Magic stocks outperform

Stock screens

We’re revisiting a stocks screen that we ran almost a year ago, which has yielded impressive results. The screen in question is based on Joel Greenblatt's so-called "Magic Formula". The formula deserves its magic moniker not only because it picked an outperforming portfolio of stocks, but also because it is so incredibly simple in its approach.

That was the idea; fund manager Dr Greenblatt wrote the book with the objective of providing an incredibly simple and effective stock picking strategy for his children to follow with relatively little effort.

When he tested the his formula, Dr Greenblatt found that in the 17 years between 1988 and 2004, stocks picked using his method on average produced returns of 30.8 per cent a year compared with 12.4 per cent a year from the S&P 500. The portfolios he assembled to test the theory was from the 3,500 largest US stocks excluding financials. The returns that Greenblatt purports would have turned £11,000 into $1m over the period he tested.

Our Greenblatt picks have been taken from the FTSE All Share, the All-Small and AIM All-Share with a market value cut-off of £50m. Over a year from the publication date of our portfolio on 26 January 2011, the shares have delivered a 5.6 per cent rise compared with the FTSE All-Share’s 3.5 per cent fall. It should be noted that these returns are somewhat flattered by being based on mid-prices, not offers to bids, and they don't include dealing costs or stamp duty. Also, the current dividend yield on the portfolio of 3.5 per cent is slightly below the 3.7 per cent boasted by the All-Share, even after a year of significant outperformance.

The magic formula uses just two measures, one for value and one for quality, to come up with its portfolio of stock picks. And the methodology is simple. Every stock screened is first ranked according to valuation and then according to quality. The rankings are added together and the 30 stocks with the highest combined rankings make up the portfolio. Unlike other screens which attempt to provide investors with ideas for further research, the idea of the magic number was that all the stocks should be bought and held for one year.

As you'd expect from such an approach, not every stock is going to be a winner - and so it proved. Shares in set-top box maker Pace fell 53 per cent over the period and there was 48 per cent drop in JKX Oil & Gas. That hasn't stopped Pace appearing in this year's picks, though. But the flops were outweighed by the gainers, often through takeover: Education Development International, a training company, was bought by Pearson, owner of this magazine, for a 74 per cent gain and home insulation specialist Eaga delivered a 68 per cent gain following a successful bid by construction group Carillion.

Here's how the two numbers are calculated:

■ Value: Mr Greenblatt uses an earnings yield to identify value, which is a bit like a price-to-earnings (PE) ratio turned on its head. It is calculated using earnings before interest and tax (Ebit) as a percentage of enterprise value (EV) - a company's market capitalisation plus its debt and minus its cash. Using Ebit and EV for the calculation effectively levels the playing field by ignoring the impact of financing choices on the underlying business.

■ Quality: Mr Greenblatt uses return on capital (ROC) to judge how good a business is. He defines ROC as Ebit divided by tangible assets (net working capital plus fixed assets).

Here’s this year’s section of Greenblatt stocks ordered by their combined ranking:

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