In the world of investing is not uncommon to find gurus that want to tell you their latest discovery, a magic formula for trading or investing that will make you richer than Warren Buffet and that will allow you to spend the rest of your life on a Caraibic island, lying on a deckchair and drinking cocktails.

Unfortunately most of the time the only one that will become richer after reading their miraculous ebook is their bank account. In fact 99% of the time you will just lose time and a lot of money following the words of a quack with no reliable track record, that earns money by selling mediocre products.

However, even if a magic formula that will make you worth more than Warren Buffett in 5 simple steps is yet to be found, I want to talk to you about one of the few reliable formula that are available, the 1% that is not pure garbage and that in this case, on the contrary, can be considered as a condensed mix of key value investing principles.

The formula I am talking about is the one developed by Joel Greenblatt — an investor, hedge fund manager, and business professor — and first described in detail in his 1980 best-selling book “ The Little Book That Beats the Market”.

Joel Greenblatt, born on December 13, 1957, is an American academic, hedge fund manager, investor, and writer. He is an adjunct professor at the Columbia University Graduate School of Business, runs Gotham funds, which he founded in 1985 with $7 million and obtained an annualized return of around 40% from 1985 to 2006. He is without any doubt one of the biggest names in value investing.

Description of the formula

In the book mentioned above, Greenblatt shows a simple but very effective formula that is intended to help investors to approach value investing from a methodical and unemotional perspective, by ranking stocks based on their price and returns on capital.

The formula is based on two main criteria, the stock price and the company cost of capital and requires that you invest in those companies that own either a high return on capital or ROC (the after-tax profit divided by the book value of invested capital) or a high earnings yield (a stock’s previous year’s earnings per share divided by the current share price). The earnings yield is the factor that shows whether the stock is selling at a good price or not. For example, if a company’s earnings are $0.50, and the stock is trading at $4/share, by dividing $0.50 by $4 you get an earnings yield of 12.5, which pretty high. Then, the return on capital shows how well a company can turn an investment into profit, therefore it is basically the profit percentage, so if someone invests $50,000 and earns $2,500, their ROC would be 5%.

The main idea behind this strategy is that if you look for companies with a high ROC, at a low price, you will find bargains, specifically companies that are undervalued by the general market, a concept that is the basis of value investing.

How does it work?

The process for the implementation of this strategy starts by looking at the list of the largest 3,500 companies that are tradable on the main US stock exchanges, these will have to be ordered based on their ROC, in fact, the company with the highest one in the first position, and so on. Then, the same thing must be done by looking at the earnings yield of every company, still with the highest in the first position.

The next thing to do is to score the companies, the score of every company is simply determined by adding ROC and earnings yield. At this stage, the companies with the lowest total score will be considered the best buys.

The third stage is the buying process. In general, to maximize the return on each investment, Greenblatt suggests to buy around 20–30 stocks, this should increase the chances of outperforming the market.

Finally, after one year, you sell the stocks and start the process all over again.

Even if this is a simple basic strategy, it is not as easy to implement because of the long time it takes to go through this large amount of data. Therefore, in order to help you better implement this strategy, Greenblatt provides an online stock screener tool to select the top 20 to 30 companies in which to invest.

An advantage of this strategy is the tax efficiency, in fact investors that use this strategy will sell losing stocks before they have held them for one year, and therefore they will take advantage of the income tax provision that allows investors to use losses to offset their gains. Moreover, they will close the profitable operations after the one-year mark, by doing so they take advantage of reduced income tax rates on long-term capital gains.

As stated many times by Greenblatt, this formula is designed to help investors “buying good companies, on average, at cheap prices, on average”.

Is important to note also that “The Magic Formula” is the result of many studies and backtests conducted by Greenblatt, in fact, over the 17-year period prior to the publication of the book it has returned an average 30% per year, versus the market’s 12% per year.

Final Thoughts

As you have seen this is a very interesting approach that I think can be useful to anyone who wants to approach the world of investing and in particular by using the principles of value investing, with a strong help provided by a standardized set of rules.

In fact in investing, most of the time, the psychological part can heavily influence the result of an investment. For example, when fear comes in, after a crash or after some bad news, you may not act accordingly to your strategy and therefore mess up a good stock-picking process.

Summing up, I think that understanding and following the principles of this formula can be a good place to start, of course past performance is not indicative for future returns but the fundamental principles under this formula are some of the key principles of value investing, an investing approach that over the long-run has proven to be one of the most consistent and effective ones.