 20 per cent in the last five years
- Rank companies based on earnings yield and then based on ROCE
- Take top 30 stocks based on the combined rank
Using the above-mentioned filters, we, at Value Research, have created a list in our stock screener which you can access anytime. You can head over to Joel Greenblatt Stock Screener page.
Greenblatt's investing strategy holds much relevance today, given that many companies are coming to the market with low returns on capital (if any), along with stratospheric valuations. While the magic formula can eliminate these pitfalls, there are still a few caveats. Outperformance may not happen every year and the formula generally works well only in the long term. So, you can do what Greenblatt does, i.e., use the formula as a screener and then use the results as a starting point to find attractive opportunities.
Also in the series:
New episodes every Friday
