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 tome 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 value investing down 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 and 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 Trinity Industries
American Railcar Industries
Source: Capital IQ, a division of Standard & Poor's. Trailing-12-month figures.
Going by the Magic Formula criteria, none of these companies meets either standard. Valmont has the highest earnings yield at 8.7%, but that is still more than 1 percentage point short of the formula's desired 10%. Valmont also has the highest ROA at 7%, which is still less than half of the formula's desired 25%. But even though these companies didn't clear 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, and then you can 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 to receive favorable tax treatment, sell all of them, and then run the screen again to find your new picks.
This approach sounds easy, but 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., owns no shares of any company mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.