Steps to invest in stocks like the professionals

Investing in value stocks have underperformed the market over the past few years. This is where the «Magic formula» by Joel Greenblatt: The world-famous hedge fund manager's easy-to-replicate strategy could help us generate good long-term returns on our stock investment. And all we have to do is follow these simple steps…

Joel Greenblatt's "magic formula":​

1. Find a good company​

Greenblatt uses a single measure to define a “good company” for a stock investment: return on invested capital (ROIC). In his opinion, companies that achieve a high ROIC, i.e. those that use their investors' money to add value to their businesses effectively, they probably have a special advantage: the ability to maintain a competitive advantage over competitors. That should, according to Greenblatt, allow the company to maintain above-average margins to preserve market share, leading to positive and stable earnings growth in our investment in stocks of this type.

To evaluate ROIC, Greenbatt looks at earnings before interest and taxes (EBIT) to measure profits and tangible capital employed (net working capital plus net fixed assets) as a measure of capital. The greater the relationship, the better the quality of the business. In practice, Greenblatt categorizes “a good company” with this calculation: EBIT ÷ (Net Fixed Assets + Working Capital).

2. Find a good company at a bargain price​

Buying a good company is not enough. To generate above average returns, we have to make our investment in stocks at bargain prices. Greenblatt's favorite valuation metric is enterprise value (EV) on earnings before interest and taxes (EBIT). He prefers this ratio to more traditional ones, such as the price-earnings ratio (TO START WITH...), because it is less influenced by changes in debt levels (EV includes both equity and debt) and taxes. But in his calculations, Greenblatt reverses the relationship to ensure that a higher number means a more attractive valuation level. This EBIT/EV ratio is called "earnings yield" and indicates how much a company earns relative to the company's purchase price. Therefore, the calculation of a bargain price is:

3. Filter your finds and buy the best​燐​

We have already managed to carry out our investment analysis in shares of promising companies at bargain prices. Now we have to filter which ones to invest in and how. First, we must rule out investing in stocks that we cannot use. Anyone with market caps less than $50 million, as they are too expensive to trade. We also eliminate investment in financial and investment stocks. public services since their business models are too different to make them comparable.  

Next, we have to classify the “good and cheap” companies based on how good and cheap they are. We can use the same metrics above (ROIC and EV) to prioritize them. And once finished, we combine the two classifications. Now that we have our stock investment analysis ready, we invest in 5-7 of them using 20-33% of the money we intend to invest during the first year, and then repeat every quarter until we have our stock investment completed. In this way, we will own around 20 shares. We sell a company that we have held for a year, and reinvest the capital. We repeat for a minimum of three years, regardless of the profitability of the investment.

Does Greenblatt's magic formula really work?⚙️​

It does, as long as we have a long-term investment time horizon. Greenblatt's magic formula is, at its core, a value stock investing strategy, and value stock investing strategies should beat the market over the long term. When Greenblatt published his book on this magic formula, the strategy boasted returns of nearly 30% annually, double what the S&P 500 generated over the same period. But value strategies can also go through long periods of low returns, and the magic formula is no exception. It's had a positive performance over the last decade, sure, but it's still underperforming the S&P 500.

Now, however, value strategies, and the magic formula, are well positioned to generate high returns again over the next decade: growth stocks, like those in the technology sector, are typically at high valuation levels, and stocks Value stocks have historically performed very well after long periods of low returns.

How can we take advantage of the magic formula?路‍♂️​

There are three ways we could use Greenblatt's magic formula:

• We could follow the formula to the letter, making a progressive equity investment in the top listed stocks each quarter and selling the ones we have held for a year. Greenblatt updates his list regularly and always shares the list of stocks recommended by the formula. We can find the filter and the list of actions here.
• We could use Greenblatt's stock list to generate ideas, looking for promising stock investment opportunities before delving into their business models. If we have the patience and ability to conduct proper in-depth qualitative analysis, we can create a more focused portfolio of our 5-10 stock investment ideas where we have the greatest conviction or avoid companies that we believe will perform poorly.
• We can use the magic formula as a starting point and develop our own completely independent stock investment analysis filter