did some research to generate a list of companies that have:

Positive earnings growth for 5 years (i.e. Requirement #2)

An ROE of 15% or greater (i.e. Requirement #3)

And included data on Industry type, Gross Margins, Operating Margins, 5 year avg.
Operating Margin, Return on Investments, Return on Assets

And included a column for current total market cap; as per one of Mohnish Pabrai's
extraordinary essays (and just common sense) I'd be happier with a company at a
$100 Million market cap. vs. $100 Billion to allow for the full benefits of long-term
compounding.

The companies were sorted in ascending order of Total Debt/Equity -- -the low debt
should suggest a strong balance sheet and avoid concerns that the above-average
ROE is the artificially-inflated with dangerous amount of leverage.

Additionally, I wanted to add a data on insider-ownership levels (Id like to see ~10%
- 30% or so), but wasnt able to find an easy way to get that info into the
spreadsheet. So Ill just consult Value Line, which is always a good idea, once I find
a business that is otherwise of interest.

Joel Greenblatt speaking at NYSSA

Joel Greenblatt (left) and Brian Zen

Related gurus' buys/sells:

Ticker

Date*

Price*

buy/sell

Picked By

ARO

2006-09-30

$27.3

Buy

Joel Greenblatt

LEA

2006-09-30

$20.9

Sell

Joel Greenblatt

LYV

2006-09-30

$20.7

Sell

Joel Greenblatt

LEA

2006-06-30

$22.5

Buy

Joel Greenblatt

AMP

2006-03-31

$43.6

Sell

Joel Greenblatt

*The price and date might not be the actual time and price at which the transactions were made. In the case of institutional
owners, the date is stated as the last day of their fiscal quarter. The prices are estimates if no accurate information available.

by Brian Zen and Garret Hamai

In the freezing cold evening of December 7th, 2005, Joel Greenblatt of Gotham Capital, armed with
delightful jokes and a magic formula, warmed the hearts and souls of about 200 security analysts in a
seminar organized by New York Society of Security Analysts (NYSSA.org). We are pleased to bring you the
financial enlightenments captured from that event:

Crunching Data, Searching Magic Formula

During his years at Wharton, Joel Greenblatt manually entered stock data based on 9 years worth
of S&P Stock Guides and created their own database for research.

Cleaned up the data by eliminating certain things. Now they use Compustat database.

Richard Pzena figured out how to enter those data into the mainframe computers at Wharton
Business School. At that time, the computers were about the size of two conference rooms.

Sometimes, the market throws off bargains because it is unreasonable about the prospects of
certain companies.

Buying Cheap Stocks Works Over Time

In the 70's, they tested Benjamin Graham's Net-net Formula and found that picking stocks below
liquidation value worked well. (Liquidation value = Current Assets - All Liabilities.)

Not every cheap stock performed well individually, but as a basket they did well.

However, these types of opportunities are practically extinct in today's market.

Many other studies have shown the strategy of buying cheap companies works over time.

Buffettized: Buying "Cheap" and "Good"

Starting out as a die-hard value investor, Greenblatt became "Buffettized" in early 90's. Why not
look for the good ones amongst the cheap companies?!

Greenblatt says that he didn't realize that trying to find cheap and good companies, rather than just
the cheap ones, was so important until the 1990s. While Graham was looking for starkly cheap
companies, Buffett wants only the good ones.

Greenblatt's friend, Richard Pzena, remains committed to buying troubled companies at dirt cheap
prices, the cigar butt approach. You see this saggy cigar butt on a dirty corner of Wall Street. You pick it
up and get one last puff out of it. The puff not very tasty. The act is not very elegant. But it's free (Laugh).

The Magic Formula Was Born

By combining Graham and Buffett, Joel Greenblatt's magic formula is a computerized system to
invest in good companies whose stocks are cheap.

Good companies = High return on capital (ROC defined as operating profit divided by net working
capital plus net fixed assets.)
Cheap stocks = High earnings yield (Earnings yield defined as pre-tax operating earnings divided by
enterprise value.)

ROC = EBIT/(Net working capital + Net fixed assets)

Earnings yield = EBIT/(Enterprise Value)

If net working capital is negative, use zero.

Here, EBIT is last 12-month's earnings before interests and taxes (EBIT).

Two key issues addressed by his magic formulas: (1) What is the return on the price you paid? (2)
What is the return on the capital the company is investing?

Ranking the "Cheapness" and "Goodness"

Greenblatt turned to his computers to rank companies by two factors, good (high ROC) and cheap
(high earnings yield). Ranking Method: If company XYZ ranked 10 out of 3,500 companies in terms
return on capital, and it ranked 20 in terms of earnings yield, the combined ranking of XYZ would be 10 +
20 = 30.

Greenblatt's "Not-Trying-Very-Hard" Model Buy the top 30 of the highest ranked companies. Hold
them for one year. Turnover the portfolio at year end to buy a new list of 30 highest ranked stocks based
on one-year's worth of new financial data.
Sell losers right before a year is up, and sell winners right after 12 months for tax benefits.

Why the One-Year Holding Period?

It is interesting to note that more stocks worked out over one-year rolling periods, rather than twoyear periods. Maybe the time window that a value stock stays undiscovered is being shortened towards
one year as more and more people start searching for values.

Besides, after one year, you get a complete set of new earnings data. It would be a good time to
run the rankings again.

