ShareRanker is an ASX implementation of Joel Greenblatt's Magic Formula, from his book The Little Book That Still Beats The Market.
Put simply, this method uses two very simple metrics - Return on Capital and Earnings Yield to help identify good businesses selling for bargain prices.
What is Magic Formula investing?
[Magic Formula Investing is] a long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices.
- Joel Greenblatt
The method ranks companies by two metrics:
- Return on Capital — how much profit a company earnings compared to its capital employed (read more); and
- Earnings Yield — the earnings per share (read more).
You then buy companies that rank highly for both metrics.1
Return on Capital helps identify companies that are run well, while Earnings Yield helps identify companies that are cheap. The thinking is that when good companies are selling cheaply, they are likely to be undervalued, and therefore more likely to increase in value.
Of course, being a simple metric, it's not correct all the time! So to avoid having all your eggs in one basket, the method recommends having a portfolio of 20-30 companies.
As you can see, it's pretty simple, and there's nothing magical about it at all!
So what do I do?
Firstly, I recommend reading Joel Greenblatt's book, The Little Book That Still Beats The Market. He explains the method both simply and concisely. You can easily read it in two hours.
In the meantime, you can follow these simple steps:
- Find a good discount broker so you don't waste money on brokerage fees.
- Every 3 months, invest in 5-7 companies ranking among the top 30 on this website until you've invested in 20-30 companies.
- After you've owned a stock for a year, it's time to sell it. If you've made a gain, wait one week after the year mark before selling, in order to reduce the capital gains tax.
If you're investing small amounts ($1,000 or less per trade), it's probably better to reduce your portfolio to 20 stocks so you don't waste all your money on brokerage fees.
It's also recommended you invest in companies with a market cap of at least $50 million.
The Wikipedia article also gives a pretty good run-down.
Does this really work?
In the book, Greenblatt claims that over the period 1988-2009, using this method in U.S. markets would have returned 23.8% per year.
Many articles online exist with independent backtests of the formula. For example, in this one the author claims a return of 13.74% per year from 1999-2009.
However you slice it, it seems to beat the market.
Notes
- Additionally, several types of stocks are excluded, such as banking and utility companies, and REITs.
Disclaimers
- I'm a software engineer, not a financial adviser. Invest at your own risk.
- The Magic Formula trademark belongs to Joel Greenblatt. He's cool.