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A CLOSER LOOK AT MAGIC FORMULA INVESTING

Interesting read here from Morningstar on Joel Greenblatt’s Magic Formula Investing. It might be worth a close look:

One of the classic debates in investing is indexing versus active management. The data is clear that few active mutual fund managers are able to beat broad market indexes such as the S&P 500 Index over extended periods. Still, there are some managers who have shown the ability to beat most broad indexes over long periods of time, including those we’ve named Fund Managers of the Year in past years and those we’ve recently named Fund Managers of the Decade.

In this piece, I’ll approach this classic debate from a different angle. Is there a seemingly ridiculously simple, mechanical, quantitative formula that can beat not only the index but also top-performing actively managed mutual funds that Morningstar has praised over the years and that have themselves beaten the index? Evidence is emerging that there may be at least one….

Is there an equally simple formula with longer, more convincing back-tested data? A few years ago, hedge fund manager and Columbia Business School adjunct professor Joel Greenblatt wrote a book called The Little Book That Beats the Market, in which he gave the details of a “magic formula” for investing that resembles Graham’s in some ways. Indeed, Greenblatt has remarked to us that he’s always been intrigued by Graham’s work and, if not the formula explained above specifically, certainly the general idea of┬ápaying a low price for a company’s earnings.Greenblatt has slightly modified Graham’s P/E or earnings yield factor by replacing it with what analysts call “EBIT,” or earnings before interest payments and taxes, which adjusts for the fact that different businesses operate with different levels of debt. Greenblatt also replaced the stock price with a firm’s enterprise value, which is its total market capitalization (stock price times total shares outstanding) plus its debt. Indeed, EBIT/Enterprise Value has become a widely accepted version of the more traditional Graham earnings yield.

Read the full piece here.