You Should Know Joel Greenblatt

Warren Buffett is the name generally discussed by value investors as the pinnacle of investment success.  He deserves every accolade thrown his way, and rightly so: he has amassed more wealth in his lifetime than almost anyone else in the history of the world, and he did by intelligent investing.  But today’s value investors have heroes other than Buffett that deserve just as much attention and study.

 

One of these is Joel Greenblatt.

 

Joel Greenblatt

 

 

 

 

 

 

 

 

 

Joel Greenblatt built most of his wealth from the late 1980’s to the early 2000’s.  He graduated from the The Wharton School at the University of Pennsylvania in 1979 and received an MBA in 1980.  Joel Greenblatt and John Petry founded the Value Investors Club, a website where investors are approved through an application process.  The members exchange formulas, analysis and special situation investment ideas.  Membership in this highly prestigious group is capped at 250 members, and the club awards $5,000 to the member who submits the best idea each week.

 

In 1985, while serving as the chairman of the board for Alliant Techsystems, he founded the hedge fund Gotham Asset Management with $7 million.  While managing Gotham is became famous for his generic-titled “Magic Formula”.  The idea of this formula was to create a quantitative investment strategy for picking stocks.  The formula was made public in his best seller “The Little Book that Beats the Market”, published in 2005 (after he had already millions with his strategy).  The Magic Formula produced returns of 30.8% from 1988 to 2004, beating the S&P 500’s return of 12.4%.

 

Investment Strategy

Greenblatt buys “cheap and good companies” with a high earnings yield and a high return on invested capital.  He finds these companies by looking at the return a company generates on its capital and at the firm’s earnings yield, which is similar to the inverse of its P/E ratio.  According to Greenblatt, beating the market is not complicated if an investor maintains a consistent approach, exercising discipline, patience and confidence when picking stocks to purchase.

 

Greenblatt’s Magic Formula

 His formula is not so much a valuation formula, but better used as a stock screener or potential value indicator (much like Tobin’s Q).  This formula ranks stocks from 1 to 50 with 1 being the most attractive stock and 50 being the least attractive.  This formula can be both a stand-alone stock screener or combined with other screeners.

 

The first step is to exclude certain companies.  The exclusion criteria is:

  • Exclude all companies with a Market Cap less than $50 million
  • Exclude all companies in the Financial sector.
  • Exclude all companies in the Utilities sector.
  • Exclude all foreign companies.

Once the above exclusion criteria is in place, the next step is to determine the remaining company’s Earnings Yield and Return on Capital:

  • Earnings Yield = EBITDA / Enterprise Value.
  • Return on Capital = EBITDA / [Fixed Assets + (Total Current Assets – Total Current Liabilities)].

The next step is to rank the remaining companies by highest earnings yield and highest return on capital.  The rank order will be determined by:

  • Add the earnings yield and return on capital together for each company.
  • Sort by highest to lowest.
  • Assign a numerical value to the top 50 companies.  1 will represent the top company, then 2, and so on.

 

Current Status

 Greenblatt’s formula is still widely used by funds and financial journalists searching for long ideas.  Much like Warren Buffett’s philosophy, Greenblatt’s common-sense conservative screen is applicable in any type of market.  The team at ValueMyStock loves it so much we created our own daily report of stocks that pass his test.  I encourage you to review our results – I’m sure you will find some real gems to consider.