Magic Multibagger Formula from Legendary Joel Greenblatt

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How often we wish to have a magical formula which can be used to find next multibagger. Well, you are in luck as legendary investor Joel Greenblatt has a magic formula for multibagger returns. This formula was backtested on S&P 500 and guess what, it gave an average yearly return of 30% and beat S&P 500 96% of the times. This formula was developed for US stock market and keeping in mind US accounting pratices & taxation laws at that point in time. While many mutual fund houses & researchers use this magic formula to filter stocks from Indian stock market, they seldom publish these results openly in public forums.

At AI Post, we are committed to bring best of investment knowledge to our Ace readers free of cost. No need to pay for training institutes 🙂 In this article, we apply Joel Greenblatt’s magic formula on Indian small cap stocks to see which stocks are worthy of this filter at current market prices.

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Who is Joel Greenblatt?

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Photo Credit: santangelsreview.com

Born in 1957 in the financial capital of the world – New York, Joel is an american hedge fund manager, investor, professor & director of a high-end investment company, Pzena Investment Management. He is currently managing assets worth $5.3 billions under his mutual fund. He co-founded Value Investment Club which has a limited 250 members across the world. He shot to fame when he published a book called “The little book that beats the market” in 1980. In this book, he first wrote about the magic formula and followed it up in 2010 by publishing another book named “The little book that still beats the market”.

Joel wants investor to keep it simple. In his own words, if you can’t figure out value of a company, you have no business investing in it. He compares process of stock investment with real estate. If you are planning to buy a $1 million house, you will find out what is the rental yield on it, how cheap it is with house next door, and houses in next town. Same should be applied before stock purchase as well. You should value a company & buy them at discounted prices and be disciplined, that’s all about it.

Magic Formula

Greenblatt’s magic formula is designed to help investors with a straight forward, no emotion approach. In his own words, his magic formula is about “Buying good companies, on average, at cheaper prices, on average”.

In his book, he outlines two main criteria for picking stocks, a) High Earning Yield and b) High Return on Capital Employed. You can rank companies first based in their Earnings Yield and then based on Return on Capital. The resultant stock list will be the outcome of this magic formula. Seems very simple but hidden is the fact that these two criteria will invariably cover many fundamental aspects. These ratios generally represent health of a company vis-a-vis stock price.

Let’s go to the step by step approach for using this formula. There are some caveats in applying these filters. Joel wrote this keeping american market in mind, so we have added our comments so you can relate them to indian stock market context.

  1. Establish a minimum market capital. Usually this formula is applied on large & mid caps but it is equally good enough to apply on small caps.
  2. Exclude Finance & Utility stocks because their business model is different and some ratios will go haywire.
  3. Exclude foreign, Non US companies (American Depository Receipts). Again, this was stated by Joel as he was referring to American stock market where company can be hosted abroad to enjoy certain tax benefits. In Indian context, we can stick to Indian companies listed on our stock exchanges.
  4. Find out Earnings Yield: Joel defined earnings yield slightly different as follows:
    • Earnings Yield = EBIT / Enterprise Value
    • This earnings yield formula is different from usual formula which is EPS / Stock Price. EPS is Earnings Per Share which is calcualted as profit per share after company pays off interests & taxes. When you use EBIT (Earnings before Interest & Taxes), you are effectively knocking off impact caused by interests & taxes. This will bring all stocks to same level since different companies operate under different tax structures & debt levels.
    • It takes Enterprise Value instead of stock price per share to factor in debt levels of the company. This is because enterprise value will account for not only price paid per share but also the debt cost used by company to generate that earnings.
  5. Find out Return on Capital Employed: This will help to determine which company is generating more profit on per rupee of capital used.
    • Return on Capital = EBIT / (Net Working Capital + Net Fixed Assets)
    • Net working capital is the capital required to run the business, and fixed assets are building, machinery, etc.
  6. Rank Them: After following above steps, you will have a list of stocks as per your chosen market capital limits. This list needs to be sorted & ranked. You can rank them by first sorting them on higher Earnings Yield and then further sort them based on higher Return on Capital Employed.
  7. Invest in Top 20 or 30 Stocks: After following steps from 1 to 6, you will have a list of stocks sorted and ranked. Invest in top 20 or 30 stocks to achieve diversification and redo this exercise every year at a set date. Sell stocks that falls out of top 20 list & buy the new stock which will make fresh entry into the list. Totally non-emotional, data based investment approach.

Magic Formula Stock List

We applied Joel’s magic formula on Indian small cap stocks by taking a market capital of more than ₹400 Cr but less than ₹2000Cr, using 20% or more as a filter for return on capital employed over last five years timeframe. Only 5 stocks were able to clear this filter within ₹1000Cr so we expanded our filter to ₹2000Cr. Please note this is not an investment advice but an illustrations using Joe’s magic formula. As it relies only on past data, it lacks qualitative filters based on future outlook.

  1. SQS India BFSI Ltd. (Market Capital ₹471 Cr)
  2. Stovec Industries Ltd. (Market Capital ₹506 Cr)
  3. Harita Seating Systems Ltd. (Market Capital ₹508 Cr)
  4. Chaman Lal Setia Exports Ltd. (Market Capital ₹548 Cr)
  5. Atul Auto Ltd. (Market Capital ₹841 Cr)
  6. GM Brewries Ltd. (Market Capital ₹1377 Cr)
  7. Apex Frozen Foods Ltd. (Market Capital ₹1418 Cr)
  8. Accelya Kale Solutions Ltd. (Market Capital ₹1494 Cr)
  9. PSP Projects Ltd. (Market Capital ₹1659 Cr)
  10. Hawkins Cookers Ltd. (Market Capital ₹1781 Cr)

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