Joel Greenblatt’s invention hits its sweet spot when markets are in recovery mode.
With the UK market continuing its steady climb back towards pre-Covid levels, there’s a sense of optimism around. The turmoil of the past year has shaken up a lot of the investment strategies tracked by Stockopedia. In that time we’ve seen some impressive gains, and one of the better ones has been from a model based on Joel Greenblatt’s ‘magic formula’.
Greenblatt enjoys near-legendary status in investment circles - and he’s particularly well respected among value investors.
Value investing - the strategy of buying shares that are cheap relative to what they earn or what they own - has a rich heritage. But while it has cemented the reputations of some of the world’s best-known investors - including Greenblatt himself - value investing has been out of favour for more than a decade.
Greenblatt always conceded that value has routine spells of underperformance. He says that part of the reason why the strategy has lasted for so long is because it has periods in the wilderness, from which it always returns. It’s in these spells of so-so performance that the discipline of value investors - professionals included - is really put to the test.
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In 2005, Greenblatt wrote a guide called The Little Book That Beats the Market, in which he set out an approach that blends value with quality and ranks the entire market for how relatively ‘good and cheap’ each stock is.
The aim of the strategy was to find companies that might be genuinely underpriced. It needed a strong stomach though, because the list would often contain broken and unloved shares. And given that this was still a value strategy, there would certainly be disappointments. But his ‘magic formula’ would offer a higher probability of success.
Tracking of this approach has seen it deliver an 80% return over the past year. When we covered this strategy here last autumn, we were seeing encouraging early signs, and the performance of the magic formula has accelerated from there.
Past performance is not a guide to future performance.
How it works
Greenblatt’s strategy uses two simple ratios: the earnings yield as a measure of ‘cheapness’ and return on capital as a measure of ‘quality’.
Earnings yield tells you how much profit a company is making in relation to its underlying value. To take account of varying levels of cash and debt in companies, a widely used way of working it out is to divide what the company earns in operating profit by its total valuation (known as the enterprise value).
You can then apply this earnings yield to every company in the market to see which are offering the best value – the higher the yield, the cheaper the company and the more bang you get for your buck.
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The return on capital focuses on how good a company is at generating a profit from the investment it makes in itself. Good quality companies are very efficient at delivering high percentage returns from the cash they reinvest to grow.
It might be opening new stores, expanding product lines or buying new plant and equipment. The return on capital is the percentage improvement in profits relative to that investment. That makes it a leading indicator of good quality companies that can grow profitably.
Greenblatt’s strategy scores every company on each ratio and then adds the scores together to get a magic formula for each one. This means that you can rank the market for companies with the best blend of cheapness and quality and always find results. Here is a selection of the current highest-ranking shares:
|Name||Mkt cap (£m)||Magic Formula Rank (%)||ROC % Greenblatt||Earnings Yield (%)||Relative Strength
|Air Partner (LSE:AIR)||43||99.6||94.9||49||-9.86||Industrials|
|Smart Metering Systems (LSE:SMS)||918.2||98.8||55.5||22.6||9.25||Technology|
|Sylvania Platinum (LSE:SLP)||306.6||98.6||52.2||22||56.1||Materials|
|Shanta Gold (LSE:SHG)||124.5||98.4||40.4||29.4||-43.3||Materials|
In the bullish conditions of recent years, the Greenblatt approach produced sometimes scary results. But in the current conditions, it’s detecting a range of larger and more familiar names.
It’s true that some of them may be out of favour for various reasons - but this is a value strategy that tries to match cheapness with quality.
Here the names range from mining stocks such as Ferrexpo (LSE:FXPO), Sylvania Platinum (LSE:SLP) and Shanta Gold (LSE:SHG) to the likes of legal and financial services group INCE, aviation services firm Air Partner (LSE:AIR)and payment processor PayPoint (LSE:PAY).
The genius of Greenblatt’s strategy lies in its simplicity. The combination of value and quality puts it in the territory of two of the strongest return-drivers in the stock market.
And at any time, this ranking approach will come up with ideas. Like many value strategies, the magic formula hits a sweet spot when the market is in recovery mode. It picks up shares that may be out of favour and underpriced as a result. As the performance of the past 12 months shows, it can deliver very strong returns when the conditions are right.
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