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How Joel Greenblatt Came Up With His Magic Formula

Joel Greenblatt (Trades, Portfolio) began his value investing career as a student at the Wharton School of the University of Pennsylvania when he found out about Benjamin Graham's famous net-net formula, which seeks to find stocks that are trading below their current net asset value. Greenblatt said he was interested in "not working that hard," so the idea of a "magic formula" that made it easy to identify bargain stocks really appealed to him.

Unfortunately, when the boom in stocks in the early '80s began, those bargains largely disappeared from the U.S. market. However, the concept of value investing stuck with him, and he began to think about how to modify Graham's Depression-era thinking. During a 2006 lecture at the Columbia Business School, he explained how he did it.

A blended approach

The solution that Greenblatt came up with was to inject Graham's net-net formula with a dose of Warren Buffett (Trades, Portfolio). At this point in his career, due in part to the influence of his Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) partner Charlie Munger (Trades, Portfolio), Buffett had moved away from the "cigar butt" investing strategy that had defined his earlier years. He was now concentrating on buying great businesses at fair value, rather than fair businesses at great value.

So Greenblatt created a blended approach, one that sought to identify good companies at cheap prices. He first defined these terms. A "good company" is one that has high returns on capital, defined as operating profit divided by net working capital plus net fixed assets.

A "cheap stock" is one with a high earnings yield, which is calculated by dividing pre-tax operating earnings by enterprise value. So the ideal investment is one that generates a lot of money relative to its assets, and one that is priced cheaply relative to the value of the whole business. Greenblatt and his team decided to weight quality and cheapness equally: 50-50.

Each stock was assigned a rank based on cheapness and quality. These rankings were then combined to create an overall ranking (so if a stock was the 10th cheapest in the market, and the 300th highest-quality, its overall rank was 310). Greenblatt then asked: What would happen if you just bought a basket of the top 30 stocks on that list and rebalanced the portfolio once a year?

The results were good: Between 1988 to 2005, this "magic formula" earned 30.2% annually, compared to the equally weighted market average annual return of 11.9% and the S&P 500 annual return of 12%. Not too bad for not working very hard.

Unfortunately, the efficacy of the magic formula seems to have worn off in the last decade. Why is this? Well, one reason could be that Greenblatt told everyone about it. In 2005, he published a book titled "The Little Book That Beats the Market," which laid out the magic formula approach. You lose your edge if you tell the world about it.

Another reason may be the proliferation of stock screening software that made executing simple strategies so easy that any investor could do it. And a more structural reason could be the general underperformance of value relative to other factors like growth and momentum over the last decade. But who knows? If value stages the comeback that so many investors have been waiting for, then perhaps the Greenblatt formula can return to its winning ways.

Disclosure: The author owns no stocks mentioned.

Read more here:

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Warren Buffett: Is It Possible to Invest Using Only Financial Statements?

Why Assessing Returns Without Risk Is Pointless

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This article first appeared on GuruFocus.