Does the money formula work? ; Sameer Bhardwaj checks if celebrity investors' strategies for picking stocks are applicable to amateurs. He finds that Joel Greenblatt's approach works.

How does one select a good stock? One way to make a goodselection is to track successful investors, but are their methodsrelevant for amateurs? We test the advice of some investment gurusand analyse whether it works for you.

Let us consider "the magic formula of Joel Greenblatt. In TheLittle Book that Beats the Market, Greenblatt talks of a simple wayto beat the market using only two fundamental variables - return oncapital (RoC) and earnings yield (EY).

RoC measures the money a company makes with its assets and iscalculated by dividing the firm's net earnings by its total assets.But Greenblatt derives it by dividing the profit before interest andtax (PBIT) by the tangible capital employed. He uses PBIT to avoiddistortions related to variance in capital structures and tax rates.The tangible capital employed is taken as it is a better measure ofthe capital required to run a business than the total assets.

EY is calculated by taking the inverse price-earnings, or P-E,ratio, but Greenblatt does so by dividing PBIT by the enterprisevalue (EV). EV gives the cost of acquiring a business and is derivedby adding the market value of equity and that of debt. Inverse P-Eratio isn't used as it does not account for the debt component.

The companies are separately ranked by descending order of RoCand EY. The two rankings are combined and those with the lowestranks are the superior stocks. But, according to Greenblatt, it doesnot apply to small-cap stocks, financial companies and utilities,owing to the difference in their capital structures compared withother firms.

To test the formula, we used 2008-09 figures to select firms andcompared their performance with the BSE-200 between March 31, 2009,and June 30, 2010. The companies with a market capitalisation ofover Rs 1,000 crore and a positive PBIT, EV and tangible capitalemployed were chosen. After removing utilities and financialcompanies (excluding banks), we had 561 firms. On comparing theirperformances with BSE-200, we found that 69 of the firms hadoutperformed the index.

We selected the top 20 companies on the basis of the combinedrank and found that the portfolio had an annualised return of 161per cent against the 72.1 per cent by the index, and none of thecompanies had lost money. The formula seemed to be working. For arobust study, we repeated the exercise for 2007-08, comparing theportfolio performance with that of the index between March 2008 andJune 2010. The annualised return was 22.3 per cent while the index'swas seven per cent. Three stocks lost money and 17 profited.

So Greenblatt's strategy does work well for long-term investors(the holding period should last at least a year). As the guruasserts, the formula may not help beat the market every year, but itdoes unfold its magic over a longer duration.

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