Joel Greenblatt’s ‘Magic Formula’ is one of the most successful stock-picking strategies of all time.
First published within his book The Little Book that Beats the Market, Greenblatt’s data showed that over a period of 17 years, stocks qualifying for the screen outperformed the market by around 30.8% per annum.
Market screen
The Magic Formula screen looks for companies that are both cheap and produce a high return on investment. Every month, analysts at investment bank Société Générale put out a list of companies that they believe qualify for the screen.
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The bank’s analysts rank companies based in their return on capital and valuation, using criteria similar to those devised by Greenblatt. Analysts place those companies with the highest return on capital, but lowest valuation at the top of the list.
All stocks in the FTSE World Developed and FTSE 350 indexes are included in the screen.
This month there were only five UK companies that made it into the top 25 qualifying companies.
High returns
Commercial banknote printer, De La Rue (LSE: DLAR) comes out on top thanks to the company’s ability to literally print money.
Indeed, De La Rue’s ROCE — a metric that compares how much money is coming out of a business, relative to how much is going in — eclipses that of its peers.
During its last financial year, De La Rue’s ROCE totalled 49.6%. To put that into perspective, according to my figures less than 3% of the world’s 8,000 largest companies managed to achieve an ROCE of greater than 40% last year.
Moreover, the group currently trades at a historic P/E of 11.5.
Market leader
Next to qualify is marketing giant WPP (LSE: WPP). WPP’s strengths lie in the group’s rapid growth over the past six years and the ability to create value for shareholders.
Since 2009, WPP’s earnings per share have expanded at an annual clip of 18%. Over the same period, the company’s shares have returned 17.9% per annum, outperforming the FTSE 100 by 9.1% p.a.
WPP currently trades at a forward P/E of 14.8 and supports a dividend yield of 3.1%.
Bargain bucket
Carillion (LSE: CLLN) qualifies for the Greenblatt screen due to the company’s bargain basement valuation and steady ROCE.
Carillion’s ROCE has averaged 9.5% p.a. during the past six years, one of the highest returns in the construction sector. The company currently trades at a forward P/E of 9.6 and supports a dividend yield of 5.5%.
Similarly, both Mitie (LSE: MTO) and Ladbrokes (LSE: LAD) qualify for the Greenblatt screen due to their low valuations and steady returns on capital.
Mitie currently trades at a forward P/E ratio of 12.7 and supports a dividend yield of 3.8%. The company’s ROCE has averaged 12.6% p.a. during the past six years. Since 2010, Mitie’s earnings per share have increased at a steady 8% p.a. and this growth is set to continue.
Falling earnings
City analysts expect Ladbrokes’ earnings per share to fall by a third this year. On this basis, the company is trading at a forward P/E of 17.7.
However, Ladbrokes is cheap on an enterprise value to earnings before interest, taxes, depreciation and amortisation (EV/EBITDA) basis. The group trades at an EV/EBITDA multiple of 7.5, almost half the sector average of 14.
Ladbrokes supports a dividend yield of 5.8%.
