AMBIT analysts Gaurav Mehta, Karan Khanna and Saurabh Mukherjea look at stocks in India using Joel Greenblatt’s Magic formula. Joel Greenblatt’s Magic Formula (in his book ‘The Little Book that Beats the Market’) ranks firms on a combination of the following two ratios: (1) a firm’s EBIT as a proportion of its Net Fixed Assets plus Net Working Capital – this ratio is akin to an adjusted RoCE; and (2) the firm’s EBIT as a proportion to its Enterprise Value – this ratio is akin to a firm’s earnings yield adjusted for capital structure.
We modify these measures slightly to arrive at the following two measures for return ratio and earnings yield respectively:
- Our ‘return ratio’ is pre-tax RoCE which includes interest and dividend income along with EBIT in the numerator and total capital including cash in the denominator.
- Our ‘earnings yield’ has the same numerator as pre-tax RoCE and the denominator is market value of capital (debt as well as equity without excluding cash).
We rank the BSE200 firms on both these parameters individually. We then add the two ranks to arrive at cumulative ranks each firm; thus, the fir ms which get high scores have both good return ratios and inexpensive valuations. Based on these scores, we then rank the firms into quintiles. The performance of quintiles is presented in Exhibit 7 and suggests that the magic does work.
The inferences remain similar even after removing the last five-year period.
The rankings are done on 1 July each year (to avoid a ‘look ahead’ bias) and the returns are measured from 1 July to the subsequent 30 June with the next portfolio coming into effect on the following 1 July.
These results continue to hold even if you were to look at average returns instead of medians used thus far.
Now some of you will say that whilst such formulas work over long periods of time, they can not outperform every year. Whilst that is true (Exhibit 10), Q1, defined by the magic formula, has beaten the BSE200 in 10 out of the last 16 years.