Joel Greenblatt Magic Formula Stocks

Joel Greenblatt didn’t plan to become one of the most influential investors in the world. His original career goal was to make a name for himself in the legal field, and he spent a year at California’s Stanford Law School before he realized that finance was his true passion. Right away, it was clear he made the right call, and he has proven he has a special gift for investing over his 40+ years in the field of finance.

Greenblatt founded his original hedge fund, Gotham Capital, in 1985, and he still serves as Managing Principal and Co-Chief Investment Officer of Gotham Capital’s successor, Gotham Asset Management. To be clear, Gotham Asset Management is a continuation of Gotham Capital’s investment advisory business and not its hedge fund.

Between his accomplishments in the Managing Principal and Co-Chief Investment Officer role, teaching at the Columbia University Graduate School of Business, and authoring a series of bestselling investment books, Greenblatt has built a considerable fortune. By every measure, he is among the world’s most successful investors, thanks to what he calls The Magic Formula.

What is Greenblatt’s Magic Formula?

There isn’t really any magic behind Joel Greenblatt’s Magic Formula, but the fact that it is simple for new investors to use and the formula consistently delivers above-market returns makes it feel a little supernatural. After all, there is no way to predict market behavior, right? Greenblatt’s formula doesn’t guarantee outcomes, but it does offer a clear, actionable strategy for smart investing.

Greenblatt is fundamentally a value investor, so he focuses on quality companies that can be purchased below market value. Other top value investors include big names like Warren Buffett, Ray Dalio, and Carl Icahn.

The Magic Formula provides a straightforward plan to evaluate stocks through objective quantitative screens, then rank them in order of price versus returns on capital. The objective is to find opportunities to buy stocks with high returns on capital at a price low enough to leave plenty of room for growth.

The Magic Formula’s success is due in large part to its focus on objectivity. Even the most sophisticated investors can be sucked into a bad trade when the market gets unreasonably enthusiastic or unnecessarily pessimistic based on external events. The Magic Formula stresses the importance of staying calm and making trades based on facts rather than emotions.

Greenblatt’s Magic Formula isn’t designed for use in every situation. It is intended for use in the methodical evaluation of large-cap stocks. The formula doesn’t work when applied to small or microcap stocks, international securities, or companies in certain sectors like finance and utilities.

Three key data points take center stage in the Magic Formula: earnings before interest and taxes (EBIT), earnings yield (earnings per share divided by stock price), and return on capital. Stocks are ranked based on these metrics, and the idea is to purchase the securities at the top of the list.

There are no sure things when it comes to stocks, and Greenblatt’s Magic Formula doesn’t promise success with every trade. However, it does outline an exit strategy that ensures investors can get out of poor decisions with grace.

Specifically, the Magic Formula recommends selling losers before the one-year mark to maximize tax advantages. When stocks do deliver returns, the Magic Formula suggests waiting a year or more to sell, so that proceeds are taxed at the lower capital gains rate.

Step-by–Step Guide To Joel Greenblatt’s Magic Formula

Joel Greenblatt’s Magic Formula has been thoroughly backtested against the S&P 500, and the overwhelming consensus is that it works.

Greenblatt’s estimate of average returns using the Magic Formula is roughly 30 percent, though the researchers who completed backtesting have found that results vary widely depending on when and which stocks are traded.

These are the basic steps:

  • Set parameters for candidates to be evaluated, including market cap ($100 million or more) and excluding foreign, utility, and financial companies.

  • Calculate earnings yield (EBIT divided by Enterprise Value (EV)) for each company.

  • Calculate return on capital (EBIT divided by Net Fixed Assets plus Working Capital) for each company.

  • Compile a list of the companies in order of their earnings yield and return on capital – the highest go at the top of the list.

  • Every month, open two or three positions in the companies on the list starting at the top.

  • A week before the one-year anniversary of each purchase, determine whether it is up or down, then sell the down stocks.

  • After the one year anniversary, sell stocks that have generated returns.

  • Repeat this process monthly.

More details on Greenblatt’s Magic Formula are available in his books:

  • You Can Be A Stock Market Genius (1997)

  • The Little Book that Beats the Market (2005)

  • The Little Book that Still Beats the Market (2010)

  • The Big Secret for the Small Investor (2011)

  • Common Sense: The Investor’s Field Guide to Equality, Opportunity, and Growth (2020)

What Stocks Does Joel Greenblatt Own?

Joel Greenblatt’s personal portfolio isn’t a matter of public record, but it’s still possible to see which stocks he has faith in by examining Gotham Asset Management’s holdings.

The firm’s top funds have distinct structures, compositions, and goals, and all are actively managed. That means higher fees than passively managed mutual funds and ETFs, and substantially higher fees than independent portfolio management through an online brokerage firm. Self-service brokerage accounts typically have minimal fees or no fees at all.

The four featured Gotham funds are as follows:

Gotham Large Value Fund (GVALX) – This mutual fund is made up of the least expensive stocks in the S&P 500 as calculated by Gotham analysts. Its annualized return is 11.18 percent since inception, which is lower than the S&P 500’s annualized return of 11.76 percent over the same period.

Gotham Index Plus Fund (GINDX) – This mutual fund features index investment with an active long/short overlay of stocks included in the S&P 500. The fund’s annualized return since inception is 10.55 percent, which is lower than the S&P 500’s annualized return of 10.65 percent for the same period.

Gotham Enhanced 500 ETF (GSPY) – This actively managed exchange-traded fund (ETF) holds all of the S&P 500 stocks. However, it weighs them differently than the S&P 500 with more emphasis on stocks that are undervalued based on Gotham analysts’ assessments. Since inception, the annualized performance stands at 4.36 percent as compared to the S&P 500’s performance of 4.45 percent for the same period.

Top five holdings include:

Gotham 1000 Value ETF (GVLU) – This actively managed ETF holds between 400 and 600 stocks out of the 1,400 largest in the United States.

Again, weighting is based on valuation – the fund leans towards undervalued stocks. This ETF launched on 06/07/2022. Its six-month performance totaled 8.20 percent as compared to the Russell 1000 Value Index’s 4.07 percent.

Top five holdings include:

Though most of Gotham Asset Management’s funds aren’t beating the market quite yet, the firm’s investors are comfortable giving Greenblatt some time to show results. They know his original hedge fund posted annualized returns of 50 percent between 1985 and 1994, and they have faith in the power of the Magic Formula.

In the meantime, retail investors can apply the Magic Formula to their portfolios without putting their money into Gotham Asset Management funds. The system is simple, methodical, and effective at generating higher-than-average results.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.