Selling has always been difficult. The other day, Greenblatt and his partners went on and on talking
about the stocks that made a huge move after they sold at intrinsic value. To remove the uncertainties
and difficulties of selling, a one-year holding period was picked. "I call it the Not-Trying-Very-Hard Model
(Laugh). My mantra is to keep things simple," said Greenblatt.

Besides, trading cost is cheap now.

Sell Rules

Sell close to intrinsic value.

Sell if something even cheaper is found.

"We never mastered the art of selling. We are semi-bubbling idiots at it," confessed Joel.

The Magic 30.8% Per Year for 17 Years

Magic formula works! Using stocks of all sizes, it produced a 17 year annual return of 30.8%. Using
only the largest 1,000 stocks, the annual return was 22.9%.

When ranked by 10 deciles (250 stocks in each, higher deciles consistently outperformed those
below them from top to bottom.

The cheap portfolio tends to have less volatility also.

The magic formula beats the market 96% of the time.

Magic Formula Investing:

The Operating Steps
In his new bestseller: "The little Book that Beats the Market", Joel Greenblatt also discussed in detail the
operating steps of the magic formula investing:
1. Go to magicformulainvesting.com (Nice plug!)
2. Specify your criteria for minimum company size.

3. Get a list top-ranked companies based on high return on capital and high earnings yield.
4. Invest 1/3 or 1/5 of your money into 5 to 7 top-ranked companies every 2 to 3 months. (Dollar-costaverage into the "good and cheap".)
5. After 9 to 10 months, construct a portfolio of 20 to 30 stocks.
6. Sell each stock after holding it for one year. For tax purposes, sell winners a few days after the oneyear holding period. Sell losers a few days before the one-year holding period.
7. Reinvest the proceeds into new top-ranked companies. Stick to this simple and mechanical system
for at lease 3 to 5 years to give the magic formula a chance to work.

Greenblatt's Personal Investment Process

Looks for value with a catalyst, so nice things happen sooner. Special situations are just value
investing with a catalyst. They are simply different places to find cheap stocks.

In his own hedge fund, Greenblatt uses the basic principals in the magic formula: Look for high
ROC and high earnings yield.
Tries to figure out what "normalized earnings" will be 3-4 years into the future.

Makes sure the stock is very cheap based on normalized earnings.

5 to 8 securities can make up 80% of his portfolio. One position could be up to 30%.

Having a concentrated portfolio works well for lazy people. Not that many stocks to track.

Thinks about how much he could lose if he's disastrously wrong.

No formal process or time frame for purchase decisions. Usually spend one month or so to do
research. In difficult situations for which he and his partners have time, research could take months.

If there is a great opportunity which, in their opinion, won't last, and if they feel they understand it,
they sometimes use the approach of "Ready, Fire, Aim!"

Has financials and utilities in the portfolio.

EBITDA Minus Maintenance CapEx

For his own investment practice, Greenblatt uses a different input for earnings.
He thinks that "EBITDA - Maintenance Capital Expenditure" would be a better measure of earnings
power, but it can be difficult to calculate.

No Edge in Foreign Markets

Greenblatt prefers to invest domestically because it's within his circle of competence and he hasn't
run out of opportunities.

He does acknowledge that you could probably find cheaper companies internationally and it is a
good idea if it is within your area of expertise.

If he was younger, he may do more with international investing.

On Long-Short Strategies

Q: "How about long the top deciles of cheap stocks and short the bottom deciles of expensive
stocks?"

A: "I am not a fan of shorting. The long-short guys blow up every eight years. I call it the 'I got it! I
got it! I ain't got it!' Strategy."

Fair Bet Yet Unfair Investing

Look for a big mess that seems too complicated, not well understood, not well followed, and
requires too much work. People don't want to do the work, but once you do the research, you will be at
an advantage.

Look for semi-complicated situations. The key is to identify what cuts to the core.

Numbers Are More Important than People

First look at the numbers as they don't lie. You can learn a lot about the management by looking at
what they've done though the numbers.

Meeting the management in person and determining their abilities is not easy. "I used to meet a
CEO and say to myself: 'This guy is smart.' Next day I meet another CEO and say to myself: 'This guy is
smart, too.' (Laugh) In the end, I feel meeting CEO is not very important because I am not good at
reading people," said Greenblatt.

What is more important is: (1) What the management has done with the cash? (2) What are the
incentives? (3) Is the salary too high? (4) Is there heavy insider selling? (5) What is their trackrecord?

Compare "what they do" with "what they say".

Bad signs: high salaries and insider sellings.

The Macro Picture Is a Distraction

In 1999 and 2000, there were plenty of non-internet values out there. If you were worried that the
burst of the internet bubble would have dragged those values further down, you would have made a big
mistake. "Fortunately, we ignore the macro picture," said Greenblatt.

In 2002 and 2003, there were plenty opportunities in small caps. If you were concerned that the
bear market could go on further, you would make another mistake.

"Now the value is in big caps. But if you look at the macro picture, the consumers could drop dead,
the housing bubble could drag everybody down?- We ignore those. We have no macro view," said
Greenblatt.

Everything is cyclical. Values can always be found somewhere.

Ignore Volatility and Stock Prices

Taking your clue from the stock prices is crazy. If you could value companies, you should ignore the
noises from volatility and stock prices.

Things such as volatility have nothing to do with buying a good, cheap company for the long run.
Greenblatt said, "It is kind of ironic that, the older I get, the longer time horizon I look at." (Laugh)

The Efficient Market Theory is a crazy way to look at the market. "Pick and choose. You can beat
the market. It is worth the work."

