To keep myself sharp and my skills honed, I routinely go to my library of investment books and re-read classics that have had an impact on me. This week I did a complete re-read of Joel Greenblatt’s classic “The Little Book That Beats The Market.” For any of you that are not familiar with the book, Joel Greenblatt presents his magic formula for picking stocks that his research indicated will beat the market most of the time.
In Chapter 10 Joel Greenblatt presented the results of magic formula stock picks. Although he did admit that the formula underperformed the market in one out of every four years tested, and the magic formula underperformed the market in one out of every six year periods tested, he provided what he called the good news as follows:
“Following the formula for any 3 year period in a row, the magic formula beat the market averages 95% of the time (160/169 three-year periods tested! But that is not all! Over three-year periods, if you follow the magic formula, you would have never lost money.”
Considering all that has happened in 2020, I thought it might be interesting to present a screen of stocks based on Joel Greenblatt’s magic formula. Furthermore, I thought it would be refreshing to look for under-followed small and mid-cap companies that could be looked at as potential research candidates capable of generating above-average and attractive total returns.
5 MidCap 2020 Magic Formula Picks
The magic formula ranks companies based on two factors: return on capital and earnings yield. However, instead of the normal earnings yield calculation which is the inverse of the P/E ratio, Joel Greenblatt utilized a different method for calculating earnings yield. With his method, he utilized pretax operating earnings (EBIT) to enterprise value.
Joel Greenblatt preferred utilizing enterprise value over market value because it takes into account both the price paid to take an equity stake in the business as well as the debt financing used by the company to generate operating earnings. In a preferred EBIT (earnings before interest and taxes) because it considered full purchase price of the business (both equity and debt).