Opinion – Grain in Grain: Discover the magic formula to beat the stock market

It doesn’t take an extremely complex strategy to earn above-market returns. Who says this is the resource manager and author of the book: Joel Greenblatt’s Magic Formula for Beating the Stock Market. I explain below how you can build this strategy and if it really works.

Undoubtedly, the author praises the model he created himself in his book. However, we know that the author himself would praise his model. So I researched academic studies that examined Greenblat’s Magic Formula (FM) strategy.

Searching Google Scholar, it is possible to find several scientific works testing this model for almost all markets around the world, including Brazil.

The academic works found describe that the FM actually produces better results than aggregate indices such as the Ibovespa.

For the Brazilian case, it is possible to cite Leonardo Milane’s master’s thesis from 2016, in which I participated in the examining board, and the article by Pétrick Conceição from 2021.

Both found that stock portfolios that follow the Greenblat model result in higher returns than the Ibovespa, as shown in the graph below extracted from Conceição’s work.

As described in Milane’s work, building portfolios with the Magic Formula takes 6 steps. These steps should be performed at least once a year to rebalance the portfolio. I describe these steps below:

1. Calculate ROIC and Earnings Yield of companies. ROIC is the ratio between EBIT (operating profit) and the sum of net working capital and net fixed assets. O Earnings Yield is the ratio between EBIT and the sum of the market value of the shares and the company’s net debt;

2. Order the assets from highest to lowest ROIC and assign a score starting at 1 for the asset with the highest ROIC, 2 for the second highest ROIC asset and so on until the lowest ROIC asset;

3. Sort assets from highest to lowest Earnings Yield and assign a score of 1 to the highest asset Earnings Yield2 for the second highest asset Earnings Yield and so on until the lowest asset. Earnings Yield;

4. Add the companies’ scores in steps 2 and 3 to arrive at the overall score for each asset;

5. Sort the assets in ascending order of overall score found in step 4;

6. Choose how many stocks you want to have in your portfolio. Greenblat suggests 30 stocks, but the portfolio can be formed with a smaller amount. So, if you want to build a portfolio with 10 stocks, select the 10 stocks with the highest score.

As Greenblat warns in his book, his model won’t work every year. It would be a long-term strategy.

According to him, FM would possibly lose out on the market in at least five months of each year. In at least 25% of the years, the portfolio that follows this model would lose the main market indices and in several cases the portfolio loses for two consecutive years.

This warning is important for everyone to understand that no matter how good a strategy is, it will never beat the market in all periods. The author himself comments on the frustration in the early years in his experience of implementing his model.

I am not recommending that you follow this strategy, but I present it as a way to help readers create a systematization for the management of their stock portfolios.

As I say, managing a stock portfolio without a strategy is like navigating a rough sea in the middle of a storm without instruments. You will end up losing yourself if you don’t have a proper strategy.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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