The Vogue of Return on Capital

There seems to be a movement towards high return on capital.

The low P/B stocks haven't work very well in the past 10 years.

Don't know if or when this trend will reverse.

One More Trick

Greenblatt disclosed: "We have one more trick. When we have gains, we look at before-tax
numbers. When we have losses, we look at after-tax numbers. (Blank stare?-pause.) That was trying to
be funny. (Laugh)"

Finding the next gold mining gem is a daunting task. I often have to use different screening criteria to come
up with interesting stock picks just to begin my analysis. Today I will be using Joel Greenblatts investing
formula for uncovering potential gold mining gems. For those of you unfamiliar with Joels formula, he uses
only two main criteria for determining the attractiveness of a stock investment. The two criteria are 1)
Return on Capital and 2) Earnings Yield.

Return on Capital ('ROC') is measured by taking a companys pre-tax operating earnings ('EBIT') and
dividing it by tangible capital employed; the higher the ratio the better. Joel uses ROC instead of the more
commonly used Return on Equity (ROE = earnings/equity) or Return on Assets (ROA = earnings/assets)
because ROC uses earnings before interest and taxes. Joels reasoning is that different companies operate
with different levels of debt and differing tax rates.

Earnings Yield is measured by taking a companys pre-tax operating earnings ("EBIT") and dividing it by
Enterprise Value (Market Value of equity + Net Interest Bearing Debt). Joel uses Earnings Yield instead of
the more commonly used Price/Earnings (P/E) ratio or Earnings/Price (E/P) ratio because P/E and E/P are
greatly influenced by debt levels and tax rates, while Earnings Yield is not.

In laymans terms ROC helps you measure how much income a business is earning in relationship to how
much it costs. A business with a high ROC means it can invest its own money into the business with a high
rate of return. Earnings Yield helps you find a company that earns more compared to price you are paying
for it.

Using Joels criteria, I screened for companies with a minimum market capitalization of $500 million, a high
ROC and a high Earnings Yield. Looking at the top 100 companies that met this criteria, I found one lone
gold mining stock, Northgate Minerals Corp. (NXG). Northgates ROC is in the 25-50% range, and the
Earnings Yield is 17%. Northgate appears to be worth serious consideration, and may be the next gold
mining gem using Joels criteria.

Joel Greenblatt is the author of The Little Book that Beats the Market. In the book he discusses in detail, the
advantages and strategies of using ROC and Earnings Yield to evaluate a stock investment. I highly
recommended reading the book as it offers a simple and well reasoned approach to finding potentially
undervalued investments.

An analysis of the screening method described in Joel Greenblatt's Little

Book That Beats The Market
Joel Greenblatt's pop-hit, The Little Book That Beats The Market (2006, John Wiley and
Sons, ISBN 0-471-73306-7), describes a simple screening method to identify stocks that
offer good value and low risk. Many web sites, newspaper articles and blogs have
commented on this book by now (February 2006). Those commentaries uniformly fail to
provide any new insight into Greenblatt's ideas. I found one fairly negative, rather
academic-flavored site that was quite critical, but after reading carefully, I concluded that
the author of that article didn't pay close attention to what Greenblatt actually says in his
book.

The Little Book describes some detailed, retrospective studies of simulated, mechanical
investing in stocks selected by his method. The simulations used data from a Comstock
"point in time" database containing the information that was actually available on a large
universe of stocks at each date in the study. Each screening and simulated trade was
based on exactly the information that was available historically at that moment in time.
This allowed Greenblatt to avoid some forms of selection bias that would have
invalidated his research.
I don't have access to the Comstock historical data, but current rankings served up by
Greenblatt's free magicformulainvesting.com web site can be pretty well replicated using
current data from Value Line. Doing so requires reading of the book's appendix carefully,
and taking into account some other comments scattered through the book. Here's what I
learned from that exercise.
I have no connection with Joel Greenblatt; I simply read his book and worked out
what I think it means. Greenblatt has neither reviewed nor commented on this
article.
I do subscribe to the Value Line data service, and I commend it to interested
readers. It's a convenient, high-quality service with superior customer support.
Comments, critiques, observations and suggestions welcome!

In a nutshell, what Greenblatt says

Restated briefly, here are some key points from The Little Book.

Stock prices vary much more, and much more rapidly, than the realistic valuations
of companies can possibly account for. Therefore, a stock may sometimes be
overpriced, and other times underpriced. Obviously we'd like to buy underpriced
stocks and sell overpriced ones. But can we tell when when a stock is
underpriced?

It's very hard to determine what a stock is "really" worth. What we can more
easily do is rank a population of stocks into an order that reveals which ones are
relatively cheap today, compared to the others. A portfolio of relatively cheap
stocks presumably has a reduced risk of loss compared to the "average" stock, and
some of them will swing back up to much higher prices, giving investors
substantial profits.

Greenblatt's screening is based on two fundamental numbers: Earnings Yield (EY)

and Return on Capital (ROC). These are conventional numbers, calculated in a
slightly unconventional fashion that eliminates certain bookkeeping fictions,
particularly "goodwill", and eliminates the effect of taxes.

His screening method is to compute EY and ROC for each stock in the universe;
sort the stocks by EY and assign each one an earnings yield rank; sort the stocks
by ROC and assign them return-on-capital ranks; add each stock's ROC and EY
ranks to get a combined ranking number, and sort by this total rank. The "best"
stocks rank simultaneously well in EY and ROC.

