It seems that every argument supporting Joel Greenblatt’s magic formula examines some flavor of a backtest to prove its effectiveness. The problem with backtests is that the results don’t tell the complete picture. Backtests are fundamentally flawed, so we should find other ways to validate or disprove the magic formula strategy.

Backtests are dangerous indicators of success for two reasons.

• Time periods can be easily cherry picked
• Survivorship bias can skewer results significantly

When it comes to backtests… the shorter the time period examined, the more important timing is. This should be obvious, as results can fluctuate greatly even in short 1-3 year periods.

But results also fluctuate over the very long term. For example, examining the performance of buy and hold during 1999 would show it greatly outperforming market timing. That same study after the 2000 crash would show buy and hold as a sub-optimal strategy. The media loves to place significance to these performance numbers as they make for sensational headlines.

On a related note, out performance between value stocks, growth stocks, and momentum trading also fluctuates depending on the starting and ending time period. Small caps and large caps performance naturally fluctuates. Various asset classes are better investments at different times.

So you can see, performance numbers even on a CAGR basis greatly differ due to the natural cycling of investments and asset classes. And even though the impact reduces over a long enough time frame, there’s still a significant difference especially at market extremes.

Take this obvious example.

An examination over 20 years would see the S&P 500 returning roughly 6.6% a year from 1989 – 2009. A cherry picked time period just slightly shifted from 1991 – 2011 of the same index would be 14.8%.

The strong diversity of strategies by various fund managers shows their performance to fluctuate depending on the time period as well. Guys like Buffett had staunch under performance to the market average during the late 90’s bubble. Yet it only took a couple years to reverse that performance data.

So while Greenblatt achieved a CAGR of 40 – 50% over a 10 year period, this alone isn’t enough evidence to prove a strategy’s validity partly due to the weakness of backtests.

Of course, along with the inherent problems with backtests and past performance data are the many stock screeners which cherry pick stocks from the past and further skew the resulting data. The further back a strategy looks back, the harder it is to obtain financial data—especially before the internet.

As far as looking for SEC financial figures online, finding any data before 1992 – 1994 is impossible if you’re strictly using their own website, sec.gov. You’d likely have to go to a library to get easy and free access.

So the limited availability before 1992 either constrains the number of people able to publish relevant backtests or constrains the backtest to the last 25 year time period.

As we’ve seen previously, even a longer time period like 20 – 25 years can be greatly misinterpreted based on current market prices and how they fall in the bear or bull market cycle.

Don’t also discount the significant effect of companies that either fell off a major index or went completely bankrupt. Many backtests simply don’t include such companies. There’s no use in providing this data for many financial websites.

Stock screeners and backtests both tend to use stocks that are still currently trading. Screeners must sift through data already there, and many stocks that fell off aren’t included in past databases, especially the farther back you go. It makes a compounding effect in skewing the results.

Let’s be clear, I’m not completely discounting the value of a backtest.

It provides a good starting point but isn’t the end-all be-all for proving or disproving a strategy. I believe a strategy like the magic formula should be valid on a logical level.

If the reasons why the magic formula works does make sense on a fundamental business level, then coupling this evidence with past performance track records of Joel Greenblatt will suffice.

It’s no different than studying Graham or Buffett and understanding what the numbers mean, why they work like they do, and how such a mindset can be implemented by the average investor. As I’ve written before, blinding following a margin of safety formula can be both difficult and disastrous, as can blindly accepting the results of a backtest.

What is the Magic Formula exactly?

Joel Greenblatt wrote a bestselling book outlining his strategy called The Little Book that Beats the Market. The magic formula ranked stocks based on these 2 metrics.

1. Earnings yield
2. Return on capital

Following the magic formula investing strategy also comes with these conditions:

• A stock should have at least $50 million in market cap
• Financial, utility and international stocks are prohibited
• Buy the top ranked 5-7 stocks every 2 to 3 months
• Sell each stock after holding for a year (1 week beforehand if the stock is a loser for a short term capital loss deduction, 1 week afterwards for a winning stock for a long term capital gain)

With a few disclaimers:

• Your portfolio will be fully diversified in about 10 months
• Outperformance should take effect in about 3-10 years

Now, let’s simply look at the formulas for earnings yield and return on capital to deduce what they mean on simple terms and if they make sense for finding solid stocks that are likely to outperform.

