Selecting stock with magic formula

Selecting stocks is often associated with something as complex and causes a lot of people assume that the ability to pick stocks can only be done by professionals in that field. It is not entirely true. Indeed there are some conditions that cause the need for special treatment to analyze a stock. Fortunately, in many cases are not like that.

Joel Greenblatt is the one who introduced the "Magic Formula", a method for stock selection. Joel Greenblatt is the founder of a hedge fund namely "Gotham Capital".
The word 'magic' itself can cause a variety of interpretations. Joel Greenblatt himself

coined the term "magic formula" because he could show that stock selection process can be done simply. "Magic Formula" was introduced by Joel Greenblatt in his book entitled "Little Books That Beats The Market". This method is far more modest when compared with the methods of Benjamin Graham's stock selection style that has been discussed in previous articles.

The philosophy of the "Magic Formula"

Basis of the "Magic Formula" is a value investing by adding a factor of the catalyst (accelerator) so that the stocks that we choose can give us in return in a shorter time.

"Magic Formula" own stock selection rested on two criteria:

1. Find stocks with the ROC (Return on Capital) is high.

2. Find stocks with high earnings yield.

Quite simple is not it?

High ROC will give us an indication that a stock provide a high return on our investment value whereas a high Earnings Yield gives us an indication that a stock's price is cheap. The combination of two things will help us in trying to find stocks that have the potential to serve as the investment field.

More About the ROC and Earnings Yield ala Joel Greenblatt

Although in general we can find the definition of the ROC and Earnings Yield on the Internet, Joel Greenblatt himself to a second modification of these parameters to better represent the concept of "Magic Formula". How is the performance of the "Magic Formula" this? Back-testing results using this method showed that the portfolio return bentukannya produce an average of 30.8% per year from 1988 until 2004, or about 2.5 times greater than the S & P 500 return. The results are pretty phenomenal considering the portfolio formation process that only uses two criteria. Let us try to understand both these criteria.

According to the definition of Joel Greenblatt, the ROC is the result of the division EBIT (Earnings Before Interest & Tax) by the number of Capital Employed (Capital employed). Ok, let's surgical components one by one. Unlike the ROA is Net Earnings divided by Total Assets, Greenblatt choose to use EBIT as numerator because it can better describe how much profit the company before the influence of interest on the loan to be paid as well as his tax obligations. EBITDA is similar to the Operating Profit. Regarding the denominator of Capital Employed, Greenblatt defines as the sum of the net working capital (current assets - current liabilities) and net fixed assets.

ROC = EBIT / (Net Working Capital + Net Fixed Assets)

Regarding Earnings Yield, a general definition states that the Earnings Yield is the inverse of P / E ratio. Thus, a stock with a P / E of 20 is said to have the earnings yield of 5%. Joel Greenblatt modify this ratio by dividing EBIT by what he called the "Enterprise Value". Enterprise Value is the sum of the market value of equity (if declared per share is also called the stock price of A) and debts. Using this definition, Greenblatt measure the performance of a stock as a business entity, including its debts. Standard definition of earnings yield (EPS / Price) is often misleading because it does not involve debt in its calculations.

Yield Earnings per share = EBIT / (total debt + stock price per share)

How it Works "Magic Formula"

After calculating the ROC and Earnings Yield of each stock, do the rating on the shares are based on two criteria. Stocks with the highest ROC will be at rank one. Similarly, the Earnings Yield. Earnings Yield Stocks with the highest ranking will be at 1. The next step is to add up the ranking of a share for the second criteria. So if a stock is ranked 10 for the ROC and is ranked fifth for Earnings Yield, then the stock has a score of 15. The smaller the score, the better the stock. The final step is to select stocks with the smallest score. The number of shares that we choose is up to our own. Just a reminder, should we not include banking stocks because of the nature of his business caused him to have a huge debt that will cause a bias in our selection.