EY and ROC are ratios whose numerator is EBIT, earnings before interest and
taxes. Using EBIT compensates for differing levels of debt and tax rates that
companies may experience. Greenblatt approximates EBIT in a way that I
couldn't replicate exactly [see his footnote on page 139], but could approximate
reasonably well.

Greenblatt's ROC = EBIT / TangibleCapitalEmployed. Tangible capital employed

is Net Working Capital plus Net Fixed Assets. "Net Working Capital" is not
exactly what is ordinarily called "working capital" (current assets minus current
liabilities). Short term obligations to suppliers are effectively interest free loans,
and the text indicates that Greenblatt adjusts for that.

Greenblatt's EY = EBIT / EnterpriseValue. Enterprise value is what you'd have to

pay to purchase the entire company: the capital value of its outstanding common
and preferred stock, plus any long term debt you'd have to pay off.

How I approximated Greenblatt's numbers

I approximated Greenblatt's numbers using Value Line data:
1. myEBIT = IncomeBeforeTaxes + Depreciation. (IncomeBeforeTaxes has
depreciation subtracted out; I added it back.)
2. ReturnOnCapitalDenominator = TotalCurrentAssets - Cash + NetPlant. (NetPlant
is the depreciated value of long-term assets.)
3. ROC = myEBIT / ReturnOnCapitalDenominator.
4. EarningsYieldDenominator = MarketCap + PreferredEquity + LongTermDebt.
5. EY = myEBIT / EarningsYieldDenominator.
In addition, I eliminated stocks with Value Line industry codes "financl", "brokers",
"thrift", "water", "reit", and all the codes designating banks, utilities, and insurance
companies. I also eliminated stocks with ROC > 300 or EY > 50; extreme values suggest
some condition in the company's history or accounting that might make its numbers not
properly comparable with the rest of the population.
A company can have "good" ROC and EY by these definitions, yet still have negative
shareholder equity, a poor net margin conventionally defined, or "negative" earnings by
the book. Therefore I added a picky scan criterion which flags stocks that have negative
shareholder equity, no earning per share, or a net profit margin less than 2%.

Expanding slightly on the magicformulainvesting.com features, I can specify a minimum

market cap for the stocks selected, or a range of allowable market caps (e.g. companies
with market caps between 25 - 1500 million dollars). I can also select logical
combinations of industry codes, although doing so obviously does not find the cheapest
stocks in the entire Value Line universe. This helps me notice relatively cheap stocks
within an industry or market segment.
Finally, I don't compute a stock's final rank from the sum of its EY rank and ROC rank.
Instead, I compute each stock's "distance" from the origin of an (EY rank,ROC rank)
scatter plot according to the Pythagorean theorem (see second illustration below). The
ideal "best" stock would have EY rank and ROC rank of #1, closest to the origin. The
resulting sorted order is not significantly different from Greenblatt's trick.
While my definitions don't exactly replicate the numbers from
magicformulainvesting.com, they do sort stocks into pretty much the same order. The
result is certainly close enough for most purposes. Greenblatt himself makes the point
that the exact definition isn't critical.

The (EY,ROC) scatter plot

It's informative to plot a scatter diagram with EY on the X-axis and ROC on the Y-axis
(the raw values as opposed to ranked position in the list). The Value Line universe is big,
even after eliminating non-industrial companies (financial etc. as noted above), so I only
plot the top 300. Among those, the ticker symbol is placed on the plot for the best 65, and
dots for the rest. Green points pass my "picky" test, red points fail it.
Here is a scatter plot of companies with >= 1500 million market cap:

The top companies from this screen exhibit a sharp ROC/EY boundary. Companies
whose EY or ROC is too small just don't make the cut; a firm can't operate with a really
good ROC but a disastrously bad EY, for example. Good companies in the above plot,
such as AEOS, UST, INTC, and DWA, fall near the 45-degree line, and farther out from
the (0,0) origin.
MVL (top of the plot) is a company that was bankrupt. Such companies usually mark
some of their capital assets down and shed long-term debt, so they might have
abnormally large ROC values. You might think, well, that's OK - the company is
operating with advantages after its bankruptcy. But consider that for "normal" companies,
there is an implicit presumption that as the business grows, the firm can reinvest some
profits to enjoy even more of that great ROC. Unfortunately, as a formerly bankrupt
company that wrote off a lot of assets or debt begins to reinvest, its ROC can be expected
to fall back toward a value that is more typical for its industry. Its ROC advantage won't
last indefinitely. Screening by itself does not reveal such issues.
MT (Mittal Steel) is a good example of a somewhat different ROC issue. MT also scores
well on a Greenblatt-type scan of large companies because its ROC is very high. Why?
The company bought a lot of former communist-block steel factories at steal prices. Now,
Mittal can produce steel very inexpensively, but those purchases were a one-time
opportunity. Some day when demand slows, those same factories will saturate the market
and drive steel prices into a very deep hole. Mittal might close some of them, or it might
use its capacity to put less advantaged competitors out of business. One way or another,
eventually there will be an ugly scene. Right now, with Asia using all the structural steel
it can get, MT seems attractive. Will China keep importing, or will it develop its own
capacity? Seeds of a future "capacity catastrophe" might be hidden in MT's present,
unnaturally superior ROC.

The (EY rank,ROC rank) scatter plot

Let's have a look at a plot whose coordinates are (EY rank,ROC rank), instead of the raw
EY and ROC values. Here are the best members of the Value Line universe with market
caps at least 25 million.

