Investing With The Gurus: Joel Greenblatt’s Magic Formula Explained

Guru Joel Greenblatt, of Gotham Asset Management LLC, didn’t get rich by just following the herd. Greenblatt has been at the helm of Gotham since its founding 1985. And Over the more than half-decade or so since he has been managing multiple Funds for clients, he has averaged a cumulative 40% plus return across his three funds.

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So, what is it that makes Greenblatt’s Gotham Funds buck the trend? Let’s find out!

The Magic Formula Explained

Mr. Greenblatt has made no secret about his investing style, and how he picks individual stocks within his Gotham Funds. In 2005, he authored The Little Book that Beats the Market, outlining his investment and stock-picking approach. In 2010, the Guru updated his publication, and came out with The Little Book that Still Beats the Market, to include data covering the (then just ended) worst recession in recent memory.

And, what’s the secret sauce to Greenblatt’s extraordinary success? Well, according to the Guru the art (and some may call it a science) is in picking well-run companies that are temporarily under-loved (under-valued), at great valuations. And then, all you do is sit back and watch the magic happen!

In the Little Book, and its companion website (Magic Formula Investing – registration required!), the Guru goes into great detail explaining what’s behind the Magic of his stock-picking success. For those of you that don’t want to read the book, here’s a summary of Greenblatt’s Magic portion:

1) Evaluate the universe of stocks on the basis of their Return on Capital and Earnings Yield, and rank each of those elements individually

2) Add the two separately-computed ranks to get a single total ranking for each stock in the list

3) Sort the list on total rank, from lowest to highest

4) Put these companies on your watch list, and continue picking at them to add to your portfolio

It’s really that simple! But how would one go about creating an effective portfolio using this Magic Formula?

Building the Magic Portfolio

Well, to build that magic portfolio, Guru Greenblatt suggests that you should focus on the top 20 or 30 names in that list (the ones with the lowest total ranking) – no more than that. And, you don’t just go out and buy an entire position straight away. Instead, you wade into the names over the next 12-months or so, buying no more than 5 to 7 names each month.

Every year, you should go through the list and sell some old names, and use the proceeds to add five to seven new names to the portfolio. It’s a matter of rinse and repeat! If you are creating a taxable portfolio, Mr. Greenblatt suggests you should pay close attention to your TOTAL (after-tax) returns.

So, how long for the Magic to work? The Guru suggests that, if you continue following this discipline over the next three to five years, you too should be able to mirror some of his success. Of course, you should use your own discretion when buying and selling. Don’t just buy when there’s a huge run-up in the markets, nor sell during a major correction – just because the “Formula says so!”.

Like any investing approach, whether its advice given by Benjamin Graham or Warren Buffet – there are always critics. One major criticism of Guru Greenblatt’s Magic Formula is that one year (12-months) is a rather short time to sell an investment from your portfolio, and buy new ones from the ranked list. To detractors of the Formula, one can only say: Look at the track record!

If you want to work some of your own Magic, then a good start might be to head on to Magic Formula Investing and get some inspiration for individual Magic stock-picks from there. The free version of the list is available by registration, but it is slightly dated. For paying members, there’s real-time data available – all ranked and ready for you to weave your own magic into a portfolio of your choice.

Proof of Magic

If you needed proof that the Magic Formula really works, all you need to do is look at the numbers. We started this post by highlighting the cumulative returns delivered by each of the three Gotham Funds managed by Guru Greenblatt and his team. Those returns include distributions. However, how would your portfolio look today, if you only bought and held the three funds over a 5-year period?

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As a retail investor, you’d be looking at just a price appreciation of over 13% over a 5-year period. When most individual investors would gratefully accept 13%, given how the markets are performing today, there’s one thing that you should keep in mind. These Funds come with slightly steep Management Expense Ratios (MERs) – between 2.81% and 3.55%. However, if you planned to buy/sell individual names instead of holding the funds, your trading expenses would likely far outweigh the MERs.

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