All investors would like to see their investment portfolios perform better than the index. There are many methods that claim success but most require heavy number crunching or a lot of qualitative research. We at Wealth Insight went around looking for a method that is simple, easy to understand, and one that can be implemented by everyone (with access to a database). One such method is Joel Greenblatt's 'magic formula'.
Joel Greenblatt is the founder and managing partner of Gotham Capital, a private investment partnership, which has given average annualised returns of 40 per cent since inception to its investors, which is a great track record by any yardstick. In his, "The little book that beats the market", he explains how the lay investor can also produce great results by using the magic formula.
What is the magic formula?
The underlying idea behind the magic formula is to consistently invest in shares of good businesses that are trading at bargain prices. One way to do this is to invest in companies with high earnings yield. Two, the magic formula requires you to invest in good businesses that can earn a high rate of return on their capital employed. Further, the magic formula allows you to combine these two criteria so that you come up with a list of stocks where the top-ranked ones are both more profitable and are also available at a bargain compared to their peers.
Does it work?
By back testing this formula using returns from the US markets, it was found that the magic formula gave returns of 30.8 per cent per annum between 1988 and 2004.
According to Joel Greenblatt, the magic formula is good because while it may not work in the short run, it always works in the long run. When he back-tested the formula, he found that over a short period of one year, the portfolio underperformed the market in a few consecutive months. There could even be one- or two-year spells when the magic formula underperforms the index. But he found that over a three-year stretch the formula outperforms the market 95 per cent of times. He says: "It doesn't work all the time. In fact, it might not work for years. Most people just won't wait that long. Their investment horizon is too short. If the strategy works only in the long run, then most people will not stick with it." Thus the formula favours the investor who possesses both patience and tenacity.
Understanding the key components
The formula has two key components: the first is Return on Capital which is a measure of how profitable the business is.
Return on capital is measured by calculating the ratio of pre-tax earnings (PBIT) to capital employed. Using profit before interest and tax allows one to compare the operating earnings of different companies without the distortions arising from differences in tax rates and debt levels. Net working capital plus net fixed assets tells us how much total capital has been deployed to conduct the business. Next, the earnings from operations are compared to the total assets used to produce those earnings.
The second component of the formula is Earnings Yield. While the first component of the magic formula tells you how profitable a business is, the second component tells you whether you are getting it at an attractive valuation.
Enterprise value takes into account both the value of the equity infused into the business and the debt financing used by the company to generate operating earnings.
The methodology
· Approximately 5,000 stocks are listed on the Bombay Stock Exchange (BSE). Choose the top 500 stocks by capitalisation.
· Rank the 500 companies on the basis of return on capital. The company which has the highest return on capital is assigned rank one and that with the lowest is assigned rank 500.
· On the same lines, we get the earnings yields of the 500 companies and rank them. The company with the highest earnings yield is assigned rank one, and the company with the lowest earnings yield receives rank 500.
· Next, we add the rankings received by each company on the two parameters to get a composite ranking. Arrange the companies in descending order of their composite ranking.
· Eliminate all financial companies and utilities from this list.
· Choose stocks from those ranked in the top 30.
Building a portfolio
The magic formula gives you a set of stocks. Next you need to develop a portfolio. If you are relying on just the magic formula, then you should have 25-30 stocks in your portfolio. But if in addition you will also do qualitative research and then cherry pick stocks from the magic formula list, then having just eight to 10 stocks in the portfolio will suffice.
Initially invest in just five stocks from those ranked at the top of the list. Invest only about 16 per cent of the money you aim to invest during the year. After two months, run the numbers once again and come up with another list, and invest in another five companies. In this way, over a one-year period you will have developed a portfolio comprising 30 stocks.
When to sell? Review the stocks that you have been holding for about one year. If a stock has registered gains, sell it a few days after the completion of one year. This will allow you to book long-term capital gains on the stock, hence you will not be liable to pay any tax. Sell stocks that are showing a loss a few days before the completion of one year. This will enable you to book short-term capital loss, which can be offset against your other gains, thus minimising your overall tax liability.
Use the proceeds from the sale along with any additional money available for investment to replace the sold companies with an equal number of new magic formula selections. Continue this process for many years. Buying profitable companies at attractive valuations, which is what the magic formula is about, is bound to yield handsome returns in the long run.
