76 The Business of Value InvestingMagic Formula
Magic Formula ( http://www.magicformulainvesting.com ) is a silly name,
but the site is quite good and the investment philosophy is based
on sound fundamentals (and free, as are most of the resources I
discuss here). The site was founded by Joel Greenblatt, an investor,
professor, and author. Greenblatt began as a value investor in the
mold of Ben Graham and Christopher Dodd. (Ben Graham was
Buffett ’ s mentor; Graham and Dodd coauthored Security Analysis ,
a book regarded without equal in value investing.)
Not much is known about Greenblatt ’ s hedge fund Gotham
Capital, as it operated very privately. What we do know is that the invest-
ment partnership began in 1985 and achieved annualized returns
exceeding 40 percent until it shut down in 1995. 5 Greenblatt ’ s invest-
ment philosophy is deeply value based, and he applied the approach
rigorously in his investment fund. Like Buffett, Greenblatt focused on
good - quality businesses that were selling for cheap in the market.
How did Greenblatt defi ne “ cheap ”? He looked at the earnings
yield of the business. The earnings yield is simply the stock price
divided by the annual earnings per share of the business. So, for
example, a stock that trades for $ 20 a share and earns $ 2 for the
year has an earnings yield of 10 percent. Obviously, the higher
the yield, the cheaper the stock as long it can continue to grow
earnings.
The other variable was fi nding good businesses. And, like
Buffett, Greenblatt defi ned “ good businesses ” as those that earn
the highest returns on invested capital (ROIC). To keep it simple,
think of ROIC as how much a business earns pretax for each dollar
invested in the business. The concept is simple. If a business gener-
ates more than a dollar in pretax income from each dollar invested
in the business, then it is creating value. The company is taking a
dollar and earning more than a dollar. For example, a company
is said to have a 20 percent ROIC if for every dollar it invests inCH005.indd 76CH005.indd 76 9/2/09 11:08:05 AM9/2/09 11:08:05 AM