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hi so one of the most popular investing books for the last decade is called the little book that beats the market by joel greenblatt it's a fantastic book and i highly recommend reading it but if you haven't read it before well don't worry i'm going to go through and give it a full review today and explain what the magic formula actually is okay so the concept behind the magic formula created by joel greenblatt is to make a list of companies that are both undervalued and good quality so that sounds pretty simple right so the first thing we have to do is create a list of all the companies from most undervalued to most expensive and joel greenblatt suggests that we rank these based on what's called the earnings yield so the earnings yield and it's essentially whether the company is making really good earnings and the value of the company is low compared to those earnings well it's a sign of a good deal so we make a list of all the companies and we rank them by this earnings yield so we have that list and now we make another list and we rank all of the companies and this time we rank them based on their return on capital now this return on capital well it's a measure of how good the company is at making money with the assets that they have so a factory that has 20 million dollars of machinery and makes 1 million dollars of earnings a year well that's 1 million dollars divided by 20 which equals 0.05 or 5 return on capital and then we have another factory that has 20 million dollars of machinery but makes two million dollars of earnings a year so that's 2 million divided by 20 million or 0.1 which is 10 percent return on capital so 10 is better than 5 percent so the second factory would be ranked above the first factory so return on capital well is a really simple basic measure of quality of a company so now we have two lists we have one where all the companies are ranked on their earnings yield and the other where it's all on their return on capital so here is a demonstration of the two lists now i've made five companies up here but pretend this is done with thousands of companies on the u.s stock exchange so we have our companies ranked on earnings yield and return on capital here so now in the second table what i've done is i've ranked them based on now what's called the magic formula number that is the ranking based on the earnings yield and the return on capital so if we look at tiny tulips for example tiny tulips came third in the earnings yield but it was first in return on capital so first place plus third place gives it a magic formula number of four roses are us well it was first in earnings yield but it was actually fourth in return on capital the one plus the four gives us a five now just like golf the lower the number here the better so tiny tulips would be the best magic formula stock from this list because it has the lowest score and that's how the magic formula works but on obviously on a larger scale so joel greenblatt the author and creator of the magic formula is a value investor professor at columbus university and runs the gotham funds hedge fund he also started what's called the value investors club which is a 250 people exclusive membership group of investors who win 5 000 every two weeks for their best investing ideas it's very famous now i like joel greenblatt because he uses a very scientific and data-backed approach to his investing and is really not that complicated and the magic formula that he created well it's very sensible and logical so as greenblatt stated in a 2006 interview with barons the magic formula is designed to help investors with buying good companies on average at cheap prices on average using the straightforward non-emotional approach investors screen for companies that are good prospects from a value investing perspective so the strategy is to follow this process first rank all of the companies and give them a magic formula ranking step two by two or three positions each month in the top 20 to 30 companies over the course of a year step three now each year you'll actually need to rebalance the portfolio by selling off the losers one week before the year ends and then sell the winners one week after this one year mark now the reason you do this and you sell off the losers first and then the winners a little bit later uh it's actually a tax strategy because once you get past one year uh you get a reduction in what's called capital gains and anyway it's just a tax strategy and then step four which is probably the hardest you repeat the process each year for a minimum of five to ten years or hopefully more so in the book the back tested period was from 1988 to 2004 which is a good sample size and as you can see the 33 return is exceptional compared to the market of about 15 over that time this is some of the best long-term returns out there and why the book gained so much popularity now the book was written some time ago and a more recent back test from 2004 to 2016 which included the 2008 financial crisis shows that the magic formula strategy still was superior over the long term but what i want to do is highlight some very very important points so if you invested in the strategy and followed the rules exactly in 2004 well in 2009 five years later you would have exactly the same as the s p 500 index fund has returned as well so you could have gone through all of this work done everything perfectly for five years and still had no advantage now this shows you just how difficult it is to follow a strategy and that hardly anybody was able to implement the plan in the book because you would lose a lot of respect for the method that hasn't really done anything for you for five whole years but if you got through this difficult period and trusted the process well you would have been rewarded significantly more than an index fund and most other investing strategies now this graph is even more interesting see this is the back test from 2015 to 2019 if you applied the same strategy you would be far worse off after this five year period than the index months i find this really