JOEL GREENBLATT - THE LITTLE BOOK THAT BEATS THE MARKET - The Magic Formula.
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Would you like to achieve these percentages, return an average of over 30% per year for 16 years and turn £10,000 into £1,000,000 over the same period!?
In this video we show how Joel Greenblatt did exactly that.
In this animated video we present The Little Book That Still Beats The Market, by Joel Greenblatt.
Joel Greenblatt is an American academic, hedge fund manager, writer and value investor.
Before we look at how Joel Greenblatt achieved such high returns, let’s look at the numbers to see how a £10,000 investment would have grown during the 16 years.
These are the annual returns. The worst year showed a 4% loss and the best year was a return of 79.9%.
The average for the period was 30.8%.
Let’s turn these percentages into an equity curve with a £10,000 starting balance.
We can see that the equity grew to almost £1,000,000. Also notice the exponential growth due to the power of compounding over time.
If the returns from the £10,000 were taken out each year and not reinvested, the profits would only have accrued to £55,000, astonishingly less. Allowing the capital to grow is probably the most important lesson to take from the video.
How did the S and P 500 compare during this period?
A compounded return would have resulted in an end balance of just under £73,000 after 16 years. This is still over a 700% return during the period, but hugely less than the 10,000% return Joel Greenblatt achieved.
He created a value investing strategy called The Magic Formula.
The strategy targets both quality and value stocks using a ranking system. The ranking system comprises of two ratios;
Return On Capital and Earnings yield. These ingredients combined have offered excellent results.
Joel Greenblatt aligns the strategy to his philosophy when he says;
"buying cheap stocks at bargain prices is the secret to making lots of money"
Ok so we have the two ratios that make up the Magic Formula, how do we put these into a single measure to select qualifying stocks?
First, we select the index of stocks for any given major exchange, let’s use the S and P 500 index as an example. We then rank those companies on a scale of 1 to 500 based on their Return On Capital, the company with the highest Return On Capital is placed at the top.
The same companies are then ranked according to their Earnings Yield and again the company returning the highest yield is placed at the top.
Finally, both rankings are combined. In this example we calculate a company ranked number one for Return On Capital but ranked 50th for Earnings Yield. The calculation is simply 1 plus 50 giving a Magic Formula score of 51.
The companies which are ranked the highest and therefore have the lowest score have the best combination of both the Earnings Yield and Return On Capital factors.
Once all the 500 companies have been given a score, the top 30 companies form a portfolio. This is precisely how Joel Greenblatt produced the returns we seen earlier.
Not only did this method beat the Indexes overall but notice how the S and P 500 had 3 annual losses in a row, totalling a negative 43.1%, whereas this method had a positive 73.5%! over the same period.
The drawdown reduction and accompanied psychological benefits make this system very interesting indeed.
Let us dig a bit deeper to determine why such a seemingly simple strategy is so effective.
Firstly, lets quickly look at the Return On Capital metric.
The Return On Capital calculation is a measure of the companies quality, for example, a quality company often suggests that the company has a deep moat.
usually through a unique product or business model which is difficult to duplicate
or a strong brand that would be difficult to derail.
In financial terms, Return On Capital is calculated by dividing the after-tax profit by the value of invested capital.
The Earnings Yield tells us how much the business earns per year in relation to its share price, it is therefore used as a measure of value.
Let’s imagine a company is worth £1,000,000 and it earns £100,000 per year, the Earnings yield is 10%. Calculated as £100,000 divided by £1,000,000.
At this point you may be thinking is there an easy way to filter and rank such stocks, well there is…
I personally use and recommend a website site called Stockopedia, they offer an exceptional scanner for numerous strategies including the Magic Formula strategy.
Lets take a look.
The Magic Formula scanner here shows the company XLMedia as the highest ranked company with a combined score of 158, it would therefore take your 1st place in a portfolio of 30 stocks.
If we click on the company name here, we are presented with a detailed stock report.
The report shows all key fundamental data including the Magic Formula shown here.
You can see here both the Return On Capital and Earnings Yield ranks that make up the combined score of 158.
Perhaps not for this review, but you could filter stocks further based on other criteria that the Stockopedia service offers, for example the momentum score, the earnings per share growth rate or balance sheet metrics, the options are endless and for those interested the link is below the video.
So why is it that such a powerful strategy where qualifying stocks can be filtered easily, is not followed by big hedge funds and institutions?
The reason is because financial managers need to show performance EVERY year and are quite often measured on a quarterly basis, whereas the Magic Formula strategy, according to Joel Greenblatt, should be considered a longer-term strategy.
On average, for 5 months of the year the Magic Formula will underperform the market and would be frowned upon by the fund managers clients.
The bottom line is that the timeframe for the Magic Formula strategy is too narrow for fund managers despite the promise that profits will likely materialise in the long run.
Although not taken from the original book we have managed to find a more up to date performance chart, this shows the Magic Formula performance from 2011 to 2018, only this time we also include the top 10, top 15 and top 20 ranked stocks. Interestingly there seems to be a correlation between improved performance and the higher ranked stocks which could be worth further investigation.
During this 7 and a half year period the top 10 ranked stocks increased by 256%, against the FTSE all share index of 68%, adding further confirmation that the strategy offers excellent returns.
Also, to reinforce Joel Greenblatt’s theory suggesting that the timescale is too long for a typical fund manager, we can see here the strategy took a large drawdown before climbing higher, clients of a fund would certainly not be happy, especially considering the index took a less dramatic drop.
Here we see the year by year performance of the previous chart, again grouped by the ranks.
Notice the top 10 ranked stocks had 2 years of negative returns against the index of 1 negative year, again despite these other years of excellent returns I’m not sure many fund managers would have held onto their jobs during this 2 year period.
Joel Greenblatt also advises taking advantage of tax laws to keep more of the profits.
In short, this means selling stocks which have lost value before the end of a 12 month period, but do the opposite for stocks that have increased in value, therefore sell them after the 12 month period.
This rule obviously depends on your country of residence. In the United states they have a lower tax rate for stocks held beyond 1 year so this selling strategy is likely to have some merit there.
That concludes our brief overview of Joel Greenblatt’s book. Let’s quickly summarise.
1) The strategy returned exceptional results from a simple concept that included just one quality and value factor, each scored by rank and then combined into a 30 stock portfolio.
2) Scanning for such stock does not need to be difficult if the right software is available.
3) Unlike a money manager, the narrow timeframe is not a constraint, although some discipline will be required during periods of drawdown.
4) A more consolidated portfolio of perhaps 10 stocks could yield better results.
5) Using the 12 month tax rule could be of benefit depending on the tax laws of the country.
Due to the simplicity of this time-tested strategy demonstrated by Joel Greenblatt, it would be difficult to score the book anything less than 4 stars.
Purchasing the book for the finer detail and using the Stockopedia scanning tool could be a very potent combination.