A 'Magic Formula' for Picking Stocks Stopped Working

 

“Warren who?

 

Joel Greenblatt isn't a household name, but the value investor was already famous in financial circles 20 years ago for returns that were at least as good as Berkshire Hathaway in its heyday. Then he wrote a bestseller, "The Little Book That Beats the Market," telling mere mortals a simple way to mimic his performance. Greenblatt called it "The Magic Formula."

 

It has stopped working, though. That tells us something about markets lately, and also about investing in general.

 

Greenblatt never promised investors they could match his hedge fund's 40% annualized returns, which involved more-sophisticated analysis.

 

But backtested results for the Magic Formula returned 31% annualized over the 17 years of data then available. (A $10,000 investment would have grown to nearly $1 million.)

 

The formula kept beating the market for about a decade after the book's publication. Its rolling five-year premium versus an S&P 500 index fund has been negative since 2016, though, according to Alexander Hubbert, a postdoctoral finance researcher at Stockholm University.

 

Hubbert has two explanations. One is that the better any winning strategy is known, the more its performance tends to fade. Greenblatt's formula combines simple measures of value and quality. (Stocks are ranked on both earnings yield [1] and return on capital [2].)

 

The formula's value focus also might just be out of fashion in a world of artificial-intelligence moonshots.

 

"I guess that some of the alpha [outperformance] may come back when the strategy has been out of favor for a while, but it is not a guarantee," wrote Hubbert when asked about his findings.

 

Greenblatt, whose firm, Gotham Funds, didn't respond to messages, has written and spoken about the likelihood of trailing the market for years -- just not this many years.

 

He has said bad periods are a feature as much as a bug, dubbing it "time arbitrage."

 

Because most fund managers can't survive long periods in the doghouse without getting money yanked away, the superior strategy gets less crowded. That helps it keep working in the long run.

 

Staying power isn't the only hurdle: Lots of stocks suggested by Greenblatt's free online screener have weaknesses. Cherry picking only those that don't might hurt results.

 

Stocks with more than $1 billion in market value that made the cut include Altria, H&R Block, Cigna, Yelp, Korn Ferry, Gartner, Versant Media and Crocs.

 

Convinced Greenblatt's method can regain its magic? You needn't follow it to the letter.

 

Unlike 20 years ago, exchange-traded "smart beta" funds that screen for many of the same factors exist, including some launched by Gotham. They're more tax-efficient than what the book describes, which involves lots of turnover. A bonus: You don't have to peek at the troubled companies they own.” [3]

 

1. Earnings yield is a financial metric that indicates the percentage of each dollar invested in a stock that the company earned in profit. It is calculated by dividing a company's trailing 12-month Earnings Per Share (EPS) by its current market share price.

The Formula

Earnings Yield equals Earning Per Share (EPS)/Market Price Per Share

It is also the exact inverse of the traditional Price-to-Earnings (P/E) ratio. For example, if a stock trades at $20 per share and earns $2 per share, its earnings yield is 10%.

Why It Matters

•           Stock Valuation: A higher earnings yield means a company is generating more earnings per dollar of share price, which can suggest the stock is undervalued.

•           Comparing to Bonds: Because it is expressed as a percentage, earnings yield allows investors to easily compare the returns of a stock against fixed-income assets like a 10-Year U.S. Treasury bond.

•           Equity Risk Premium: Generally, investors expect stocks to have a higher earnings yield than risk-free bonds to compensate for the added risk of equity investing.

 

2. Return on Capital (ROC)—also known as Return on Invested Capital (ROIC) or Return on Capital Employed (ROCE)—is a financial metric that measures how effectively a company uses all its funding sources (both debt and equity) to generate profits. It shows the exact percentage of return a business earns on every dollar invested in its operations.

The Formula

ROC equals NOPAT/Invested Capital.

•           NOPAT (Net Operating Profit After Tax): A company's operating income (EBIT) adjusted for taxes. It reflects the core profit generated by operations before interest expenses are factored in.

•           Invested Capital: The total amount of money used to fund the business. It is usually calculated as: Total Debt + Total Shareholders' Equity - Cash (as cash is generally considered a non-operating asset).

Why It Matters

•           Assesses Management Quality: A high ROC indicates that management is highly efficient at allocating capital to profitable projects, whereas a low or falling ROC suggests capital is being wasted.

•           Signals Value Creation: The ultimate goal is for a company’s ROC to exceed its Weighted Average Cost of Capital (WACC). If a company earns a higher return on its investments than it costs to raise that capital, it is actively creating shareholder value.

•           Quality Investing: Professional investors use ROC to identify "quality" companies. Companies with a consistently high ROC are generally more profitable and can command market premiums.

Important Distinction: Return on vs. Return of Capital

Do not confuse Return on Capital with Return of Capital.

•           Return on Capital: Your percentage profit or yield on an investment (which is taxable).

•           Return of Capital: A payout from an investment that simply returns your original principal. This type of distribution is typically nontaxable at the time of receipt because it lowers the cost basis of your investment.

 

3. A 'Magic Formula' for Picking Stocks Stopped Working. Jakab, Spencer.  Wall Street Journal, Eastern edition; New York, N.Y.. 02 June 2026: B12.