This picture is clearer because ranked points by definition can't fall on top of each other.
Now the top-ranked companies, such as XJT and VTS, are near the origin. Again, red
items fail the "picky" test for one reason or another. Some companies that were nearer the
origin in December and January, such as EGY and AEOS, have migrated outward as the
share prices went up.

Still a need for analysis

This screen produces some gems, and some stocks with real issues. Veritas (VTS) looks
promising. It's essentially a software company that provides subterranean mapping of oil
fields worldwide. It has a growing database of the most promising fields. The company
managed itself through lean years without debt. It has great EY and ROC. Now, with the
advent of what seems to be a new, persistently higher level of oil prices, Veritas is taking
on a line of revolving debt and hiring more geophysical scientists. Even though energyrelated stocks have run up a long way, VTS might be a really good purchase.
On the other hand, consider XJT. ExpressJet provides commuter services for a larger
airline, under contract. I believe there was a recent report that big brother has decided to
diversify its outsourcing. The commercial airline game is brutal; XJT may be cheap for
good reason - it sells its services to one or a few customers who have every reason to
squeeze hard.
These are just some of the issues that can arise if one blindly follows a numerical value
screen. Still other problems may arise if a company's books can't be trusted, due to honest
or dishonest mistakes.

Why does Greenblatt's method produce such good results?

Despite these limitations, Greenblatt's screen produces an excellent list of candidates to
consider. His premise that these companies are inherently less risky than the "average"
stock in the universe is probably true, because their raw numbers demonstrate that they
have the requisites to succeed, if they are managed properly. And they're cheap buys in a
tangible, concrete sense that is hard to dispute.
Greenblatt believes we can earn really remarkable rates of return by buying these
companies, yet the widely accepted risk/return principle of investing holds that greater
risk is required to get higher rates of return. Is there some hidden risk here? Or is that
canonical belief simply wrong?
His explanation is the simplest one: in the long run stock prices do reflect risk in an
average way, but they are very inaccurate in the short term. The risk/return principle is
intimately related to another axiom of financial theory, which holds that at any moment,
the probability of a small price up-move is about equal to the probability of a small
down-move. This is equivalent to claiming that stock price returns have a log-normal
probability distribution.

That is roughly true for the market as a whole, but it is probably not true for the subpopulation of stocks selected by Greenblatt's screen. These stocks are already relatively
cheap, and since their EY and ROC indicate that the essential requirements for a
successful business are satisfied, the probability of a down-move is not about the same as
the probability of an up-move for these stocks. The rate-of-return distribution for this
population of stocks is probably quite asymmetric.

Which raises another question ...

We just saw that without additional analysis, depending on screening alone may lead you
into mistakes. Yet Greenblatt's mechanical simulations, which demonstrated
extraordinary returns, obviously didn't incorporate such analysis - although he might have
applied additional, "picky" criteria that are not fully explained in The Little Book.
So ask yourself this. Suppose you accept the risk/return principle. By applying additional
analysis that was not done in Greenblatt's simulation, you are selecting even less risky
stocks from the screened population. Do you believe that applying such analysis will
actually reduce your rate of return?
- Roger Ison, 27 Feb. 2006
Three-Factor Screen
Phil Graham sought the cheapest stocks, and Warren Buffett sought stocks in great
companies at bargain prices. A three-factor screen is being touted to pick so-called good
cheap stocks, but it is old wine in a new bottle.
An article entitled "Magic Formula Of Little Book Just May Work" by Jesse Eisinger on
pages C1 and C5 in the 9 November 2005 Wall Street Journal discusses a method of
picking stocks that is essentially a screen. The source of the magic formula is a 2005
book entitled The Little Book That Beats the Market by Joel Greenblatt, who is also the
author of a 1997 book entitled You Can Be a Stock Market Genius (Even If You're Not
Too Smart). Eisinger reports that the "Little Book is one of the best, clearest guides to
[so-called] value investing. ... in a world where individual-investor advice is dominated
by jargon-filled short-termism on the one hand and oversimplified [slice and dice]
indexing on the other. ... He [Mr. Greenblatt] writes ... with the fervor of a true believer."
The following is a paraphrase of selected excerpts from the article, followed by a
cautionary comment.
The magic formula is to invest in good companies when they are cheap. Good companies
earn high returns on their investments. Cheap companies have share prices that are low
based on past earnings. The proxies for these two criteria are accounting return on capital
and market earnings yield. Accounting return on capital is here defined as operating profit
as a percentage of net working capital and net fixed assets. Market earnings yield is here
defined as pretax operating earnings compared with enterprise value, which is the market
capitalization of the stock plus the net debt.

