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This guy here is Joel Green Blat, and he developed the magic formula to beat the stock market. He put everything about this formula in this book here, and I'm going to explain to you in practice exactly how it works, how to apply it in your daily life, and I'm also going to unravel the following mystery: if there is an almost infallible magic formula, why is it that almost no one succeeds with it?
And I'll say more: is this magic formula replicable in the Brazilian stock market? As Green Blat says in the CCO chapter, it's a very simple premise, which doesn't mean it's easy. In his words, if you stay firm and only buy good and cheap companies, you can systematically buy many slices of the good companies that the market, which historically is the manic-depressive, is getting rid of.
From this phrase, I draw the following lesson: the secret is to buy good companies at low prices. This applies to companies, but it also applies to any type of investment we talk about here: apartments, cars, art, watches. You just have to be careful not to buy something cheap that stays cheap forever.
I like to use an example I heard from Florian Bartunek: Old investor Nato says the following: if you buy a purple 1991 Corça with scratches on the side, you'll probably buy it cheap but you'll sell it cheap too, so you have to be very careful when buying cheap things. As a stock analyst, my job here at Market Makers is to dive headfirst into the world of stocks.
If you follow us here, you probably already know that we have our portfolio and our stock fund, which is inspired by this portfolio. This fund is where not only we, the Market Makers employees, deposit our money, but also where many of our family and friends place their bets. In other words, if the portfolio does well, we and those who follow it will make money, and if it does badly, we will all lose.
And because I experience the market firsthand every day, I'm tired of seeing gurus or financial influencers promising magic formulas that don't actually work very well in practice. In fact, many of them have even disappeared due to the recent bad mood of people with variable income. Really, be suspicious of any immediate promise of enrichment that someone offers you; it doesn't exist.
But then what is the difference between thousands of magic formulas sold? Out there on the internet, and the magic formula of Joel Greenblad... Well, a good part of Joel's credibility and his investment method comes from the surprising profitability he had between 1985 and 2005. His stock portfolio accumulated an annual return of 49%, man, 49% is an impressive number, and these impressive numbers gave him enough reason to write the book we 're talking about now.
The book is just under 200 pages, right? It's quite short, and the formula can be summarized as follows: you need to list the stocks based on two indicators. The first is the earnings yield, and the second is the return on invested capital. The traditional RK works as follows: the earnings yield is a measure to know if the company is cheap.
In the case of the Magic Formula, it is calculated by dividing the EBIT by the EV. I'll explain it simply: EBIT is the acronym for earnings before interest and taxes, which tells us what profit was generated by a company's operation. So, let's go: the company has revenue. It has costs. Expenses are taken into account, and when we deduct all of that, we arrive at the company's operating profit, which is the EBIT, as he mentions.
EV, or Enterprise Value, is the total value of the company distributed among shareholders and creditors. Roughly speaking, it's the company's market value plus its net debt. For example, a company with an EBIT of 300 million and an EV of 1 billion has an unearnings ratio of 30%. The Earnings Ratio (ERR) is used to assess whether a company is a good or bad investment.
To combine these two indicators, Greenbank uses the following method: first, it pulls data from all 3,500 largest companies on the American stock exchange. Then, each company receives a ranking from 1 to 3,500 based on its HOIK (Highest Earnings Ratio). The company with the highest HOIK receives first place, and so on.
After that, it does the same thing based on the average earnings ratio; the company with the highest average earnings ratio receives first place, and here it presents the lowest earnings ratio. Finally, it sums the rankings received using each of the two criteria. In other words, the RO and the un-zild mean that if a company ranks first in terms of RK and first in un-zild, it receives a score composed of two, right?
It's 1 plus 1. In this way, each company out of the 3500 available receives a score, and those with the lowest scores will be chosen for the portfolio, because it reflects the one with the highest HK plus the highest nild. Greenblad tested this strategy over a 17-year period between 1988 and 2004, and the conclusion was that a portfolio composed of the 30 stocks with the best combination of RK plus earning zeld would have a return of 30.8 per annum.
A return like that would transform $11,000 into more than $1 million, or in other words, increase your assets 96 times. For comparison, the average market return was 12.3 per annum, and the $11,000 would have become $ 9,000. As I said, the game itself, Greenblad applied this formula in practice, and that's why it had this...
Such a surprising return! I'll put a table here on the screen that's in the book with the results of the Magic Formula between 1988 and 2004. There you can see the comparison between the Magic Formula and the market average and the S&P 500, which is their main fund and stock index. This leads us to the burning question: is the Magic Formula so accurate and effective?
Why do n't all investors use it? To state the obvious, there are various investment strategies and philosophies, and some investors think differently from others. But the main issue is that the Magic Formula works over long periods of time, and many investors give up halfway through when the strategy isn't beating the market in a given period.
