Greenblatt tested his algorithm through starting with the largest 3,500 stocks trading on the major US stock exchange. Then a rank from 1 to 3,500 was assigned to each stock based on its ROC, ranking stock with highest ROC as 1. The process is then repeated according to calculated earnings yield factor, ranking the stock with highest EBIT / TEV as rank 1 and stock with lowest EBIT / TEV as rank 3,500. A combined rank for each stock is then generated by summing ROC rank with earnings yield factor rank for each stock. As example: stock of “ROC rank” equals 12 and “earnings yield factor rank” equals 587 will have a combined rank of 599. Stock with lower combined rank considered more attractive than those with higher ranks. Greenblatt then studied the performance of theoretical purchasing of 30 stocks with lowest combined ranking holding the portfolio for one year before selling and then repeating the process. The study illustrated that the expected return is 30.8% per year of the period from 1988 to 2004. This means that such investment would have turned $10,000 into over $960,000 while the return would be only $71,000 across the same period assuming that the market returns 12.3% annually. (cf. Grey/Carlisle 2013, p.38).
Finding Quality, Academically
The definition of gross profitability to total assets (GPA) is introduced.
GPA equals: (Revenue-Cost of Goods sold) / Total Assets. It is noted that the higher the stock’s GPA, the higher the quality of the stock. As advised by Novy-Marx, the gross profitability is believed to be the cleanest measure of true economic profitability rather than other factors such as earnings or EBIT. As noted by Novy-Marx, the income statements could provide misleading profitability measures sometimes. As example; a firm with both lower production costs and higher sales apparently considered more profitable than other companies. However, this could be not the real case when taking into consideration marketing expenses and sales force commission. (cf. Grey/Carlisle 2013, p.45).
Finding Price, Academically
The definition of book value to market capitalization (BM) is introduced.
BM equals: Book Value / Market Price. BM is preferred to be used rather than price to book value (P/B) because it is more directly comparable with the Magic Formula’s EBIT / TEV. As advised by Eugene Fama and Ken French, BM capitalization is considered as superior matric because it has less variance against time compared to other measures based on income. (cf. Grey/Carlisle 2013, p.48).
Grey, Wesley ; Tobias Carlisle (2013): Quantitative Value. A Practioners guide to automating intelligent investment and eliminating behavioral errors. John Wily & Sons. Hoboken, New Jersey.