If you're a busy investor with more than just stock-picking on your plate, you might want to consider a mechanical investing strategy. And if you're interested in stocks, one of the most intriguing of these strategies is Joel Greenblatt's "magic formula."
Greenblatt details this approach in his enriching and funny The Little Book That Beats the Market. His strategy revolves around two factors:
- How cheap is the stock?
- How profitable is the company?
This simplified approach really boils down value investing to its essence. When you find a company whose price fails to reflect its high profits, you might have a winner.
A cheap business and a profitable company
To find cheap companies, the magic formula looks for a high earnings yield -- basically, a company's earnings before interest and taxes, or EBIT, divided by its enterprise value. EBIT is also known as operating earnings. Enterprise value includes the company's market capitalization and its net debt. In general, the higher the earnings yield, the better. The magic formula looks for a yield higher than 10%.
To find profitable companies, Greenblatt's magic formula seeks businesses that generate pre-tax returns on assets, or ROA, greater than 25%. For example, for every $100 in assets a company holds, it would produce at least $25 in net profit. In general, the higher the ROA, the better the business.
So how do some of the biggest companies in commercial services and supplies fare?
|R.R. Donnelley & Sons||$6,098||$735||12.1%||8.9%|
|Ritchie Bros. Auctioneers||$2,677||$104||3.9%||10.7%|
Source: S&P's Capital IQ.
Going by the magic formula criteria, none of these companies meets both standards, but R.R. Donnelley and Pitney Bowes both offer the formula's desired 10% earnings yield. None of the listed companies offers the formula's desired 25% ROA.
R.R. Donnelley & Sons
Ritchie Bros. Auctioneers
Foolish bottom line
The key advantage of the magic formula is speedy decision-making. You can run a screen and mechanically buy the stocks, then spend your free time doing the activities you love. However, such an approach means that you need to pick a lot of stocks (say, 25 or 30), because you haven't performed any strategic analysis of your investments. According to the formula, you should hold the stocks for one year in order to receive favorable tax treatment, sell all of them, and then run the screen again to find your new picks.
While this approach sounds easy, Greenblatt cautions that it can be tough to stick with during hard times. In some years, this mechanical strategy simply won't work. However, Greenblatt's extensive backtesting suggests that over the long haul, his magic formula can significantly outperform the market.
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