The Magic Formula was tested for 17 years, and in that period, it failed to beat the market once every 4 years; in fact, in some periods, it generated results inferior to the market for 35 consecutive years. And then the question is, could you watch your portfolio have such negative results over 3 or 4 years by faithfully believing in the Magic Formula?
Not everyone has that kind of guts. Another important factor described in the book is that if the Magic Formula worked all the time, everyone would probably follow it, and if everyone followed it, the basic premise would cease to work because bargains would no longer exist. The third factor is that, despite the long-term success of the Magic Formula, many managers don't want to risk performing poorly while the market performs well.
In other words, it's better to be wrong with everyone than to be wrong alone, right? Imagine the short-term damage to the manager's credibility. Now, let's say you and I are willing to apply the Magic Formula to our investments, but there's a catch: you and I are Brazilian, and the game in Blat is American.
Would this formula work here in Brazil? Obviously, finding data on all stocks traded on the Brazilian stock exchange every year and applying the Magic Formula would be a very laborious task. But luckily, there are some academic studies that have attested to its effectiveness in Brazil. One of them is the monograph by Gabriel Roman from the Federal University of Rio Grande do Sul, and today he's on the investment list at Clube do Valor.
He tested the... The " Magic Formula" strategy, tested over 20 years between 2000 and 2020, proved to outperform the Brazilian market average. More interestingly, the study shows that a strategy using only Earnings Zero ( EBIT) over EV, excluding RK, produced returns superior to the traditional "Magic Formula," as shown in this table.
As you can see, the "Magic Formula" applied between 2000 and 2020 had an annualized return of 23.88%. This is significantly higher than the 9.68% of the Bovespa index, the main benchmark for Brazilian stocks. In other words, if you applied this strategy to the Brazilian stock market, you would see your assets multiply 72 times in those 20 years, without considering taxes and transaction costs.
Even more surprising, if the investor had classified the stocks using only Earnings Zero, the annualized return of their strategy would be 2099.17%, a number very close to the return achieved by the traditional formula. The magic formula applied during the breakout period, as I mentioned earlier in the United States, is a strategy many investors fail to adopt because there are bad periods when it does n't beat the market.
Many wouldn't question whether the strategy has stopped working, and this table here, the Rolling Year Win, is a good measure to show this. It compares the strategy's performance with the market in moving time windows, indicating in what percentage of these windows the strategy would beat the market return.
In other words, if the Magic Formula had a Roll- in One Year Win of 77.38%, it means that approximately 77 out of every 100 times the strategy would be yielding above the Ibovespa index in the 1-year period, and below in the other 23 times. The problem lies in those 23 times; it's in these moments that the investor is more likely to give up on using the Magic Formula.
However, if we extend the time period, we notice that the strategy has a lower chance of underperforming the market. The Rolling Year Win of the Magic Formula is 88.89%. The 5-year figure is 91.71%, and the 10-year figure shows that the Magic Formula never lost to the IB Vesp. This is why investors who decide to use this strategy need to understand that it only works perfectly over longer time horizons.
If you're paying close attention to everything I'm telling you here, you might wonder why the previous table tested the results of different strategies for only 20 stocks, when we said that the original Magic Formula by John Blat was used for Trent Roman stocks, the student who conducted this study, shows that the strategy produces higher returns using exactly 20 stocks in the portfolio, as this graph here shows.
Perhaps you're wondering if the Magic Formula works so well, what is the value of active management, or rather, why I, Mateus Suares, continue doing my work here as a stock analyst at Market Makers? My answer is this: active management brings elements that go beyond the quantitative factor of the Magic Formula.
In our case, as we have the privilege of talking to great minds in the financial market, CEOs of... When we talk about companies, we end up having a market thermometer for each stock, so we can tell if managers are excessively optimistic or pessimistic about a particular stock, and this helps us make better investment decisions.
These conversations also generate investment ideas that certainly wouldn't be in the "Magic Formula," right? If we talk about companies in special situations, for example, we've already explained the rationale for this investment thesis to members of our community, but it has little to do with the company's ranking, like Zelda or Rockin'.
In fact, we don't need to go that far; evaluating commodity companies solely by looking at these two indicators can make the analysis fragile, since the sector's profits and returns are not recurring. If we consider the commodity price cycle, add to that the fact that we distribute the weights of each stock in the portfolio based on the margin of safety we see for each investment.
In other words, the weights we assign to each stock are different from each other. Furthermore, believing in quantitative data without understanding the fundamentals behind the business can lead you to sell stocks when, in fact, you should be doing the exact opposite. It's not difficult to... Creating conviction in something when you don't really know the business you're buying into...
And as we've seen, the market will test you daily. And you have your preferred method for investing in stocks. Did you already know the Magic Formula? Are you a follower of it? Tell us in the comments! I'll leave it here for today, until next time.
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