Mr. Greenblatt advises individual investors to buy a basket of top stocks and turn them
over on a strict schedule, depending on how they perform. For maximum tax advantage,
sell losers just before a year is up, and winners just after a year.
Looked at in hindsight, the returns of the magic-formula method allegedly beat the
market. From 1988 through 2004 (7 years), according to Mr. Greenblatt's book, the (1)
high-book-return and (2) low-price stocks of (3) the largest 1,000 companies had (4)
stock market returns of 22.9% annually, compared to 12.4% for the S&P 500. When (1)
2,500 companies [one-half of U.S. industrial stocks; probably the largest] are ranked
for (2) price and (3) book returns (based on the formula), then in terms of (4) stock
market returns, the top 10% outperformed the second 10%, which outperformed the
third 10%, and so on. It works in order.
The approach is difficult not because it is hard to understand, but because it requires
patience and trust that you are right when the market is indicating that you are wrong.
Some limitations to the approach include the tendency to choose stocks whose high book
returns and growth in size or market capitalization may be in the past. Some of the
magic-formula stocks with more than $1 billion in stock-market capitalization include
many fast-growing specialty retailers and niche pharmaceutical companies, some of
which will burn out.
That is why Mr. Greenblatt argues that novice investors buy at least 20 to 30 of them. For
himself, he buys a smaller number that he can know deeply. But that requires something
not easily taught in a book: good instincts and judgment to distinguish true cheap gems
from one-hit wonders.
COMMENT: There are two problems with this magic formula investing three-factor
screen of (1) market size, (2) book return on capital, and (3) combination market-andbook earnings/size yield, to maximize (4) stock market return. The current values of the
magic formula investing criteria are available from S&P Compustat that provides
financial and other information on more than 5,000 U.S. industrial stocks and from other
commercial databases, but their use as a stock picking method is dubious.
Neither Mr. Eisinger nor Mr. Greenblatt holds a Ph.D. degree in financial economics, and
this might explain their silence about the first problem. Two of the three screens or
factors are not independent of stock market return. The market capitalization of a
company's total stock, a k a size, as here defined, is not independent of stock market
return. Earnings/size yield, as here defined, is not independent of stock market return,
because earnings/size yield entails size. Only return on capital, as here defined, is
independent of stock market return.
Size is logically circular as an explanatory factor in any econometric model of stock
market return, because both size and market return entail stock price. An econometric
model with size as a factor, or with size as part of a factor, is not scientifically valid.
Therefore, back-testing the magic formula investing three-factor screen is vicious circular
reasoning, fatally fallacious, meaningless, and non-interpretable. The magic formula

investing three-factor screening method for picking stocks is fatally flawed and disguised
market timing.
When being back-tested for (4) stock market return, and compared to benchmarks such as
the S&P 500 Index of common stocks, the magic formula investing three-factor screening
method is essentially and effectively an asset pricing model of return; and as such, it is a
variation of the pseudo-scientific Three-Factor Model of return for stock portfolio
pricing. Both return models have three factors, each of which entails one of three
variables: (1) size, defined as market capitalization; (2) a variable that does not entail
price; and (3) a yield on price, defined in various ways, such as earnings/price,
earnings/size, or earnings/enterprise value. For both return models, the factors related to
the size and yield-on-price variables are logically circular.
Both Mr. Eisinger and Mr. Greenblatt have reason to know about the second problem
with this magic formula investing three-factor screen. An investor can choose to ignore
the first problem, which involves theory, and believe in magic. But an investor cannot
ignore the second problem, which is practical implementation of the theory behind the
magic formula investing three-factor screen.
The Greenblattt Magic Cube of three dimensions is a black box, and the details of
sorting, ranking, and picking individual stocks are proprietary. And the devil is in the
details. More transparency is needed for fuller accountability. The Greenblattt universe of
investment opportunities is already screened for (1) publicly traded common stocks, (2)
U.S. based companies, and (3) industrial firms. This universe of U.S. industrial common
stocks is sorted by the three screens in some order, and the order is arbitrarily chosen. A
different order results in a different selection of stocks if the net remaining universe is
used instead of the gross beginning universe of investment opportunities to determine
averages or cut-off points. The gross cheapest stocks that are the net best are not the same
as the gross best stocks that are the ne cheapest.
In addition, each screen or dimension is a continuum that is partitioned into categories,
and the number of categories is arbitrarily chosen. If each of the three dimensions is split
into two parts, then 1/8 of the universe is selected; and if each dimension is split into ten
parts, then 1/1000 of the universe is selected. For the universe of U.S. industrial stocks of
about 5,000 companies, this ranges from 625 to 5 stocks selected.
Furthermore, there must be breakpoints between the adjacent categories, and the
breakpoint values and/or the method of determining the breakpoint values is arbitrarily
chosen. The categories might be deciles, for example, and the breakpoint values would
follow this choice of relative comparative values. Or the categories might be simply pass
or no pass, depending on the absolute minimum acceptable value of each criteria. For an
example of such absolute minimums, "large" might be more than $1 billion in market
capitalization; "good" might be higher than the risk-free rate on U.S. Treasury bonds,
adjusted for price-level inflation, plus an equity risk premium; and "cheap" might be
higher than the earnings/price ratio on the S&P 500 index of common stocks.

In summary, the magic formula investing three-factor screen will continue to work even
after everyone "knows" it, because mathematics will continue to work even after
everyone "knows" it. Logically circular back-testing is purely mathematical. Vicious
circular reasoning can be subtle to detect, even for intellectuals with doctoral degrees and
for practitioners who have made fortunes in the stock market. It is a familiar phenomenon
for someone who has successfully invested in the stock market to believe he has a magic
touch and then write a book about his alleged method, leaving readers to discover that
there is no magic or science about his stock-picking success.

