The two metrics which Mr. Greenblatt uses is “Return on Capital” and “Earnings Yield”. In the appendix of “The Little Book That Beats The Market”, he defines these terms as follows:
Return on Capital = EBIT/(Net Working Capital + Net Fixed Assets)
EBIT = earnings before interest and taxes
Earnings Yield = EBIT/Enterprise Value
For more details on Mr. Greenblatt’s methodology, consult his book or his website: www.magicformulainvesting.com
He ranks a list of stocks (e.g. top 1,000 US non-financial, non utility stocks with over $1 billion revenue) by “Return on Capital” and “Earnings Yield” (the largest Return on Capital would be ranked 1, and the largest Earnings Yield would also be ranked 1). And then he adds the two ranks to get a combined rank. Then, for example, the top 30 ranked would be purchased and held for a year.
Comparing the returns for this portfolio (1988 thru 2009) to that of the S&P 500, the portfolio beat the S&P 500 in every year except the following: 1989,1990,1993,1999,2002,2008.
The Periods of Recession in the US during this time period (1988 thru 2009) were:
- July 1990 – March 1991
- March 2001 – November 2001
- December 2007 – June 2009
As we can see, this strategy did better than the market in the 2001 recession, but worse in the 1990 and 2008 recessions.