Joel Greenblatt’s magic formula defines Return on Capital as ROC = EBIT / (Net fixed Assets + Working Capital). Many have contested that the formula works and is a great tool to use when searching for undervalued stocks. Mr. Greenblatt is the founder of Gatham Capital and is one of the premier value investors in the world. That said on the magic formula which is described in “the little book that beats the market.” There are nine rules to follow which Greenblatt claims will beat the S&P 500 (S&P Indices:.INX) 96% of the time, and has averaged a 17-year annual return of 30.8%. The nine rules are described as:
- Establish a minimum market capitalization (usually greater than $50 million).
- Exclude utility and financial stocks
- Exclude foreign companies (American Depositary Receipts)
- Determine company’s earnings yield = EBIT / enterprise value.
- Determine company’s return on capital = ebit / (net fixed assets + working capital)
- Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
- Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
- Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
- Continue over a long-term (3–5+ year) period.
The formula is well-known and there is no questioning its consistency against the S&P 500 (S&P Indices:.INX). However, when factoring ROC it appears that it would be more prudent to use a 3 or 5-year average to better show the company’s ability to allocate capital and make profitable investments (as we have suggested in the past). Therefore we ask, ‘Could Joel Greenblatt’s Magic Formula Be Improved By Averaging ROC?’ When comparing different ROC term values for companies in the finance, technology and consumer staples, there was some interesting data revealed. Please see table below:
Company 1YR ROC 3YR ROC 5YR ROC
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JPMorgan Chase & Co. (NYSE:JPM) 2.10% 1.79% 1.72%
Morgan Stanley (NYSE:MS) 0.88% 0.74% 0.59%
Intel Corporation (NASDAQ:INTC) 24.76% 19.70% 17.63%
QUALCOMM, Inc. (NASDAQ:QCOM) 19.94% 17.61% 16.01%
The Procter & Gamble Company (NYSE:PG) 11.83% 12.95% 13.10%
L’Oreal (EPA:OR) 14.04% 13.00% 13.46%
When looking at the numbers it appears that the financials have more of an applicable ROC when using a 3-year or 5-year average. The numbers come down and are more consistent with real ROC, as opposed to just one year that can fluctuate due a variety of reasons. Most notably we see this discrepancy with Intel and Qualcomm, both companies’ 3 and 5-year average are significantly lower than the 1-year ROC value. Intel Corporation (NASDAQ:INTC) really emphasizes the issue at hand, as its 1-year ROC is 24.76%, while its 5-year ROC was 17.63% – over a 7% difference.
When applying Joel Greenblatt’s magic formula, it is only wise to consider a 3 to 5-year ROC as it is much more indicative of the company’s ability to generate returns. Moreover, it provides investors with a more useful and accurate input into the formula when making an investment decision. There is too much inconsistency in the numbers when applying a simple 1-year ROC. By the investor utilizing a longer-term ROC more accurate results will likely be generated.