Interactive Investor "Magic Formula Shares" article includes BMN15 Nov 2020 17:45
https://www.ii.co.uk/analysis-commentary/ten-magic-formula-stocks-investors-looking-value-and-quality-ii513627
"Joel Greenblatt’s value investing method is not good for the impatient, but long term it can hold up well, Ben Hobson argues.
Value investing has had a rough ride over the past 10 years. The part-art, part-science discipline of buying stocks that are cheap relative to what they earn or what they own is a well-worn strategy, but it’s also a painful one when it’s out of favour.
Over many decades, statistical research shows undeniable outperformance from value strategies over time. But between periods of market-beating returns, “value” has spells in the wilderness. It’s these moments of agony that mean many value investors - professionals included - struggle to stick with their strategies. And this is what we have seen over the past decade.
Back in 2005, an American investor called Joel Greenblatt came up with a new kind of value strategy that still resonates with investors today. In The Little Book That Beats the Market, he set out an approach that blends value with quality and ranks the entire market for how relatively good and cheap each stock is.
With this approach, Greenblatt said investors could easily find companies that might be genuinely underpriced. Sure, the list would often contain broken and unloved shares. And given that this was still a value strategy, there would certainly be disappointments. But his so-called magic formula would offer a higher probability of success.
A model of the magic formula strategy applied to the UK market shows just how good - but also how variable - the results can be. Between 2017 and 2019 it delivered reasonable returns, but like many other strategies, the market crash of 2020 hit it hard.
Since then, we’ve seen a steady recovery in the performance of magic formula stocks. Moreover, at a time of market uncertainty, it could be an interesting place to start looking for quality shares that are on sale.
How the magic formula works
Greenblatt’s strategy uses two simple ratios: the earnings yield as a measure of cheapness and return on capital as a measure of quality.
Earnings yield tells you how much profit a company is making in relation to its underlying value. To take account of varying levels of cash and debt in companies, a widely used way of working it out is to divide what the company earns in operating profit by its total valuation (known as the enterprise value).
You can then apply this earnings yield to every company in the market to see which are offering the best value – the higher the yield, the cheaper the company and the more bang you get for your buck.
The return on capital focuses on how good a company is at generating a profit from the investment it makes in itself. Good quality companies are very efficient at delivering high percentage returns from the cash they reinvest to grow.
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