In this article we take a look at 10 best magic formula stocks to buy now based on legendary investor Joel Greenblatt’s strategy and stock holdings. Click to skip ahead our discussion and jump to the 5 Best Magic Formula Stocks To Buy Now.
Joel Greenblatt is an American value investor and hedge fund manager known for his investment strategy called “magic formula” investing. Greenblatt founded Gotham Capital in 1985 and presided over an annualized return of 30% from 1985 to 1994 by investing in special situations like spinoffs, tender offers, mergers, acquisitions and bankruptcies. Greenblatt currently serves as managing principal and co-chief investment officer of Gotham Asset Management. The fund’s portfolio is worth over $3.11 billion, as of Sept. 30.
What is Magic Formula Investing?
Greenblatt revealed his famous magic formula investing strategy in his bestselling book titled “The Little Book That Beats The Market.” Greenblatt argued that stocks which have discounted valuations and high returns on capital can produce outperforming results for long-term investors. Greenblatt said in his book that his strategy produced back-tested returns of 30.8% per year from 1988 through 2004, compared to S&P 500’s 12.4% return during the same period. Gotham had a 24% return from 1998 through 2009.
The magic formula investing strategy has several constraints which are programmed into an online stock screener developed by Greenblatt’s firm. Magic formula investing only applies to companies that have market caps of more than $100 million. The strategy also excludes financial companies, utility companies, and non-U.S. companies.
After determining their earnings yield (EBIT / enterprise value) and return on capital (EBIT / (net fixed assets + working capital), companies are ranked by highest earnings yield and highest return on capital. Usually, investors are recommended to invest in the top 20-30 companies from this ranked list, accumulating 2-3 positions per month over a period of one year. This process is repeated over a period of 5-10 years. Portfolios are re-balanced by ejecting losers or underperformers one week before the year-term ends and selling winners one week after the year mark.
Keep in mind that while calculating earnings yield for a company, you should include the value of the company’s shares and debt it uses to generate earnings. When calculating a company’s return on capital, Greenblatt’s strategy uses earnings before interest and taxes to make sure we calculate the real health of the operating business.
The crux of Greenblatt strategy is to buy cheaper stocks that have value and sell stocks that are expensive relative to their true value. This strategy practically combines Warren Buffett’s quality measures with Benjamin Graham’s deep value approach. The fundamental thesis of magic formula investing is that public companies are functionally similar to private companies. Therefore, you should analyze their value based on metrics like the price you are paying and return on capital.
In his first-quarter letter to investors, Joel Greenblatt said:
“However, the real opportunity can be seen by taking a look at the pricing disparity of the cheapest stocks within each universe. We also have a 30-year valuation history for the cheapest stocks in the Russell 1000 comprising our 1000 US Value composite. This composite chooses the cheapest stocks within the Russell 1000 according to our valuation methodology and puts more weight on those considered cheapest. The composite holds over 700 stocks with a diversity similar to an equally weighted portfolio of approximately 300 stocks. This composite of the cheapest stocks within the Russell 1000 now sits in the 86th percentile towards cheap over our 30-year research history corresponding with a two-year forward expected return of over 50% based on similar valuation levels in the past.”
Is Value Investing Still Relevant?
Despite everything, magic formula investing is still deeply rooted in the value investing philosophy, which is losing its charm. Value stocks are lagging behind broader markets for over a decade. Value investors are suffering across the board. Warren Buffett’s Berkshire Hathaway posted nearly $50 billion in losses in May. Value investor Ted Aronson, the cofounder and co-CEO of AJO Partners, recently announced to shutter his shop after severe losses. The coronavirus crisis and the rise of big tech stocks are further casting doubts on the validity of value investing.
It’s not just value investors that are facing the effects of the rapidly changing market dynamics. The hedge fund industry’s reputation has been tarnished in the last decade during which its hedged returns couldn’t keep up with the unhedged returns of the market indices. On the other hand, Insider Monkey’s research was able to identify in advance a select group of hedge fund holdings that outperformed the S&P 500 ETFs by more than 78 percentage points since March 2017 (see the details here). We were also able to identify in advance a select group of hedge fund holdings that significantly underperformed the market. We have been tracking and sharing the list of these stocks since February 2017 and they lost 13% through November 16. That’s why we believe hedge fund sentiment is an extremely useful indicator that investors should pay attention to. You can subscribe to our free newsletter on our homepage to receive our stories in your inbox.