Earnings yield = EBIT / Enterprise Value

Before we make any conclusions, let’s define the numerator and denominator. EBIT stands for earnings before interest and taxes. It hones in on how the core of the business is performing (or its operations). It ignores the effects of taxes (obviously) and non-operating factors like changes in investments or assets.

Basically, EBIT wants to see what did the company earn after paying expenses before complicated financial maneuvering from management or accounting affected final net income.

Next is enterprise value. This calculation is a bit more involved…

Enterprise value = Market cap + Long and Short Term Debt + Minority Interest + Preferred equity + Unfunded pension liabilities – value of associate companies – cash and cash equivalents

Let’s look at the terms we understand most. Market cap and debt are two things we don’t want to see high as value investors. Cash is something we do want to see. The higher the market cap, the less likely a company is overvalued. The more debt, the more risk involved. The less cash, the less liquid a company is.

Notice that the enterprise value in the denominator. So the lower this value—which is what we want—the higher the earnings yield.

Another way to look at earnings yield is that it is mostly the inverse of P/E. We want lower P/E in the same way we want higher earnings yield. But the earnings yield only looks at the earnings numerator as it relates to operating (core) results, and includes a sort of liquidation value in the price denominator.

Someone buying out a company would essentially be paying the enterprise value. He would have to pay the market cap to shareholders and cover the liabilities. He would also get the cash on hand, so the price actually paid for the business would be less in this regard.

Does it make sense to use earnings yield?

You always want to include some sort of valuation when calculating if a stock has a margin of safety—or discount to intrinsic value.

This beauty of earning yield is that it covers all 3 financial statements at once while also considering market valuation. The inclusion of debt ensures a company isn’t overleveraged or driving earnings with debt. The earnings numerator mitigates a lot of possible earnings manipulation and accounting shenanigans a company might be trying to do. The inclusion of cash gives a boost to stocks with large amounts of cash.

In the same token, including earnings makes sure you’re investing in a solid business model. Wall Street will likely reward stocks with high earnings, rendering a greater possibility of short term results in the stock price. It also may undervalue businesses that are otherwise strong on a fundamental basis yet temporarily appearing weaker due to changes is assets. I love all of that.

However, one obvious weakness presents itself.

From this calculation, a company could still score a high earnings yield with a small amount of cash. In the long run, cash and cash equivalents helps a stock weather short term struggles in the business—by allowing the business to inject cash to maintain decent earnings without getting into significant debt.

Greenblatt brilliantly mitigates this weakness in the magic formula approach by adding the rule of selling a stock after holding for 1 year. A stock burning cash won’t be able to withstand more than one year of core business earnings struggles, but it doesn’t matter because you’re selling before that point.

Now let’s look at return on capital.

Return on capital = EBIT / [net tangible assets + working capital]

We’ve already discussed EBIT with the earnings yield. Net tangible assets gives you a good indicator of intrinsic value and another measure of what a business would be worth in a potential liquidation. Net assets is just total assets minus total liabilities. You can look at that as the net worth of a business. High net assets indicates a business with a high book value—an either (or both) a high amount of income producing assets or low amount of expenses or debt.

The tangible aspect of net assets ensures a stock’s book value isn’t highly propped up by less trustworthy calculations of asset value such as goodwill. I’ve discussed in another blog post about how intangible assets can be unreliable as they are based on estimations and are more difficult to value than hard assets.

Working capital is a good measure of a company’s short term liquidity. It’s simply current assets minus current liabilities. A high working capital means a company can likely produce high amounts of free cash flow in a short time period. Many investors consider this as a high potential for growth.

Common components of current assets include cash and cash equivalents, inventory, and accounts receivable (completed orders that haven’t been converted to cash yet). Current liabilities include short term debt, which can be problematic to a business when current assets isn’t high. In such a case, a company would likely have to take on some long term debt to weather a short term earnings struggle.

