Thursday, November 5, 2015

How to pick Stocks like Ace Value Investor - Magical Formula by Joel Greenblatt's

In my previous post which gives idea to getting started with Value Investing in India and also stressed on the behavior finance and provided investor manifesto to follow.

There are lot of principles, methods, formulas we can follow to pick the stocks, which in the long run will create enormous wealth. Two basic things to follow is invest in good business run by credible management team and second is constant keep on investing the stock & wait till you can reap.

You might think that value investment is merely a formula to be follow, but keep in mind is not, read this article you will understand.

On wall street,Joel Greeblatt is a legendary stock picker, known for the invention of Magic Formula Investing, and founder of the New York Securities Auction Corporation (NYSAC). Greenblatt is founder and managing partner of Gotham Asset Management, LLC. In fact, when he published his first book, 'You Can Be A Stock Market Genius', many hedge funds claimed they were following his approach. He is the author of two investment books, including Joel Greenblatt: The little Book that Beats the Market. He is also an Adjunct Professor with Columbia Business School.

Greenblatt tries to find cheap and good companies. He looks for value with a catalyst, so nice things happen sooner. Greenblatt likes special situations, and thinks that they are simply different places to find cheap stocks. In his own hedge fund, Greenblatt uses the basic principals in the Magic Formula: Look for high ROC and high earnings yield. He tries to figure out what "normalized earnings" will be 3-4 years into the future. Greenblatt makes sure the stock is very cheap based on normalized earnings. He is very concentrated in investing, 5 to 8 securities can make up 80% of his portfolio. One position could be as high as 30%.     

MAGIC FORMULA

The formula stands on two ratios; one on the basis of earnings yield and the second on the basis of  return on capital employed (RoCE), and finally a third one adding rankings from the earlier two lists.

BUILDING PORTFOLIO

One way to build a portfolio is to buy the top stocks ranked. Investors need to do due diligence on stocks that clear the magic formula test. Sustainability of the business and management quality are absolutely essential. Stock-picking can be subjective and depend upon the individual's understanding of the company/sector and his/her risk profile. The magic formula suggests that one must look at the top 20 stocks, but it suggested that one must pick 10 (looking at qualitative aspects) and allocate equal money to each of them.

OTHER PARAMETERS
Investors should also take into account profitability and low debt to equity ratio. Greenblatt suggests, as and when the stocks become expensive, investors should also consider booking profit. This formula does not apply to financial, commodity and cyclical companies.

METHODOLOGY
  • Approximately 5,000 stocks are listed on the Bombay Stock Exchange (BSE). Choose the top 500 stocks by capitalisation.
  • Rank the 500 companies on the basis of return on capital. The company which has the highest return on capital is assigned rank one and that with the lowest is assigned rank 500.
  • On the same lines, we get the earnings yields of the 500 companies and rank them. The company with the highest earnings yield is assigned rank one, and the company with the lowest earnings yield receives rank 500.
  • Next, we add the rankings received by each company on the two parameters to get a composite ranking. Arrange the companies in descending order of their composite ranking.
  • Eliminate all financial companies and utilities from this list.
  • Choose stocks from those ranked in the top 10 based on your risk profile.




To understand what the “magic formula” is all about, we have to turn to equitymaster who have conducted an in-depth study of the subject. Equitymaster explains that the formula involves ranking a universe of stocks based on their return on capital and earnings multiples. They also assure that the formula works because Joel Greenblatt was able to compound his wealth at a phenomenal rate of 40% CAGR which multiplied his wealth 836 times in 20 years.

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