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Joel Greenblatt’s Magic Formula – ASX style

Joel Greenblatt is a famous author and investor –well known for his bestselling book The Little Book That Beats the Market, which featured an automated investment strategy he called the ‘Magic Formula’.

The strategy is based on selecting high quality stocks that are trading at cheap prices. That might appear simple, but it’s far from that. For quality, he used return on capital and for cheapness, he used earnings yield and then he ranks all the stocks in his universe by the highest values for each, add the two ranks together to get one total score and then select the top 20-30 highest ranked companies.

Investors were recommended to hold the stocks for a year, rerun the filter, rinse and repeat.

Here’s my top ten results running the Magic Formula on the universe of ASX stocks, excluding companies with a market cap under $50 million.

Company Name Market Cap Price Total score
Acrux Limited (ASX: ACR) $195m $1.14 48
Drillsearch Energy Limited (ASX: DLS) $357.4m $0.74 49
Monadelphous Group Limited (ASX: MND) $822m $8.78 54
MACA Ltd  (ASX: MLD) $195m $0.82 79
Saunders International Ltd  (ASX: SND) $71.5m $0.91 80
Doray Minerals Limited (ASX: DRM) $50.6m $0.38 86
CI Resources Limited (ASX: CII) $64.1m $0.88 91
Seymour Whyte Ltd  (ASX: SWL) $114.4m $1.26 97
Beadell Resources Ltd  (ASX: BDR) $171.7m $0.21 99
GR Engineering Services Ltd  (ASX: GNG) $105.3m $0.69 101

Source: Capital IQ

Now the problem with the formula should be apparent from the number of mining services companies in the list above. Of the top ten stocks, fully half of them are mining services companies, Monadelphous, MACA, Saunders, Seymour White and GR Engineering, which shows that the magic formula depends on historical data, and doesn’t take into account future projections.

Many of you will know the mining services sector is facing an epic reduction in mining investment, which has yet to fully impact them. Then we have two gold miners, Doray and Beadell. Who knows where the gold price will be in 12 months’ time?

A portfolio consisting of these ten stocks might not be a great idea, given the outlook for the sectors they belong to. But I guess that’s the point of the formula – picking out-of-favour stocks, which are cheap, but have produced strong returns on capital in the past year.

I’ll revisit this article in 12 months – we’ll see how it goes. In the meantime, I’ll leave it up to you to come to your own conclusions.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

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