Joel Greenblatt first shown his magic formula of investement on his book "The little Book that beats the market". This formula is nothing more than a systemic investement strategy that aims for companies that are following some paramater-compliant established in advance.
This methodology of filtering and ranking companies due to their indicators first began with Benjamin Graham, value investing. Graham believed that the investors who use this value investing method, with companies tha provide a well-founded information base and have a history of positive results, would also be able to make this return in the long run.
Graham's formula, briefly, consisted of buying companies whose stock prices were so low that if the company sold all of its patrimony and honored its debts, it would still be worth more than the market evaluated. He was successful using his strategy for several decades after the crash of 1929. At that time, the market was seen as something of extreme risk, which led to many stocks being traded at bargain prices, resulting in the great success of Graham's strategy (does this reminds you of crypto).
Currently, with the popularization of the stock market and with optimism regarding the stock exchange, actions that meet all the requirements established by Graham's strategy are rare. So Joel invented the magic formula, searching for a way to adapt this systemic investement strategy (graham's) to our time.
According to his book, his methodology had an anual return of 30,8% in 17 years between 1988 and 2004. That means if he invested 11.000 USD in 1988 following this magic formula he would have 1 million USD after this 17 years.
ust to make it more clear how impressive those numbers are, the market in this same period of time only had 12,3%. With this profitability and using the same 11.000 USD as before, he would only had received 79.000USD in 17 years, a HUGE differente.
So his formula ranks companis from first to 3500, so here's his indicators:
- Return on capital - Shows how profitable the company is.
- Profit return - indicator obtained by dividing operating profit by the company's value (market value plus net debt). This multiple tells us whether the company is traded discounted or not.
The magic formula combines these two factors and, given the sum of both, seeks those companies that are at the top of the ranking. In this way, it seeks to buy profitable companies that are discounted. Therefore, this formula allows the investor to systematically search - based on indicators and multiples - for companies that are undervalued in the market.
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