Magic formula investing blogs

Essentially, the formula looks for businesses with a large earnings yield and a high return on capital. The premise is that, over the long run, stocks of firms that are both cheap and good would vastly outperform the stocks of firms that are just cheap -- and it definitely seems to have worked. The Original Magic Formula Joel Greenblatt's love for cheap stocks of good companies started long before he developed his latest Magic Formula, however.

It's probably no surprise that the backbone of Joel Greenblatt's original magic formula rested on Benjamin Graham's net net stocks strategy. Greenblatt had been following Graham for years, carefully studying the principles and philosophies of the Dean of Wall Street, and was deeply impressed by, in his words, "the dramatic success of companies that the market priced below their value in liquidation Graham screened out stocks that failed to show a decent past record and those that were losing money.

By putting together a diversified list, Graham hoped to take advantage of the population returns of net net stocks and ride that fantastic statistical record to great profits. In his paper, Joel Greenblatt wondered what would happen if he carved up the world of net net stocks even further, eliminating a lot of the terrible firms from contention. To do this he turned to one of the most widely recognized valuation metric in value investing: the PE ratio.

Using both Graham's net current asset value and value investing's classic PE ratio, he put together 4 different portfolios and compared those portfolios against the OTC and Value Line's own value index from to According to Joel Greenblatt, this period was characterized by an extreme amount of volatility which made for a much more robust test. He then drew net net stocks from the roughly candidates left in order to put together his model portfolios.

The portfolios themselves were equal weighted, so the actual yearly returns of each portfolio were just the average returns of the stocks within each portfolio. All of the portfolios beat the indexes by a wide margin. By combining liquidation value with smaller PE ratios, however, results exploded.

Take a look at portfolio 4. During that time, the market fell from to 50, a decline of But at the end of the study, the market was still underwater From a starting value of , each ended the 6 year period before taxes and fees as follows: Portfolio 1: Portfolio 3: Portfolio 4: As you can see, the highest quality net nets, represented by Portfolio 4, more then doubled the return of the lowest quality net nets in the study.

Greenblatt et al even included returns after commissions and taxes, for those of you who aren't holding your portfolio in a tax free retirement account for some strange reason. It's important to realize what this means for average investors. Granted, Greenblatt's study only covered a period of 6 years, but in my experience buying net net stocks with tiny PE ratios has proven to be a very profitable strategy.

In fact, most of my best performing stocks have been these sort of net nets. Also keep in mind just how tumultuous the markets were during that period which, as Greenblatt wrote, made for a much more robust test. As an aside: if you're stuck holding your funds outside a tax shelter, for some reason, you can boost the tax efficiency of your portfolio by just holding your stocks for longer.

This becomes a lot more viable if you're investing in the highest quality net nets. Still, the more observant of you might have noticed a few potential flaws with the study and results. At first glance, it definitely appears that you can't hold a large number of stocks in a portfolio using Joel Greenblatt's criteria.

If you look to the right of each period's return, you'll see exactly how many stocks he held. For instance, they say: The big benefits of compounding come way far out in the future, which makes it hard to see; Saving when we are young is difficult; Saving when we are making money is also difficult, since often times the more money we make the more we tend to spend.

But maybe there is more that can be done in order to help investors save for the long-term and truly grasp the power of compounding. Things like financial education, incenting savings for young investors, and more nudging around the benefits of funding retirement accounts and Ks are all things that may help. But regardless of what those methods are, they all need time to show their true value.

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