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Joel Greenblatt Magic Formula of Investing

03 Oct 2023

Introduction:

You must have heard of several rags-to-riches stories of stock market investors. Investors like Rakesh Jhunjhunwala, Vijay Kedia, Porinju Veliyath, and Radhakishan Damani have made billions by investing in the right stocks.

But do you know that one thing all these investors have in common? They can identify and invest in multi-bagger stocks. Those stocks that can deliver more than 100% returns within a short period are known as multi-bagger stocks.

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Consider this. Had you invested Rs. 10 lakhs in Uniply Industries shares in 2014, your investment would have become approximately Rs. 1.4 crores within a year. Similarly, had you invested Rs. 1 lakh in Garware Technical Fibres stocks in 2010, the value of your investment would have grown to Rs. 2.6 crores by 2020.

However, the challenge is to identify such multi-bagger stocks. You might wonder if there is a magic solution that can make your task easier. But what if we tell you there indeed is a magic formula to identify multi-bagger stocks?

Joel Greenblatt proposed a magic formula in 2005 to identify stocks that can yield high returns and beat the market average by a fair margin. Keep reading to learn about Joel Greenblatt and his magic formula for investing.

Who was Joel Greenblatt?

Joel Greenblatt is one of the most successful American investors and a professor at the University of Columbia. Born on 13 December 1957, he is known for his value investing and hedge fund managing capabilities. He runs an Asset Management Company – Gotham Funds – with his partner Robert Goldstein.

Greenblatt introduced his magic formula for investing in his book named ‘The Little Book That Beats The Market’. He studied several prominent investing strategies, including the momentum investment strategy, value investing strategy, and the deep-value investing strategy to derive his magic formula, which can help you select stocks that can provide significantly higher returns in the mid-to-long term.

What is Joel Greenblatt’s magic formula for investing?

Joel Greenblatt’s magic formula for investing works on two principles – the current price of a stock and the parent company’s net operational costs. It suggests you invest in the stocks of companies with extraordinary return on capital employed (ROCE) or high earnings yield. These factors indicate whether a stock is selling at a fair valuation or not.

You can calculate the ROCE of a company by dividing its earnings before interest and taxes (EBIT) by the tangible capital, i.e., the sum of adjusted net working capital and net fixed assets.

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

Whereas, you can derive a company’s earnings yield by dividing its earnings per share, i.e., profits divided by outstanding shares, by the market price of each share.

You can use these two parameters to compare stocks of various companies and segregate them based on your analysis. You can even create two different lists of stocks based on ROCE and earnings yield, and then, select the common ones.

Joel Greenblatt suggested the following three steps in his magic formula investing strategy:

Step 1: Evaluate the ROC and earnings yield of different stocks and prepare a list in descending order

Step 2: Select the best stocks from the list. You can select around 20-30 shares at a time

Step 3: Invest in the selected stocks and wait for the long term to see the magic. Try creating a diversified portfolio of more than 20 companies

While proposing his magic formula, Greenblatt found that it is less effective on stocks belonging to the utility, financial sector, and foreign companies. So, you can filter out such stocks in Step 1 to get the best results.

Advantages and limitations of Joel Greenblatt’s magic formula

The advantages of using Joel Greenblatt’s magic formula for investing include:

  • A simple-to-use strategy involving some straightforward mathematical calculations
  • The strategy has a high success rate
  • No need for round-the-clock portfolio monitoring
  • Helps to create a diversified portfolio

The limitations include:

  • The strategy may not work under all market conditions
  • Less effective on stocks belonging to the utility, financial sector, and foreign companies
  • Involves high risks

The final words

Greenblatt’s magic formula for investing can help you identify muti-bagger stocks and invest for the long term to get excellent returns. However, it involves certain risks and limitations. So, before making your investing decisions, ensure you are well aware of all the aspects.

If you need a Demat account to begin your investment journey, you can open it for free with Motilal Oswal.

 

Related Articles:  What is a Death Cross | Everything You Need to Know About Risk Management | Understanding Dividend Payout Ratio

 

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