Unit Pricing
Price is not value, and unit pricing is not valuation. Unit pricing in this context does refer
to market price per share of stock but rather to what the investor gets by owning that
share of stock. A unit price may be useful for comparison shopping, but how many people
buy even their commodity groceries strictly on the basis of calculated unit prices? That is
how many value and growth investors unwittingly buy their stocks and mutual funds. Are
common stocks fungible?
Unit prices are expressed either in number of units per dollar or other currency or in
dollars or other currency per unit. Unit prices for common stocks are expressed as price
ratios such as the P/E ratio (the dollar market price per unit of earnings), the P/BV ratio
(the dollar market price per unit of book value), and the dividend yield or D/P ratio (the
number of dividend units per dollar market price).
The fact that unit prices are quantifiable, monetizable and easy to calculate explains their
attraction. They are also superficial in the sense that no judgment or expertise or even
experience is needed to calculate them. They have the advantage of convenience. Screens
based on external financial accounting data bring to mind the Sufi story about the man
searching at night under a lamp post for his lost house keys. When asked by a passerby
where he was when he last had the keys, he said it was near his house. When then asked
why he was searching so far away from his house, he said because this is where the light
is.

Grail
There is a perennial search for a screen that is a good proxy for investment value. Such a
screen is a grail for some so-called value investors. Various screens have been proposed
over the years. Some questions come to mind concerning such a grail screen.
First, how high is the correlation between any given screen and investment value, in
terms of the stocks selected? If a particular screen results in selecting the same stocks as
estimates of investment value, then the correlation between the screen and the investment

value estimate is perfect and the coefficient of correlation between them is one hundred
percent. What is the minimum acceptable correlation coefficient to justify use of a screen
in lieu of estimates of investment value?
Second, since correlation is a statistical concept based on a group of stock selections as
opposed to a single stock selection, would it be necessary to have a minimum number of
stock selections in order to realize the validity of the correlation? If so, what is the
minimum number of selected stocks in the portfolio?
Third, correlation is calculated between a sample of a sufficient number of pairs of
points. Each pair consists of a point for the screen value for a particular stock and a point
for investment value of that same stock. As a practical matter, the concept of investment
value is operationalized as a range of values and not as a single point estimate, and
sometimes to select or deselect a stock, this investment value range is unbounded on
either the upper tail or the lower tail, respectively. In other circumstances, to select or
deselect a stock, a margin of safety is calculated from the estimated investment value
mean and the quoted market price, and the size of this margin can vary subjectively from
stock to stock depending on the size and shape (moments) of the distribution of
investment value and other considerations. Without losing information for informed
rational decisions about selecting or deselecting a stock, how can a simple correlation
coefficient be calculated from a distribution of investment value, an unbounded
distribution of investment value, or a fuzzy distribution of the margin of safety of a
stock?
Fourth, before calculating correlation coefficients, someone with an appropriate circle of
competence would need to estimate investment value of the company and its common
stock. Such expertise is idiosyncratic and constitutes a valuable person-specific
monopoly of knowledge. Setting aside for the time being the practical difficulties of
finding such qualified persons, how would you operationally define and grade the circle
of competence of the expert appraisers?
Fifth, assuming that we have the results of such a correlation analysis with assessments of
statistical reliability, is this correlation that is calculated using in part historical data and
20/20 hindsight expected to hold beyond the fiscal periods on which the screen data are
based? For example, assume the screen is the Price to Book Value ratio (P/BV). If the
correlation between P/BV and investment value turns out to have the highest coefficient
in the empirical study, will P/BV remain the single best proxy of investment value both
for all stocks in all markets and for all future stock market cycles?
Sixth, assuming that we have access to estimates of investment value of a sufficient
number of stocks within the circles of competence of the associated expert appraisers,
what would be the purpose of calculating the statistical correlation coefficients between
the investment value selections and the selections by various screens? Would it be done
for an academic paper? Would the authors of the paper estimate investment values?
It is clear that screening, regardless of the number or sophistication of the screens used, is

not a reliable substitute for valuation. Screening is superficial, and valuation is deep.
Screening is an efficient way to reduce a universe of stocks within an already
circumscribed circle of competence to a short list of stocks for in-depth study. Valuation
is an independent process that has no necessary relation to screening and can be done
without any screening whatsoever. Screening is more useful in a top-down approach that
begins with a universe of stocks than in a bottom-up approach that begins with a single
stock idea.

GLOBAL VALUE INVESTING

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A multifaceted approach to value investing with stock valuation based on intrinsic value
estimated from cash returns, appraised value of assets, and other facets of value.

Link List
The links listed below appear as active hyperlinks at Links A to M and
Links N to Z where a fuller description of each appears. They are listed
here for quick preview.

NAME

DESCRIPTION
Links A to M

AAII Stock Investor

databases; screen, rank & graph 8,000 stocks; fee

American Partnership Board

limited partnerships online auction system

Ameritrade

low-cost, on-line transaction service

Annual Report Gallery

online financial reports and links

BEAR Valuations

business equity appraisal reports; fee

Big Charts

quick charts & interactive charts for stock data

Bloomberg

quotes, data, analysis, funds, world markets, energy

Bloomberg: International Yield Curves

G-7 and Dutch governments

Bonds Online

quotes/search for U.S. corporate & other bonds

Business Directory

100,000+ companies online and links

CBS Market Watch

global markets; foreign exchange

CERES

Coalition for Environmentally Responsible Economies

CEP

Council on Economic Priorities

CNNfn World Stock Markets

indexes for bourses in four global regions

Corporate Library

corporate governance issues and information

CPA Class

U.S. generally accepted accounting principles (GAAP)

CPCUG

historical graphs of markets and economies

Data Downlink Corporation

spreadsheet-formatted financial data

Datek

low-cost, on-line transaction service

DBC Online: Financial Markets:

