Stocks with the magic touch

After a brilliant introduction to business, equity markets and valuation, Greenblatt asks the same question he used to put to students in the Columbia University business class he taught. Namely why, in any 12-month period, does a company’s share price tend to swing more wildly than the inherent value of its underlying businesses?

Greenblatt isn’t interested in why the market often seems to lose sight of value, although he ponders that emotion and the difficulty of forecasting and pricing businesses are likely to blame. But while smart and valid answers to the question may exist, he concludes that investors should think less about the why – “who knows and who cares” – and just accept wild swings as an inherent feature of markets.

Instead, Greenblatt argues, the only thing investors should concern themselves with is finding above-average companies that happen to be trading at below-average prices. His magic formula, he claims, allows anyone to do this.

For the investor who wants a hands-off approach to their portfolio – but is bothered enough to at least try to beat passive investing over the long haul – the screen promises the perfect solution.

It’s also straightforward. The magic formula is principally interested in finding stocks with high earnings yields (as a proxy for cheapness) and high returns on capital (as a proxy for good businesses). It does this by ranking all stocks in each screening universe against each of these fundamentals (which are detailed in full below), and then combining the two scores. The lowest combined scores form a ready-made portfolio of 30 stocks, which Greenblatt suggests holding for a year. Simple.

Over time, this method has much to commend it. In the 17 years before Greenblatt published his book, the screen posted an average annual return of 30.8 per cent, or more than double the S&P 500. Further back testing revealed that while selections often failed to beat the market in any given year, magic formula selections beat the market 95 per cent of the time over a three-year period, and every time when the screening universe was extended to the 3,500 largest US stocks.

Our versions of the screen have been less spectacular, but are still well up on the FTSE All-Share Index since we started them in January 2011. After 11 years, they have also matched another feature that Greenblatt identified in his book: the tendency of the screen’s top 10 selections to outperform the top 15, and so on. Last year’s picks broadly followed this trend, with the top 10 returning 18.9 per cent versus 10.7 per cent from the full 30 and 12.7 per cent from the benchmark.

This means the 30-stock portfolio has posted a total return of 176 per cent over 11 years. Factor in a 1.5 per cent annual dealing charge, and this falls to 134 per cent, versus 96 per cent for the All-Share (see table below). Add dealing charges to the 10-stock screen and its long-term annual returns amount to 285 per cent – more than double the benchmark.

To my mind, two reasons help to explain the screen’s success. The first is the way its selections benefit from momentum. As Greenblatt points out, a high return on capital is often a sign of a business with some sort of special advantage. While these advantages can be eroded over time, as good businesses attract competition, they are also a good proxy for the ability to keep earning above-average profits, at least in the short term. Not only does this attract investors to buy in, but should provide a business with above-average spare capital for reinvestment. One caveat to this is that the screen often re-selects stocks from the previous year. This year, 15 of 2021’s resource-heavy picks reappear, suggesting companies don’t always re-rate as wildly as Greenblatt suggests.

Second is a general point on stock screens. If the success of passive investing has reminded us of anything, it is that beating the market consistently is very hard. But if you’re going to try, then stockpicking only makes sense in the context of the returns on offer from the rest of the market. Apply this process dispassionately, year after year, and it might even start to look like magic.

2021 PERFORMANCE

The measures used for value and quality are as follows:

VALUE

Greenblatt uses an earnings yield in his magic formula. This is equivalent to a price/earnings (PE) ratio with the numerator and denominator inverted and expressed as a percentage. Greenblatt’s earnings yield looks at a whole-company valuation by factoring in the value of a company’s net debt or cash as well as the value of its shares, ie its market capitalisation. The formula's earnings yield compares its latest earnings before interest and tax (Ebit) with enterprise value (EV). In its simple form, EV subtracts a company’s cash and adds its borrowings onto its market capitalisation.

QUALITY

To measure quality, Greenblatt looks at how much Ebit is generated relative to a company’s 'tangible assets'. Tangible assets consist of net working capital added to net fixed assets. The idea is that tangible assets represent the assets that are actually being used in a company's operations to generate profits.

The table, to conclude, shows the top 30 ranked Magic Formula stocks for the next 12 months: