15 Magic Formula shares for good quality at cheap prices

Inspired by the thinking of Warren Buffett, value investor Joel Greenblatt first explained his ‘Magic Formula’ strategy to help his children profit from stock market investing. Stock screen expert Ben Hobson highlights 15 firms using the Gotham Capital fund manager's approach.

There is a saying that Britain and the US are two nations divided by a common language.

I discovered exactly what that means early one Monday morning a few summers back while trying to make myself understood in a bustling deli somewhere in Midtown Manhattan. 

I’d only landed in New York the previous night. In the interim I had been scrambling to find my bearings, figure out the subway and prepare for one of the biggest interviews of my life.

Thirty floors up in a skyscraper around the corner, there was a morning meeting finishing up at the offices of Gotham Capital. You could see it through the sheet glass wall. A long boardroom table packed with attendees and headed by Joel Greenblatt, one of the world’s most highly regarded investors.

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In the hour or so that followed, I tried to remain composed and ask him as much as I could. We talked about his career, his strategies and the appeal of quality and value as investing factors.

We also covered the quirks of New York’s grid system and what a newbie New York tourist like me really needed to know (walk fast and don’t hold up the queue when ordering coffee in a deli).

A magic formula for investors

Greenblatt’s rise to prominence began with a stunning 10-year spell up to 1995 when he compounded his investment returns at 50% per year. In the years that followed he cemented his reputation with a series of books about his approach. One in particular, written in 2006, captured the imagination of many. It was called The Little Book That Beats the Market.

Part of Greenblatt’s appeal is his view that there is no need to rely on professionals or academics when it comes to managing your own money.

In 1999, he even started an online forum called ‘Value Investors Club’, where members come together to share investment ideas - and it’s still going strong today. 

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The name ‘Value Investors Club’ tells you a lot about the type of investor Greenblatt is. His approach is inspired by the thinking of legends such as Ben Graham and Warren Buffett. He wants to find good quality shares trading at cheap prices.

In his research, Greenblatt worked out a way of scouring the market systematically using what he called the ‘Magic Formula’.

It combined the principles of ‘good’ and ‘cheap’ using two financial ratios as proxies. Every share would be scored and ranked on each measure and then the two ranks were added together to get an overall Magic Formula score – the lower, the better.

Measuring ‘good’ and ‘cheap’

The two financial ratios Greenblatt uses are the earnings yield as a measure of ‘cheapness’ and return on capital employed as a measure of ‘quality’.

Earnings yield tells you how much profit a company makes in relation to its total value. In this case, the firm’s value adds together its market capitalisation with the amount of cash or debt it has. This is called the enterprise value.

To find the earnings yield, you divide what the company earns in operating profit (sometimes called EBIT, or earnings before interest and tax) by its enterprise value. The higher the yield, the cheaper the share. If you do this for every company in the market, you can see which are the cheapest and which are the most expensive.

Return on capital employed, or ROCE,is a measure of how efficient a company is at reinvesting its own capital to generate a continuing return. It’s very much a measure of the strength of profitability.

Greenblatt’s approach to ROCE divides the company’s operating profit by its net working capital plus net fixed assets. It’s easy to be put off by abstract accounting terms like these. But the crux is that ROCE is simply trying to get as close as possible to understanding the relationship between the company’s profit and how much capital is needed to generate it.

Good quality companies are very efficient at delivering high percentage returns from the cash they reinvest to grow. So the higher the ROCE, the better.

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In the years since Greenblatt wrote about the Magic Formula, there has been a lot of discussion about how it might be improved. With greater access to accounting data and computing power, regular investors can be very specific about what goes into these calculations - and that’s a good thing.

Greenblatt’s strategy scores every company on each ratio and then adds them together to get a Magic Formula for each. It’s an appealing approach because you can rank the market for companies with the best blend of cheapness and quality and always find results.

A strategy for any occasion

Greenblatt’s Magic Formula aims to find companies that might be genuinely underpriced. But be warned - it produces lists that often contain beaten-up and unloved shares.

His view was that you should buy the list over time and refresh it periodically. But it is also a strategy that can be used to find potential one-off value ideas for investigation or simply feeling the pulse of current market trends.

Here is a selection of the current highest-ranking shares:

Source: SharePad.

You might notice that there are a few numbers missing in the Magic Formula sequence. That is because I have applied some ‘low bars’ to remove companies that are not trading or otherwise un-investable. There is also a minimum market cap threshold of £50 million.

One of the themes in this “good and cheap” list is that mining companies currently dominate. Note that the likes of Ferrexpo (LSE:FXPO), which operates in Ukraine, and Polymetal International (LSE:POLY), which operates in Russia, both carry an element of ‘war risk’. That tells you a lot about the kinds of shares that the Magic Formula detects - they may be profitable but they are often cheap for sometimes alarming reasons.

Beyond mining stocks, the strategy rules pick up a range of beaten-up shares, such as 888 Holdings (LSE:888), De La Rue (LSE:DLAR) and Integrated Diagnostics Holdings (LSE:IDHC). Smiths News (LSE:SNWS) and Big Yellow Group (LSE:BYG).

Greenblatt always acknowledged that this was a difficult approach for many investors because it lacks excitement and demands patience. Like many value strategies, it means focusing on unloved shares that are out of favour and unpredictable.

However, this simple strategy is based on two well-understood profit drivers in equities: value and quality. After a long sell-off in shares last year, this could be poised to perform well in the months ahead. I’ll return to the portfolio later this year to see if Greenblatt's approach has managed to weave its magic.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.