Industry Groups

38 industry groups

Decisioneering Crystal Ball

risk analysis and Monte Carlo simulation software

DecisionPro

management decision analytics

Dismal Scientist

economic information and analysis

eBondTrade

prices and online trading for investment-grade municipal

bonds

EDGAR Online

real-time SEC filings; insider trading reports; fee and free

Escape Artist

offshore investments

eTrade

low-cost, on-line transaction service

FASB Exposure Drafts

proposed U.S. financial accounting standards

FinanCenter

finance calculators for stocks, bonds, and mutual funds

FinancialCAD

financial engineering software for option pricing and other

modeling

Financial Data Finder

OSU Fisher College of Business search directory

Financial Players Center

finance education -- Time Value of Money

FindLaw

for lawyers, students, the public, and business

FreeEDGAR

free unlimited real-time SEC filings

FINWeb

financial economics journals & papers

Form 1040

U.S. Federal & State income tax information, forms, and

links
Gomez Advisors

Personal Finance: Internet-Broker Scorecard

Governing Corporate Objective

Shareholders vs Stakeholders

Hoover's Online

capsules on over 11,000 companies, U.S. and non-U.S.

Inflation Calculator

1800 to 1995; U.S. Consumer Price Index

Intrinsic Value Associates

institutional equity research and valuation

InvestingSites - Brokers

list of links to full-service and on-line brokers

Invest Offshore

offshore tax havens around the world; private banking,

investments

Investor Protection Trust

your Investment Quotient-IQ; 50 state listings

InvestorGuide

investing and personal finance; advisor data

Jadco Stock Charts

actual and projected revenues and earnings

James' Calculator

financial calculator for NPV, FV and ROR

Kiplinger Financial Calculators

8 including stocks, bonds & mutual funds

LENS Investment Management

activist money manger criteria and methods

LivEDGAR

M&A database for comparable deals and data

Market Guide

provider of financial information; real-time

MatLab for Finance

computational and visualization analytical tools; fee only

MEAP's Currency Conversion

Calculator

daily rates for 35 currencies

Media General Financial Services

database of NYSE, AmEx & Nasdaq financials

MergerStat

control-premium study for valuing a controlling interest

Moody's Investor Services

ratings and real-time rating actions

Moody's Manuals

screen, rank, spreadsheet & graph; US & non-US, fee only

Morningstar Net

market data; quick takes; portfolio radar; fund and company

screens

Multex Investor

clearinghouse of institutional research; fee

Links N to Z

NAIC

education; investment clubs; DRIPs, S&P screening; fee

only
Natural Investing

making decisions in alignment with personal values

Numa Option Calculator

adjusted Black-Scholes model to value European options

OnLine Investment Services

Discount Stock Brokers Ranked report

Perspective on Value

Why Share-Owner Value?

Public Register's Annual Report Service free annual reports on 3,600+ public companies
Random.org

true random number service

Quicken.com

comprehensive data, SEC filings, stock evaluator

Quote.com

stock, fund, index and money market quotes; research;

SEC filings; free & fee

Research: Magazine: InvestorNet

market and company data; free & fee

Resources for Economists on the

Internet

selective, narrowly-focused

Reuters Money Network

screen U.S. stocks, bonds, funds, CDs, etc.; fee only

Robert's Online Applications

pricers for options, commissions, etc.

Savings Bond Wizard

U.S. Treasury; redemption values; reports

SmartMoney

broker ratings; quotes & data; calculators & worksheets

SocialFunds.com

socially responsible investing funds

S&P Blue List

U.S. corporate & municipal bonds current offerings

S&P Compustat PC

financial data, global, ACE, I/B/E/S

S&P ComStock

worldwide real-time market data

S&P Equity Investor Services

Earnings Guide, Stock Guide, etc.; fee only

S&P Personal Wealth

U.S. & global stocks, bonds; holdings, analysis; fee & free

S&P Ratings Services

ratings criteria for 8 categories

Statistica

animated interactive probability calculator

Stockpoint

investing tools, screen and sort, export; free

StockSelector

four stock "value" calculators and Dow analysis

StockSense

discounted cash flow models for stock valuation; examples

Stock Smart

comprehensive worldwide company data; fee

StockTools

screens, quotes, industry groups, portfolios, and graph

wizard

StockVal

model that returns a warranted price-earnings ratio

U.S. SEC Archive Search

historical filings

U.S. SEC EDGAR Search

internet database of corporate information; new filings

U.S. Tax Resources

Federal and States income tax forms and publications

University Angels

investor and entrepreneur equity capital network

Value Line Investment Survey

screen, rank & graph 5,000 stocks; fee only

Venture Capital Resource Library

database; list & browse investment opportunities

Wall Street City

collection of single-question personal finance "calculators"

Wall Street Research Net

economy, industry, company and fund data

Wiley & Sons

download spreadsheet programs for valuation

World Economic Forum

global competitiveness reports

World Wide Web Resources in

Economics

mainly broad academic topics

WorldlyInvestor.com

American Depositary Receipts; EDGAR Online; global

indices; currencies

Xenon Laboratories

worldwide currency converter

Yield Curves

for terms of 3 months to 30 years

Zacks Investment Research

analysts earnings estimates and other data

ZDNet Search

personal stock quote & private portfolio applications

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1.

Provides useful product, service or information

for the intended audience of this Web site.

2.

Provides at least part of this stuff for free without

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3.

Provides this free stuff in greater quantity or

higher quality than other content providers.

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