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, 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 EBIT divided by its enterprise value. EBIT is earnings before interest and taxes, otherwise known as operating earnings. Enterprise value includes the company's market capitalization, then adds 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 returns on assets greater than 25%. In other words, for every $100 in assets it holds, the company would produce at least $25 in net profit. In general, the higher the ROA, the better the business. Greenblatt looks for companies with an ROA higher than 25%.
So how do Compass Diversified Holdings
|Compass Diversified Holdings||$911||$75||8.3%||5.0%|
Automatic Data Processing
Source: Capital IQ, a division of Standard & Poor's. Trailing-12-month figures.
Going by the Magic Formula criteria, none of these companies meets both standards. DDI is the only listed company that exceeds the formula's desired 10% earnings yield, but Compass turned in a solid 8.3%. DDI also offers the highest ROA of the listed companies at 11.4%. Sure, these companies didn't meet the high bars for the Magic Formula screen, but that certainly doesn't mean they can't be profitable investments. High-quality companies are rarely on sale, so they often won't make the Magic Formula cut.
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), since 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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Jim Royal, Ph.D., does not own shares of any company mentioned. Motley Fool newsletter services have recommended buying shares of Automatic Data Processing and Paychex. 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.