Joel Greenblatt: Biography, Magic Formula Explained

Joel Greenblatt: American academic, funds manager, value investor, and writer.

Early life & education

Joel Greenblatt was born in Great Neck, New York on the 13^th of December 1957. He is a graduate of the Wharton School of the University of Pennsylvania where he received his B.S summa cum laude, and M.B.A in 1979 and 1980 respectively. 

Career Profile

Greenblatt began his career journey by starting up his hedge fund—Gotham Capital, in 1985 with a startup capital of $7 million.  From the inception till 2006 the company recorded an annual return of 40%.  The American academic has solidly built his career in asset management over time. Without any doubt, an expert at what he does. Listed below are some of his past and current career roles.

●      Managing Principal and Co-Chief Investment Officer at Gotham Asset Management

●      An adjunct professor at the Business school of Columbia University where he teaches Value and Special Situation Investing.

●      Co-Founder with John Petry of an investment club —an online platform called the ‘Value Investors Club’. A platform where investors through an application process approved exchange value and other useful investment ideas. A 2012 study revealed that the approvals and recommendations of members were undoubtedly substantial and beneficial to the investment community.

●      Founder of New York Securities Auction Corporation

●      Former chairman of the board of directors of Alliant Techsystems (1994- 1995), an aerospace and defence contractor listed on the NYSE

●      The director of Pzena Investment Management Inc., a global investment management firm

●      Formerly served on the investment Boards of the University of Pennsylvania and the UJA Federation

Joel Greenblatt explaining one of his investing approaches. 

Magic Formula

Greenblatt is commonly known for his “magic formula” presented in a book he published in 2006 titled The Little Book That Beats the Market. Greenblatt has always followed the investment philosophy of ‘value investing’ which is focused on seeking out large companies quoting low prices in relation to their intrinsic value. From this philosophy, Greenblatt coined the ‘magic formula’

The magic formula refers to a strategy that is rules-based which teaches both new and old-time investors simple and easy-know-how methods for value investing. It works through the ranking of stocks based on their price and annual returns. It also makes use of quantitative screens of companies and stocks and aimed at beating the stock market average returns by using the S&P 500 to signify the market return. In a 2006 interview, Greenblatt stated that the magic formula strategy is designed to aid investors with “buying good companies, on average, at cheap prices, on average.” The investors who make use of the magic formula strategy get to sell the losing stocks before holding the stocks for a year thereby, taking advantage of reduced income tax rates on long-term capital gains.

In his book, Greenblatt identifies two major requirements for stock investing which are (i) stock price i.e identifying shares trading at low prices and (ii) company cost of capital. Using his online stock screener tool, investors are able to select the top 20 to 30 ranked companies fit for investing, rather than carrying out analytical research companies and stocks from scratch. The rankings are made according to the company’s:

-        stock earnings calculated as earnings before interests and taxes (EBIT)

-        yield calculated as earnings per share (EPS) divided by the current stock price

-        return on capital which reflects the turnout of earnings generation from assets

Greenblatt has stated that his magic formula has generated 30% annual returns. Through the use of the magic formula, investors can approach value investing from a methodical perspective with no emotions attached. This formula is only applied to large-cap companies with market capitalizations above $100 million with the exclusion of micro-cap companies—financial and utility companies. Application of the magic formula can be broken into the following steps:

-        Target companies with a market capital of $100 million minimum

-        Exclude financial and utility stocks during company selection

-        Exclude American Depository Receipts

-        Evaluate the selected company’s earnings yield (EBIT ÷ Enterprise value)

-        Evaluate selected company’s return on capital [EBIT ÷ Net Fixed Assets + Working Capital)]

-        Rank each company according to the highest earnings yields and highest return on capital

-        Purchase 2-3 positions in the top 20-30 companies every month within a year

-        Before the end of each year, sell off losing stocks at least a week to the end-of-year, and sell of wining stocks after a week into the new year

-        Go through the process for the next 5 to 10 years or more

The formula not only helps investors identify companies that are quoting at a lower price, but also, selecting those companies that are fit for investing. To identify such companies, the profitability of the assets (ROA) must be put into considerations. Companies that have good profits compared to the cost of the assets that generate them have the ability to double up the reinvesting benefits and generate even greater value. In the past 16 years, the American academic has recorded an annual return of 30.8% through Gotham funds. Greenblatt has repeatedly referred to the formula as ‘magic’ because through the strategy he received an annual profit average of 24% returns between 1988 and 2009. Investing in index funds during that period would normally yield a 9.55% return.

Joel Greenblatt Books/Journal

-        Market Sense and Nonsense: How the Market Really Works (and How They Don’t) (2012).

-        The Big Secret for the Small Investor: A New Route to Long-Term Investment Success (2011).

-        The Little Book that Beats the Market (2006).

-        You Can Be A Stock Market Genius (1997).

-        How the Small Investor Can Beat the Market (Journal Publication) (1980).

Joel Greenblatt explains the Magic formula.