This American Investor's 'Magic Formula' For Stock Market Is A Mix Of Warren Buffett's & Benjamin Graham's

Billionaire Warren Buffett and Benjamin Graham are two legendary investors who are considered among the greatest of all time.

But there¡¯s another well-known investor in the world who in fact combined both Warren Buffett's and Benjamin Graham¡¯s approach to put together a unique investing strategy called the ¡®magic formula¡¯.

Joel Greenblatt's Magic Formula

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65-year-old Joel Greenblatt's ¡®Magic Formula¡¯ is a unique investing strategy that combines Warren Buffett¡¯s value investing and Benjamin Graham¡¯s deep-value approach. It provides a systematic way to identify potentially undervalued stocks with strong profitability through this approach.

For the unversed, Joel is an influential American investor and managing principal and co-chief investment officer of a US-based investment management company Gotham Asset Management.

By authoring ¡®The Little Book That Beats the Market¡¯ and its follow-up ¡®The Little Book That Still Beats the Market¡¯, Greenblatt¡¯s goal was to write books simple enough that his children could understand and use yet have them reflect the core values used by Greenblatt to manage his portfolio.

How The Magic Formula Works

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Greenblatt described the magic formula first time in the book where he outlines two criteria for stock investing: Stock price and company cost of capital. Instead of conducting a fundamental analysis of companies and stocks, investors use Greenblatt's online stock screener tool to select the 30 to 50 top-ranked companies in which to invest. Click here for the magic formula screener tool, as per Investopedia.

Company rankings are based on:

-Their stock's earnings which are calculated as earnings before interest and taxes (EBIT).

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

-Their return on capital measures how efficiently they generate earnings from their assets.

Also Read: Mohnish Pabrai: The 'Copycat Crorepati' Who Made Billions By Following Warren Buffett¡¯s Strategy

"Helps Buy Good Companies At Cheap Prices"

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As Greenblatt stated in a 2006 interview, the magic formula is designed to help investors with ¡°buying good companies, on average, at cheap prices, on average.¡± Using this straightforward, non-emotional approach, investors screen for companies that are good prospects from a value investing perspective.

Magic formula investing uses a set of quantitative screens to eliminate certain companies and ranks the remainder in order of highest yield and returns. By slowly building and rebalancing the portfolio every year, it is possible to achieve reasonably high returns.

The key metrics for investing with the magic formula method are the earnings yield and return on capital. Earnings yield is determined by dividing each company's earnings before interest and taxes by the total value of the enterprise. Return on capital is determined by dividing the company's EBIT by the sum of its net fixed assets and working capital.

As per a Forbes report, Greenblatt follows Benjamin Graham¡¯s ¡°margin of safety¡± philosophy to allow some room for estimation errors. Graham said that if you think a company is worth $70 and it is selling for $40, buy it. If you are wrong and the fair value is closer to $60 or even $50, you will still be purchasing the stock at a discount.

Greenblatt finds stocks selling at bargain prices by seeking out companies with high ratios of EBIT (earnings before interest and taxes) to enterprise value. Enterprise value is equal to the market value of equity (including preferred stock) plus interest-bearing debt minus excess cash.

Also Read; 15 Books Recommended By Billionaire Warren Buffett For Investors

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