Greenblatt Magic Formula, always read the leaflet before using it!

Olivier Dambrine 27 Aug 2011

I sometimes wonder whether some financial newspapers are really adept at explaining what's really going on in the world. For everyday market updates, journalists are trying hard to second guess why the stock markets go up or down. If you read their newspapers on the web it's not uncommon for a story to be updated in a very short time: Agfa-Gevaert posted fantastic results.. 15 minutes later: Agfa- Gevaert disappoints with lower than expected earnings. The story changes as quickly as the stock price. Also at macro-level, the newspapers always seem to have an explanation for what's going on in the market but to me they don't seem to be very confident.

To fill the remainder of the pages, newspapers often try to tackle items in more detail. They discuss subjects to which they're not very close and by trying to put their own spin on the subject they completely miss the point.

This is exactly what happened in an article published by the Belgian newspaper 'de Tijd' on 6 August 2011. One of their journalists wrote an article on Greenblatt's Magic formula: I really hope people didn't use this article as a basis for investment decisions, but it does give us a perfect opportunity to explain a few point about the formula and why MFIE's screener is the only commercially available screener that implements the formula correctly for stocks globally.

The author starts by giving a short explanation of the formula. After that it goes horribly wrong.

First of all, he applies the formula to only the stocks on the Belgian stock exchange. He correctly excludes certain companies on which the formula doesn't work, but that brings the total to around 150 companies. Now it doesn't require a brain surgeon to work out the fact that screening a list of 150 companies is very restricted. How on earth can you find cheap stocks if you only look at a set of 150 stock? In our valuescreeners tool we screen 22.000 stocks and looking at the top 30 you won't find a Belgian company in there. In fact the highest ranking Belgian company - Picanol - is only at position 88 in our screeners. The first company reported in the article - Belgacom - ranks at position 327 and Resulix, the article's number 2, ranks at 643.

The author makes another cardinal mistake, this time in the formula. While the Greenblatt magic formula sounds simple, calculating it is slightly more complicated. In the appendix of his book you will find a detailed description of all elements of the formula and it took our team quite some time to get this exactly right. If the author would have understood this section, he would have noticed that Greenblatt really uses pre-tax operating earnings instead of EBIT, excluding non-operating income. So while in the general section Greenblatt always mentions EBIT, he doesn't really use EBIT! Off course this difference will lead to a completely different ranking. In the MFIE screener the companies at the top of the ranking are: Picanol, Omega Pharma, Melexis, Roularta,.. The first 2 don't even appear in the author's list, the last 2 are at position 14 and 19. Instead a company like Belgacom is ranked number 1 in the article's list but as Siddy Jobe at Bank Degroof commented, Belgacom booked a 400 million Euro non-operating income in 2010.

After compiling an incorrect MF-list, the author casually concludes that stock screening takes away a big part of the 'fun' of investing. Isn't this a remarkable statement in the light of the recent stock market drop and the fact that many people lost significant amounts of money by speculating on the prices of glamour stocks? Shouldn't investing be about earning a good profit on your capital by investing in sound businesses and purchasing their stocks at a margin of safety?

There's many articles like this one but I wouldn't conclude that all financial press is always wrong. There are very good journalists who help us make sense of different subjects by summarizing complicated content. But one should always read these articles with a healthy degree of scepticism. There's always a chance that the author didn't take the time necessary to fully understand the subject.

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Greenblatt Magic Formula