But Greenblatt believes in patience and long-term vision. In its annual report, Gotham categorically said:
“The important thing for us is to stick to our strategy even if it is not working over shorter time periods. We have over 60 years of combined investment experience valuing and investing in publicly traded businesses. We know how to value businesses by using various measures of absolute and relative value. So, that’s how we invest. We buy companies that are at the biggest discount to our assessment of value and sell short (where applicable) those companies that are most expensive relative to our assessment of value. We do not plan to change this strategy or adopt other methodologies when short-term stock prices do not reflect the values that we see.”
Since 1996, Joel Greenblatt teaches Value investing MBA’s classes at Columbia University Graduate School of Business. Greenblatt’s latest book “Common Sense: The Investor’s Guide to Equality, Opportunity, and Growth” was published in September 2020 and talks about education, public policy, economic outlook and equality.
Let’s take a closer look at Joel Greenblatt’s best magic formula stocks to buy now by analyzing his hedge fund’s 13F data for the third quarter of 2020. By the way, if you are a value investor, you will be surprised when you find out the top 5 “magic formula stocks”.
10. eBay Inc (NASDAQ: EBAY)
eBay ranks 10th in the list of Gotham Asset Management’s top 10 holdings, as of the third quarter of 2020. Joel Greenblatt’s fund increased its hold on eBay stock by 4% in the third quarter. The fund’s total stake in the ecommerce company is now worth over $21.27 million.
eBay is expected to be one of the biggest beneficiaries of the ecommerce boom. According to a new report by ACI Worldwide, there was a 21% increase in e-commerce transactions worldwide, mainly due to a strong consumer demand for household items, remote education and electronics.
eBay earnings in the third quarter surpassed estimates, with gross merchandise volume, or GMV, growing 22% on a year-over-year basis. eBay’s active user count increased 5% in the quarter to reach 183 million.
Steel City Capital talked about EBAY in its 2020 Q3 investor letter:
“EBAY (Long): The Partnership has taken some profits in EBAY although our position remains sizeable at 10% of capital. A substantial portion of the investment thesis has played out, namely that activist-owner Elliot Management would instigate the sale of both StubHub and EBAY’s portfolio of classified businesses. The sale of StubHub was completed in early 2020 for net cash proceeds of ~$3.1 billion, and in the third quarter, the company announced it had entered into an agreement to sell the classifieds portfolio to Adevinta (ADE) for $2.0 billion of net cash and ~$6.7 billion worth of shares. The market responded positively to ADE’s acquisition and today the share-based consideration is worth ~$9.0 billion.
With a key component of the thesis realized, why not completely exit the position? The answer is what remains – the core EBAY marketplace – continues to trade at a modest price relative to its cash generating capacity. At the shares’ current price of $53, EBAY’s market capitalization is $37.5 billion. This includes $5.8 billion of cash and investments, implying a value net of cash of $31.7 billion. The company should generate an additional $1.25 billion of free cash flow in the second half of the year, receive $2.0 billion in net cash proceeds from ADE, and shares in ADE worth another $9.0 billion at current prices. Backing out these additional items results in a clean market cap of $19.5 million for EBAY’s core marketplace.
By 2022, EBAY’s managed payments initiative should more or less offset the cash flow the company will lose as a result of the sale of the classifieds portfolio. Steady state free cash flow should remain in the realm of $2.0 billion. To this end, I believe we are paying an effective 10x P/FCF multiple for the core marketplace business. Say what you want about EBAY, but this is hardly a demanding valuation for a capital-light (a positive in an inflationary world) ecommerce operator (a positive in a pandemic-stricken world).”
9. Berkshire Hathaway Inc. Class A (NYSE: BRK.A)
Berkshire Hathaway ranks 9th in our list of the best magic formula stocks to buy now. Gotham went bullish on Berkshire Hathaway Inc. Class A (NYSE: BRK.A) in the third quarter, upping its stake in Warren Buffett’s company by 86%. Gotham now owns 105,111 shares of the company, worth over $22.38 million.
