Use This 'Magic Formula' to Beat the Market Investing

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While achieving success in the stock market is never effortless, at least one renowned investor believes that racking up appreciable long-term gains is easier than commonly believed.

Joel Greenblatt, founder of Gotham Capital hedge fund and an adjunct professor at Columbia University's Graduate Business School, introduced his concept of "Magic Formula" investing in "The Little Book That Beats the Market." First published in 2005, the book became an investing classic, selling hundreds of thousands of copies. In 2010, he updated his findings in a follow-up titled "The Little Book That Still Beats the Market."

Greenblatt believes that identifying and investing in companies with both a high return on capital and a high earnings yield will produce market-beating results. This is the essence of the Magic Formula, although he employs a proprietary ranking system to select his investments.

According to Barron's, the Magic Formula produced an average annualized return of 19.5 percent when back-tested on stocks with market capitalizations of $1 billion-plus between 1988 and 2009. This performance outpaced the return of the S&P 500 index (^GPSC) by more than 10 percentage points over the same period. Greenblatt's Gotham Capital fund is itself well regarded for using this technique to post 40 percent annualized returns between 1985 and 2006.

While the global economy has weathered a deep recession and a painfully slow recovery since the debut of the "Little Book's," the core principles -- which emphasize finding undervalued stocks -- still hold true. And in a market that seems to consistently chase new highs, his "Magic Formula" may be more relevant than ever.

Understanding the Ratios

In his brief book, Greenblatt repeatedly assures the reader that return on capital and earnings yield are straightforward, easy-to-use ratios. He calculates return on capital using three terms: earnings before interest and taxes/(net working capital + net fixed assets).

EBIT makes it easier to compare earnings between companies that may have different debt levels and tax rates. Net working capital is comprised of current assets minus current liabilities, excluding cash. Net fixed assets is made up of the net depreciated cost of property and equipment.

The point of return on capital, according to Greenblatt, is to "purchase a business that can invest its own money at high rates of return rather than purchasing a business that can only invest at lower ones."

The second measure, earnings yield, is simply: EBIT/enterprise value, where "enterprise value" is a company's market capitalization (both common and preferred stock) plus its net interest-bearing debt. Essentially, enterprise value allows an investor to see a corporation through the eyes of an owner purchasing a business stake, as it represents not just the equity acquired, but the liabilities assumed.

Earnings yield measures earnings before interest and taxes on that investment stake. The higher the yield, the more earnings a company's equity and debt are producing. On this metric, Greenblatt exhorts investors to "purchase a business that earns more relative to the price you are paying than less. In other words, a higher earnings yield is better than a lower one."

Why the Magic Formula Is Especially Relevant for Seniors

As Warren Buffet has often done, Greenblatt cites legendary investor Benjamin Graham as an influence on his investing style. Among Graham's numerous contributions to investment theory is the following insight: A stock that can be purchased for less than the liquidation value of its assets is a bargain for the taking.

As Greenblatt points out in his book, such stocks were found in abundance in the decades following the Great Depression, when Graham's investing career was at its zenith -- but not so much now.

Another limitation of this (and many other value approaches) is the difficulty of timing. Identifying and purchasing a company you believe to be undervalued begs a fundamental question: When will the market agree with your logic and bid up the company's price? Some stocks remain undervalued for years upon years. Graham's strategy zeroes in on mismatches between market value and liquidation value, but it doesn't speak at all to timing.

The Magic Formula, however, identifies stocks that are undervalued relative to their income-generating ability -- as evidenced by a high earnings yield. Coupling this with a present positive return on assets eliminates from the screening process stocks that may be bargains or value situations but that don't yet show substantial earnings power. Thus the formula narrows selections to stocks producing current results, which have potential to be noticed sooner by market participants.

This potential well serves the typical senior/retiree investor, who may willingly be in for a one-, three- or five-year investment, but doesn't necessarily want an open-ended holding period. Greenblatt recommends using his strategy for at least three years and even provides a method in "The Little Book" for utilizing one-year holding periods.

Getting Started With the Magic Formula

Perhaps the easiest way to get ideas for Magic Formula stocks is to visit Greenblatt's education site: You'll find a handy stock screener based on the professor's particular criteria and adjustments, which is free to use upon registration. The formula tends to favor small-capitalization stocks, and the screener is set to a $50 million market cap by default, so conservative investors may want to play around with larger capitalizations, say $500 million or above.

If you prefer to go it alone, the last section of "The Little Book That Beats the Market" gives some handy tips for finding Magic Formula stocks with the type of screening tools your online broker might provide. The most pertinent advice is to substitute return on assets if return on capital isn't an option, and to screen for low price/earnings ratios as a proxy for earnings yield (they share a roughly inverse relationship). In any case, simply paying attention to return on capital and earnings yield in 2015 may lend a little magic to your stock investing results.

Asit Sharma is a Motley Fool contributing writer. Try any of our Foolish newsletter services free for 30 days. Check out our free report on one great stock to buy for 2015 and beyond.
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