A Foolish View of a Magic Formula

Don't have as much time to research stocks as you'd like? That doesn't mean you have to settle for index fund returns. Value investor and Columbia professor Joel Greenblatt shares his "Magic Formula" for market-beating stock returns in his book The Little Book That Beats the Market.

The Magic Formula ranks stocks based on two factors: how cheap the stock is relative to the company's earnings, and how profitable the company is. Greenblatt suggests buying the top-ranked stocks, holding them a year (give or take a week for tax purposes), and then reinvesting in the latest batch of top stocks.

That may seem too simple. But when Greenblatt backtested his formula on the 3,500 largest U.S. stocks, excluding utilities and financials, he found that the top 30 stocks generated an annualized return of 30.8% from 1988 through 2004, compared with 12.4% for the S&P 500 Index (excluding trading costs and taxes). Moreover, when he ordered those stocks by ranking, then split them into 10 groups of 350 each, he found that the higher a group's ranking, the higher its returns.

A Foolish twist
I decided to boost the Magic Formula with help from The Motley Fool's CAPS community. Greenblatt observed that fundamental research by knowledgeable investors improved upon his approach. Why not use the wisdom reflected in CAPS scores to refine a list of stocks that do well according to the Magic Formula criteria -- and hopefully sidestep some value traps?

To do so, I ran a stock screen looking for stocks on the major U.S. exchanges with high returns on capital of at least 15%, and relatively high operating earnings yields of 7% or more. Like Greenblatt, I filtered out utilities and financials, as well as stocks with market caps less than $500 million, or share prices less than $5. After ranking the results, I then selected only stocks that earned a top five-star rating on CAPS. Here are the seven highest-ranking stocks that passed the screen:

Stock

Profitability (RoC)

Earnings Yield (EBIT/EV)

Market Cap ($mm)

TeleNav (Nasdaq: TNAV  ) 33% 14%  $733
Partner Communications (Nasdaq: PTNR  ) 25% 14%  $2,311
National Presto Industries (NYSE: NPK  ) 20% 16%  $694
Alliance Resource Partners (Nasdaq: ARLP  ) 23% 13%  $2,832
Colgate-Palmolive (NYSE: CL  ) 39% 8%  $42,407
Philip Morris International (NYSE: PM  ) 32% 9%  $117,677
Alliance Holdings (Nasdaq: AHGP  ) 22% 10%  $2,991

Source: Capital IQ and The Motley Fool as of June 29, 2011.

Since I last ran the screen, Joy Global and Western Union fell out of the top seven and were replaced by Colgate-Palmolive and Philip Morris.

Patience is a virtue
The Magic Formula is designed for the long haul, and it's not for the faint of heart. In Greenblatt's backtest, it underperformed the market in one of every four one-year periods, and one of every six two-year periods. Over three-year periods, though, it beat the market in 19 of every 20 periods tested (that's 95% of the time).

Foolish takeaway
Stocks that score well under the Magic Formula criteria have the potential to significantly outperform the market, but its mechanical approach sometimes gives value traps high rankings. Using CAPS to refine those results could help you avoid such pitfalls, while building a portfolio of inexpensive stocks in highly profitable companies.

Interested in these high-scoring stocks? Add them to My Watchlist, our free personalized stock tracking service, now:

Fool contributor Cindy Johnson owns shares of TeleNav. The Motley Fool owns shares of Philip Morris International and National Presto Industries. Motley Fool newsletter services have recommended buying shares of Western Union, Alliance Resource Partners LP, Partner Communications, and Philip Morris International. Motley Fool newsletter services have recommended creating a write covered strangle position in Western Union. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 01, 2011, at 3:28 PM, awmoran wrote:

    I purchased tnav

    TNAV TeleNav, Inc. 11-Oct-10 price 5.10

    after reading Magic formula.

    That stock is up a total 244.29%

    and annualized 456.11%

    My entire Magic Formula Portfolio is up 34% in 10 months.

    I love what this book is all about.

  • Report this Comment On September 02, 2014, at 12:45 PM, KenEFool wrote:

    Flawed. You said...

    "The Magic Formula ranks stocks based on two factors: how cheap the stock is relative to the company's earnings, and how profitable the company is. "

    That is wrong. The 2nd FACTOR is Return on Capital, not "how profitable." Its purpose is to avoid value traps by identifying good companies.

    So your improvement merely "added" a factor already in the MF. There ARE many ways to improve the formula, of course. They involve improving both elements with composites of value and quality, as well as adding others such as financial strength and momentum (any academic papers on efficacy of CAPS? -interesting).

    But that would defeat the brilliant point of the MF...

    Simplicity.

    Regards,

    Ken

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