Joel Greenblatt, founder of Gotham Capital, introduced his “Magic Formula” in the 2005 bestseller “The Little Book That Beats the Market.” This deceptively simple strategy aims to identify high-quality companies trading at attractive valuations.
Key Criteria of the Magic Formula
Greenblatt’s approach focuses on just two factors:
- Earnings Yield: This is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its enterprise value (market capitalization + debt – cash). A higher earnings yield indicates a more attractive valuation.
- Return on Capital: This measures how efficiently a company generates profits from its invested capital. Greenblatt calculates this by dividing EBIT by the sum of net working capital and net fixed assets.
The Magic Formula ranks stocks based on these two metrics, favoring those with the best combined scores. Greenblatt’s backtesting showed this method significantly outperformed the market over long periods.
Adding Momentum: Potential for Enhanced Returns
While the Magic Formula has proven effective, some investors have sought to improve upon it by incorporating momentum. The rationale is that stocks exhibiting recent price strength may be more likely to continue outperforming in the near term. This combination aims to capture both value and positive market sentiment.
5 High-Momentum Magic Formula Stocks
Let’s examine five companies that pass Validea’s interpretation of Greenblatt’s model while also demonstrating strong price momentum:
1. Allison Transmission Holdings Inc (ALSN)
This manufacturer of vehicle transmissions scores a perfect 100% on Validea’s Greenblatt-inspired model. ALSN boasts an impressive earnings yield of 10.25%, ranking it in the top 15% of stocks in Validea’s database. Its return on tangible capital is equally strong at 54.37%, placing it in the top 10% of analyzed companies. ALSN’s relative strength of 84 over the past six months indicates significant momentum.
This school bus manufacturer also achieves a 100% score on the Greenblatt model. BLBD’s earnings yield of 8.89% and return on tangible capital of 69.12% are both well above average. The stock has shown exceptional momentum, with a 12-month return (excluding the most recent month) of 134.34%, placing it in the top 3% of stocks for this metric.
The iconic footwear maker earns a perfect 100% score from Validea’s Greenblatt model. CROX boasts an attractive earnings yield of 11.92% and an impressive return on tangible capital of 69.57%. Its six-month relative strength of 53 indicates solid momentum.
This technology research and development company scores 90% on the Greenblatt model. IDCC’s earnings yield of 11.28% and return on tangible capital of 59.92% are both strong. The stock has demonstrated exceptional momentum, with a 12-month return (excluding the most recent month) of 73.24%, ranking it in the top 8% of stocks for this metric.
This cabinet manufacturer also achieves a 90% score on Validea’s Greenblatt model. MBC offers an attractive earnings yield of 12.03% and a solid return on tangible capital of 36.58%. While its recent momentum has been less pronounced than the other stocks on this list, its fundamentals align well with Greenblatt’s criteria.
The Power of Combining Strategies
These five stocks demonstrate how Greenblatt’s Magic Formula can be enhanced by incorporating momentum factors. By focusing on companies with both attractive valuations and strong recent performance, investors may potentially improve their odds of success.
Further Research
