Joel Greenblatt’s Winning Formula To Pick Stocks

11 min read

Joel Greenblatt’s got an investing formula that works like magic. That’s how he’s always buying good stocks cheaply – and it’s what’s made him one of the most successful fund managers ever. Luckily, Greenblatt’s not keeping this formula secret. I’m going to tell you how it works, so you can copy his success.

So what’s this magic formula?

Simply put, it means buying stocks that are both “good” and “cheap”, using a couple simple equations to ensure you get both.

A “good” business will generate high returns on capital invested. That’s because more profit per dollar invested will fill shareholders’ pockets fast, sure, but also because these companies tend to have something special. Maybe a competitive edge, for example, that lets the company keep its profits while growing market share. And high returns on capital tend to last, leading to high future earnings growth. Simply said, a business with high returns on capital isn’t just good today: it’s likely to stay good in the future.

But it’s not enough to just buy a good business. You also want to buy it “cheap”. Look, even a top company has risks – and you need to make sure you’ve got a margin of safety in case things don’t go as hoped.

For Greenblatt, that means buying a business that earns more, compared to the price you pay. An easy way to calculate that is looking at its earnings yield – how much earnings before interest and taxes (EBIT) you can expect vs. the total value of the company, or its enterprise value. The higher the yield, the more “value” you get.

So Greenblatt’s approach combines value investing and quality investing. It’s about buying a high-quality company at an attractive price. Or, seen another way, it’s about buying a cheap company that’s not junk. Yes, you’re looking for the best of both worlds (hence, “magic”).

So how do you use the formula?

First, find the 30-50 best stocks.

1. Pick your universe.

You’ll want areas with reliable data (so avoid emerging markets off the beaten path), and you’ll also want small-caps (they’re more likely mispriced). In his screen, Greenblatt includes the 3,500 biggest companies on major US indexes.

You might remove stocks too small to trade easily (under $50 million market cap), utilities/finance stocks (different capital structures make them hard to compare), foreign companies (also hard to compare), and companies that just reported earnings (data issues).

2. Calculate the business’s return on capital invested.

To assess how good a business is, calculate its return on capital, using:

return on capital = earnings before interest and taxes / (net working capital + net fixed assets).

Greenblatt uses return on capital over return on equity (earnings / equity) or return on assets (earnings / total assets) for two reasons: first, earnings before taxes lets you compare companies with different capital and tax structures better, and second, tangible capital employed (net working capital + net fixed assets) shows how much capital a business really needs. Removing intangible assets like goodwill lets you focus on how much funding is needed for receivables/inventory (net working capital) and real estate/factories/equipment (net fixed assets). If you can’t find return on capital data, use return on assets instead.

3. Calculate the stock’s earnings yield.

To assess how cheap stocks are vs. earnings, calculate earnings yield for each company using:

earnings yield = earnings before interest and taxes / enterprise value.

Enterprise value is calculated as market value of equity + net interest-bearing debt. Greenblatt likes this ratio over narrower price-to-earnings (P/E) as it lets you compare businesses with different capital/tax structures better.

4. Rank companies on both metrics.

Next, rank companies based on their return on capital and earnings yield (separately). Then add the two ranks to get a final ranking of companies with the best combination of those two factors. This is key: a company good but not great on both scores might rank higher than a company scoring really highly on one but poorly on the other. The goal here is stocks that are both good and cheap, not just one or the other.

If this ranking process seems overwhelming, use this shortcut: on a screener like Finviz, go to the “fundamental” tab, pick “return on investment” over +25%. Then set forward P/E over 5 (to avoid data issues) and under 10, and rank stocks by P/E.

Alternatively, use the “map” to see stocks with high return on investment (up axis; higher is better) and low P/E (across axis; lower is better). Stocks top left are the most attractive.

I’ve shown you all this so you understand how the measure’s calculated and can tweak the data yourself.

But there’s an even simpler, better method if you focus on US stocks – use Greenblatt’s own screen, which he shares here. He’s kindly made it public so anyone can see the magic formula calculated right. And it’s updated real-time, so bookmark it.

Then, build and manage your portfolio.

Now that you’ve got 30-50 top companies, put your money to work:

5. Buy 5-7 of those companies. To start, invest only 20-33% of the money you plan to invest this year. That’s dollar-cost averaging, which smooths your entry price.