So if a high net tangible assets and working capital seem to be indicators of a healthy long term business, why is it beneficial for those metrics to actually be low?

Does it make sense to use return on capital?

Well, a low return on capital (thus inferring a high net tangible assets or working capital) could be signaling a company that is very inefficient. An inefficient company would either indicate lagging earnings results or a business that is highly capital intensive. Both of those could mean a poor core business model.

It’s obvious why a high EBIT is preferred. Additionally, low return on capital could signal a short term earnings struggle, which Wall Street is likely to punish in the year or years to follow.

A company with high intangible assets in relation to total net assets is likely to be rewarded with a high return on capital. This is something that Warren Buffett has tended to look for as well. He seems to prefer low capital intensive businesses a lot of the time. Greenblatt obviously prefers this as well.

Notice that this second component of the magic formula has nothing to do with how the stock is valued. The earnings yield will ensure the valuation is favorable, while the return on capital will ensure that the company itself is dedicated to and successful at increasing shareholder value at a rapid pace.

High return on capital is often a defining characteristic of successful growth stocks. By including this as a significant aspect of magic formula investing, Greenblatt includes exposure to the quickly rising stock price appreciation that these companies often experience. By also including earnings yield, he hits a nice synergy of both growth and value. He’s getting growth, but at an attractive price.

Observe that a short term earnings struggle (especially in the operating income figures) would negatively impact both earnings yield and return on capital. This makes a lot of sense for the magic formula, which is highly dependent on short term results with the limitation of a single year holding.

So what’s the verdict?

All-in-all, the magic formula provides exposure to both growth and value by insuring high short term core business earnings, high cash flow and earnings growth potential especially in the short term, and doing all of this at prices that are likely to be discounted by the market.

The magic formula avoids highly leveraged companies. This makes sense in a short term approach as well because those type of stocks can decline in share price in the blink of an eye.

It also utilizes the simple principles that lead many investors to success—such as dollar cost averaging, diversification, portfolio maintenance, and long term investing. Yes, it’s not a complete buy and hold strategy as each stock is sold after a year, but by dollar cost averaging many of the benefits of long term investing are still intact. And any attempt of market timing is eliminated.

That being said, I have one defining problem in that regard.

By selling after just one year, you lose one of the most magical potentials of stock market investing. That is, the double compounding effect of growing dividends.

When you buy stocks that consistently grow their dividend, your investment income from this purchase [your yield on cost] grows every year. Assuming the company is able to continue growing earnings, it should be able to continue growing that dividend as well. Having a dividend yield of 10% a year (and growing) on your original purchase after 10 years or so of holding a stock is an extremely attractive proposition.

While this is of course a big assumption—not all companies will continue such outstanding results—it’s not an unrealistic assumption. The math simply states that steady dividend growth can create such a result.

Then, if you reinvest those dividends back into the stock your results compound on an even greater scale. Over long periods of time, like decades, this contributes to a substantial amount of total return.

You can certainly argue that similar compounding can happen by selling stock and redeploying capital. But, this is contingent on consistent favorable results. A short term strategy that produces losses for consecutive years isn’t taking advantage of compounding interest.

As long as a company is paying a dividend, the investor is taking advantage of compounding interest. It isn’t hard to find stocks that are healthy, undervalued, and likely to sustain dividend payments. It’s way easier than finding a high returning stock.

I also like the idea of an increasing amount of portfolio income into retirement. Sure, you could technically outperform a strategy like mine and then invest into bonds, but the total yield is likely to be quite smaller than an investor with a complete portfolio of stocks with 40+ years of growing dividends.

In the end, it’s an argument of semantics.

The most important aspect of an investing strategy isn’t the results it’s given other people, but how the strategy aligns with your personal values and how likely you are to stick with it.

You could use Greenblatt’s Magic Formula, use bits and pieces of it, or ignore it completely. As long as you use a margin of safety formula you are comfortable with— one that includes the basics like diversification, dollar cost averaging, and long term investing— you’ll be fine.