To offset the negative effects of the coronavirus crisis, Berkshire doubled down on its stock repurchase program, buying back $9 billion worth of its own shares in the third quarter, up from $5.1 billion in the second quarter. In the third quarter, the Oracle of Omaha’s firm said its net earnings jumped 82% on a year-over-year basis to $30.137 billion.
Giverny Capital talked about Berkshire in its 2020 Q2 investor letter:
“Another weak performer in the second quarter was Berkshire Hathaway. While Berkshire’s commercial insurance business should benefit from the harder underwriting market described above, and Geico shares some traits with Progressive, we confess to a bit of anxiety about this holding. We were surprised to learn at Berkshire’s shareholders meeting in May that CEO Warren Buffett could not find any good investment ideas in March, when the market plunged 35%. He opined that Berkshire might need every bit of its $137 billion in cash to weather the COVID-19 induced recession. We appreciate that Berkshire needs to hold cash to backstop its large insurance operations and that this is a frightening time, but we’re also reminded of the old Peter Lynch quip that more money has been lost preparing for corrections than in corrections themselves. We’d love to see Berkshire put more of its capital to work or return it to the owners.
In fairness, we hear Berkshire has been aggressive about writing more insurance in this environment, and it made a $10 billion investment in gas transmission and storage assets in early July. But not even the best investor in the world can outperform the S&P Index if one-third of his portfolio is in cash.”
8. Johnson & Johnson (NYSE: JNJ)
JNJ ranks 8th in our list of the 10 best magic formula stocks to buy now. Joel Greenblatt shed Johnson & Johnson (NYSE: JNJ) in the third quarter, selling about 21% of the stock. Gotham now owns 158,880 shares of the healthcare company, worth $23.65 million.
Johnson & Johnson is in the news as the company announced Dec. 18 it enrolled 45,000 participants for the first late-stage trial of its COVID-19 single-dose vaccine candidate. Interim data from the trial is expected in January, which shows it is lagging behind rivals like Pfizer and Moderna whose vaccines have already won approvals from the FDA.
Earlier this year, a U.S. court ordered Johnson & Johnson to pay $2.1 billion in damages after it was revealed that the company’s talcum powder caused ovarian cancer.
Johnson & Johnson is up over 5% year to date.
7. Walmart Inc (NYSE: WMT)
WMT ranks 7th in our list of the 10 best magic formula stocks to buy now. Gotham Asset Management sold 23% of its stake in retail giant Walmart in the third quarter, ending the period with a $26.34 million stake in the company.
Walmart has been one of the top beneficiaries of the changes brought about by the COVID-19 pandemic. The company crushed analysts’ estimates in the third quarter, reporting a same-store sales growth of 6.4%, versus an expected 3.9%. The biggest jump came in the digital side of the business, which continues to see an explosive growth.
Walmart’s CFO Brett Biggs said that the coronavirus resulted in big changes in consumer behavior, causing “three to five years of acceleration in e-commerce, really in a period of weeks and months.”
6. Oracle Corporation (NYSE: ORCL)
Oracle ranks 6th on the list of Gotham Asset Management’s top holdings, even after the fund unloaded about 20% of its stake in the company in the third quarter. Oracle stock accounts for about 0.92% of the hedge fund’s portfolio. Moving into the fourth quarter, Gotham had $28.92 million worth of Oracle shares.
Oracle is up over 17% year to date. The company is desperately trying to increase its penetration in the lucrative public Cloud market, but still lags behind giants like AWS, Microsoft Azure and Google.
Oracle is very close to finalizing a deal that would give it over 12% stake in TikTok. The company’s Cloud infrastructure was recently chosen by Zoom for its data and processing needs. In the fiscal second quarter, Oracle’s cloud services and license support revenue came in at $7.11 billion, growing 4% and beating analysts’ forecasts of $7.04 billion.
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Disclosure: None. 10 Best Magic Formula Stocks To Buy Now is originally published at Insider Monkey.