6. Repeat step 5 every 2-3 months until you’ve invested all the money you chose to allocate to your magic formula portfolio. After 9-10 months, you’ll have 20-30 stocks. I’ll explain later why diversifying across so many stocks matters with this strategy.

7. Sell each stock after holding 1 year. For taxable accounts, sell stocks with a gain after holding a few days over a year and stocks with a loss a few days under a year. Then replace them with new stocks from the formula.

8. Keep this up for at least 3-5 years, no matter the performance. It takes time for the magic formula to work, so give it enough.

Does it really work?

It does – if you follow the rules and invest long-term.

The magic formula isn’t some complicated measure engineered to ace backtests. It’s grounded in economic logic and extremely simple – so, since it’s worked in the past, it’s more likely to work in the future.

What’s more, Greenblatt tested the formula thoroughly and found it beat the S&P 500, with solid returns not explained by transaction costs, survivorship bias or data quirks. In fact, the magic formula was so successful it became the core of Greenblatt’s hedge fund Gotham Asset Management’s approach.

That said, Greenblatt tested this formula ~10 years ago and it hasn’t been as thoroughly tested since. And since most value-like strategies have struggled recently, its performance this past decade was likely lackluster. But to me, that doesn’t really matter: what matters is what the magic formula does next, long-term.

So is there still magic in the formula?

To believe in “magic”, understand why it works.

It works because markets aren’t perfectly efficient. While a business’s intrinsic value doesn’t really change daily, weekly or even monthly, its price often does. That’s because, as value investing founder Benjamin Graham famously explained, short-term “Mr. Market” acts wildly emotional, often paying too much for hyped stocks but not enough for out-of-favor stocks unless they’re ultra-cheap. But long-term, Mr. Market gets it right and price converges to intrinsic value.

If Greenblatt’s magic formula works, it’s because it’s great at finding quality businesses more likely trading at a discount to intrinsic value. These are businesses maybe in out-of-favor industries, with bad recent press, complex business models or simply smaller. By focusing not just on whether a stock is cheap vs. earnings but also if the business is high-quality, you cut the risk of buying a cheap stock that’s cheap for a reason (i.e. it’s a dud, and will stay a dud). Over time, you profit as price rises to fair value.

But how can such a simple formula find those businesses so well? A hugely overlooked factor in the strategy’s success is that you’re not betting on one company, but a portfolio of stocks with those traits. Use the formula on a single stock and it may not work (in fact, ~50% chance any stock underperforms the market). But buy a portfolio of stocks with those traits and you profit from investors on average underpaying, so over time price converges to intrinsic value. Think of it like running a casino: you pay out sometimes, but on average, and long-term, you make a lot.

What are the risks?

If markets suddenly become super-efficient, this formula may not work as well. But while that’s a real risk theoretically, one look at 2021’s meme stocks shows markets are still far from perfectly efficient.

A bigger risk is that any single stock in your portfolio struggles or fails. But the magic formula mitigates that through diversification across many stocks. Sure, a few may fail – but on average, and over time, the rest should outperform.

Another risk is that value investing goes out of favor for a long stretch, like recently. When that happens, the magic formula likely struggles. But if you believe in the logic, stick with it: value investing always comes back in favor eventually.

Finally, a risk is that you get impatient and break the formula’s rules. The biggest mistake is selling too soon. You must give the formula time to work, holding stocks at least 1 year and ideally 3-5 years. Selling too soon means you lock in underperformance and miss out on the convergence of price to intrinsic value.

You also must rebalance regularly, adding new stocks and selling old ones. It’s tempting to hold onto winners, but that means missing new opportunities and concentrating risk in a few stocks. Stick to the formula and you’ll benefit from diversification.

Wrapping up

Now you know Joel Greenblatt’s magic formula for investing. By systematically buying good businesses at bargain prices and holding them long-term, you can profit as other investors eventually wake up to the companies’ true worth.

While the formula may sound simple, that’s the beauty. By focusing on timeless principles of value and quality investing, not trying to game the market, you’ve got an approach that’s likely to work not just in the past or present, but the future too. And by diversifying risk across many stocks, you don’t need to be right on every pick.

Give the magic formula a try. Start small, stick to the rules and stay patient. Over time, you’ll see the magic in this simple but powerful approach.

Safe Trading
Team of Elite CurrenSea 🇺🇦❤️

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