fascinating as the longer time frame has proven to work really well but a shorter time frame well it can be problematic so the strategy appears to have merit over say a long term time frame like 10 years plus but because it's such a long time frame it's so difficult to implement so because it is so difficult to mentally stay with a strategy like this i think it will always work think about it from a human psychology point of view if you had five years of inferior returns well you're probably going to get fed up with that and you're probably going to make some changes to that strategy and i bet after these five years a lot of people just completely disregard the strategy anymore and just move on to some new approach if i was honest with myself and i had five years of inferior returns well i would think i'm doing something wrong and i would probably look for an improvement in my plan because after those five years well i don't really want to wait for 15 years just in case like what if i am wrong what if this strategy doesn't work anymore i don't really want to wait those that big long time frame that really the data suggests you do need to wait that long so the strategy i think is a really good one but the discipline required to stick with it for such a long period of time i think it makes it nearly too difficult and that's why i think the strategy will always work because generally most people is going to be way too difficult to stick to for such a long period of time so even when artificial intelligence starts doing stock selections for people and running managed funds and following the magic formula well what will happen is they'll be inferior to returns for a period of time maybe like the last five years and people will still pull money out of these funds so for those people out there who really just want a set and forget strategy and they have to just look at it probably once a year well this might be the perfect thing for you so this is the magic formula website so it's a very simple website to use what we're going to do is we want to put in a number for the minimum market cap now i like to start at 1 000 million so that's one billion dollars is the minimum market cap and then the number of stocks i like to keep it at 50.
so then i just break guest stocks and that's it it just literally has ranked them for us these are the 50 companies that would be the top 50 of the magic formula so that's remember earnings yield and return on capital combined together ranked on a new list and this is that list so here are the top 50 companies and look i've looked at a lot of these companies before and you can see some of them here i've got alexian pharmaceuticals i've got uh biogen uh big lots is an interesting company that i'm i've been i've been looking a little bit at recently uh what else do we got here there's anyway discoveries coming up on a lot of uh hedge fund managers and stuff they've been investing in discovery so here it is here uh foxcorp i've heard about that recently from one of my subscribers and as you can see there's a pretty substantial list here of of different companies so uh what i would do next is it says well i've done 1 billion so let's make it now 10 billion and i get these stocks so now we're talking pretty much large cap companies so abbvie we've got abbvie here i can see uh amgen we've got well biogen still on this list which is good to know um you can see there's intel now intel corp i've done a a video on intel before so now we've got just the bigger companies something i like to do next is now i've got a virtual feel for what companies are here now let's go small so let's go the smallest range we can do which is 50 million so now we're going to have pretty much nearly the entire market so we've got small very small micro cap companies and we've got the big companies as well so this will be a more uh i think probably the best of the lists but i like to see whether some of the big companies have made it into the smaller list as well so biogen biogen has come up on every of the three screens we've done so far biogen has come up on all three so that's a very good sign i should then go and do some research which if you've watched some of my videos you'll know that a few about a week ago i i'm really bullish on biogen so another thing we can do is actually just sort them by 30 stocks so now we've got a smaller list so it's just the top 30 now so that's probably plenty you probably don't need to go much more than that anyway so here are the 30.
now don't overlook those smaller companies just because their market cap size is in just the 50 million range well that's often overlooked by hedge funds and big investors so i definitely want to look there so let me explain exactly how i use this screen now i use it as a starting point to do a far deeper research into a company and there are some fantastic ideas here and some of the companies on this list well i have done research on now trying to stockpit like this does have its own disadvantages i will definitely overlook some companies and make some mistakes because some of the companies that are on this list are just about to turn around and explode but unfortunately i'm probably going to rule some of these companies out for whatever reason maybe i just don't like the industry or i think the business model is too complicated or even i just see something wrong with the financials from my point of view so the easier decision here is to just trust the back-tested data and just invest in the same methodology as joel greenblatt suggested and don't worry about it for the long term so do i trust this method well honestly i'm still undecided see i can see the science is staring at me in the face and i can see that it will work over the long long term but i'm just still a bit unsure that a magic formula can exist definitely read the book for a better understanding into this strategy it's a really easy read and i'll leave a link in the description as well i hope you enjoyed this video hit that like button for me and i'll see you in the next video you
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