Buy cheap, sell high – when Joel Greenblatt first developed his technique for selecting good, cheap companies to invest in, he kept the process simple. For the founder of successful New York hedge fund Gotham Capital, the Magic Formula Investing screen remains a key tool in his armoury, even forming the basis of his latest Formula Investing US Value mutual funds, and its apparent simplicity has won it many followers in the investment community.

At its heart, the Magic Formula involves selecting a basket of between 20 and 30 stocks – some of which may have the potential to make a prospective investor blanch. Unloved, misunderstood, occasionally debt laden or with broken business models, Greenblatt’s selection is not a magic bullet and the large basket reflects the likelihood that some of these companies may well struggle to become investment successes. However, these are profitable businesses and by putting trust in the ‘quant’, the theory is that it won’t take too many success stories for the screen to pay off.

Greenblatt’s formula looks to two metrics in a given stock: a high return on capital and a high earnings yield – or, to put that another way, it has to be ‘good’ and ’cheap’. The return on capital measures how effective the company is at making a profit from its assets – this is used as a proxy for how ‘good’ the company is. The earnings yield takes a company’s operating profit and divides it by its enterprise value – the higher the earnings yield the more ‘cheap’ the stock. By ranking the market from high to low for each indicator and adding the two ranks an investor can come up with a ‘Magic Formula’ score for all the eligible companies in the market.

The advantage of this screen is that there will always be companies that are trading at a discount for any number of reasons, and the Magic Formula picks them out. While Greenblatt detailed his techniques in the popular “The Little Book That Still Beats The Market”, his US focus has deprived UK investors from easily applying the screen on this side of the pond (his own website readily produces the results for US stocks). That’s frustrating for those who have been eyeing with interest the impressive returns cited in his book – according to Greenblatt at least, the Magic Formula…

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