So-called ‘systematic value’ strategies that use fixed rules to hunt down companies with strong quality characteristics at attractive prices are not only naturally appealing to many investors but also the basis of some of the world’s most admired Guru inspired models. But while the concept of investing in ‘cheap’ and ‘good’ companies may seem intuitive, one of the most famous examples of this approach has endured a protracted period of underperformance in the UK... until recently.
The strategy in question is the ‘Magic Formula’ - an approach devised by Joel Greenblatt, who cemented his reputation as a star fund manager after producing 50% annualised returns at Gotham Capital over a 10 year period. In his now famous book that followed - The Little Book That Beats The Market - Greenblatt spelt out to individual investors how they could free themselves from the shackles of underperforming funds by using a Magic Formula for finding cheap, good quality shares that would improve their returns.
Inspired by the value investing principles of Benjamin Graham, Greenblatt’s Magic Formula was hardly as mystical as it sounded. He introduced two simple measures to rank every company in the market, adding them together to produce an overall Magic Formula score. The first of the two metrics is Earnings Yield, which is a measure of how much profit a company ‘yields’ in proportion to it’s value - the higher the earnings yield, the cheaper the company and the more bang for you get for your buck. Greenblatt’s second metric is Return on Capital, which is an indicator of how efficient a company is at generating a profit from the investment it makes in itself - the more profitable the company is, the higher the perceived ‘quality’ of the stock. You can read more about the precise workings of the Magic Formula here.
Has the magic gone?
Greenblatt claimed that his backtests over 17 years to 2006 showed that a portfolio of around 30 companies with the best combination of both metrics would have produced a very impressive annual return of around 30.8% per year - a return that would turn £10,000 into almost £150,000 over 10 years! But he also cautioned that the Magic Formula wouldn’t always work and there would be periods - perhaps running into a few years - when his methodology was likely to…
