🗞 The Magic Formula That Earned 50% Annually For 10 Years

Happy Sunday!

Here’s what’s on the docket for this week’s newsletter:

• 🔢 The Magic Formula That Generated 50% Returns For A Decade

• 📊 KLA Corporation: Earnings Review

Let’s dive in!

The Magic Formula That Generated 50% Returns For A Decade

Joel Greenblatt is famous in the investment world for many reasons.

• He’s the author of several renowned investment books such as “You Can Be a Stock Market Genius” and “The Little Book That Beats The Market”.

• He’s an adjunct professor of value investing courses at Columbia’s Business School.

• He’s the founder of one of the most popular online stock pitch forums called Value Investor’s Club.

But perhaps more impressive than all of that, Greenblatt has one of the most legendary hedge fund track records of all-time.

From 1985 to 1995, Joel Greenblatt’s Gotham Capital generated 50% annual returns for 10 straight years!

How did he do it?

Greenblatt’s journey to investing stardom wasn’t typical.

Unlike many investors, Greenblatt didn’t stick to any individual security type. Gotham Capital made its returns buying and shorting all sorts of assets including stocks, bonds, spin-offs, options, warrants, preferred shares, bank debt, trade claims, merger securities, and more.

But while the investment vehicles varied, the formula Greenblatt used to actually find the opportunities was consistent.

According to “The Little Book That Beats the Market”, Greenblatt would screen for stocks that had a high earnings yield and high returns on capital. By using just these two criteria, Greenblatt was able to identify a universe of companies that stood at the intersection of cheapness and durability.

Greenblatt would then rank order the companies under each list. So the stock with the cheapest valuation would receive a 1 and the stock with the highest returns on capital would also receive a 1, and on down the list from there.

He would then combine the scores and order the companies based on the lowest total number. This was Greenblatt’s Magic Formula. 

From 1988 to 2004, the 30 companies that scored the lowest on Greenblatt’s Magic Formula list (rebalanced monthly) absolutely crushed the S&P 500.

Side note: If you’re curious what companies this formula would produce today, we tested it using the FinChat Screener. The criteria were as follows:

• Earnings Yield: 10% or higher

• Return on Capital Employed (10yr Average): 15% or higher

Only 39 companies in the US made the list. Here were the top 25 companies by market cap:

In 1995, Greenblatt closed Gotham Capital to outside investors after he had become “sufficiently rich”.

The closing of that fund capped one of the greatest runs of all-time among hedge fund managers.

However, while the limited partnership has now been closed for 30 years, Greenblatt still manages capital through a variety of mutual funds.

Here’s a look at the latest holdings of one of his largest funds, the Gotham Absolute Return Fund:

Platform Update

Introducing AI Equity Reports 🚀 

This week, the FinChat team rolled out AI Equity Reports.

By selecting a company’s “Research” tab, FinChat users can now get up to speed on a business faster than ever.

These reports include:

• ✅ Business Summaries

• ✅ Fundamental Snapshot

• ✅ Moat Analysis

• ✅ Analyst Estimates

• ✅ Insider Ownership

And much more!

FinChat In The Wild: JRo’s Notes

KLA Corporation Q3:2025 Earnings

KLA Corporation’s Q3 revenue increased 30% and non-GAAP EPS grew 60% from the same period in the prior year. The company’s quarterly free cash flow (FCF) grew 18% to $990 million, which equates to an FCF margin of 32% and FCF conversion (on non-GAAP net income) of 88%. KLA generated a return on equity (ROE) of 104% (above its five-year average through F2024 of 100%) and return on invested capital (ROIC) of 29% (above its five-year average of 25%).

KLA’s ROE is so much higher than its ROIC (which is still very strong) because of its prudent use of debt, with a debt-to-equity ratio of about 1.5x. In fact, KLA’s strong ROIC (and the impact sustainably high ROIC has on driving free cash flows) is what allows it to intelligently use leverage to boost returns on equity. This management team is exceptional at using the balance sheet to drive growth of intrinsic value per share.

KLA’s balance sheet is very healthy with net debt of $2.061 billion, five-year average FCF of $2.589 billion, and trailing twelve-month (TTM) FCF of $3.514 billion. So, its net debt-to-average FCF is 0.8x and its net debt-to-TTM FCF is only 0.6x, meaning that with either measure of FCF you use, KLA has the ability to pay off all of its net debt with less than one year’s free cash flow. Additionally, its weighted average cost of debt is 4.67% and its weighted average debt maturity is over 19 years. KLA’s interest coverage (EBIT/interest expense) is 15x, meaning it could pay fifteen years of interest expense with about one year’s worth of operating income. This is the type of balance sheet optimization we are looking for from our management teams.

KLA has a target to return 85% of FCF to investors through dividends and share buybacks over time. Recently, it increased the dividend per share by 12%, which is its 16th consecutive year of increasing the dividend. KLA increased its dividend at a 15% compounded annual growth rate (CAGR) since 2006. KLA also announced a new $5 billion share repurchase authorization (and it still has $462 million remaining under its current buyback authorization). So, KLA can buy in about 5.5% of its current market cap of $100 billion. Since calendar year 2020, KLA has allocated about $12.6 billion to buying in stock at an average price of $379 (compared to today’s stock price of about $750).

KLA shares trade at a NTM P/E of 23x, which is six points above its ten-year average forward P/E of 17x. So, its P/E is optically high. But its P/E drops to 20x on F2027 consensus estimates, and I’m not sure historical P/E is the most relevant benchmark for a business of KLA’s business and managerial quality that I think is entering a period of accelerating growth driven by increased semiconductor complexity at the leading edge (driven by AI and the further digitization of the global economy). Increased semiconductor complexity (i.e. moving to smaller nodes) generally means more process steps and more steps in the process means more process control technology (like KLA provides) is needed to check for defects at the various stages of the manufacturing process. Additional growth should be fueled by the onshoring of advanced semiconductor manufacturing capacity in the United States, Europe, and Japan (as well as massive state-sponsored semiconductor investment in China).

Additionally, and importantly to my thesis, KLA has higher exposure to leading edge (3 nanometer and 2 nanometer) semiconductor manufacturing because a higher percentage of KLA’s revenue comes from foundry and logic and a lower percentage of its revenue is generated from memory (NAND and DRAM) compared to the other two leading U.S. based semiconductor capital equipment peers (Applied Materials and Lam Research). Leading-edge chips are more complex to manufacture (because of larger die sizes, more layers, more steps, smaller and more packed circuitry/transistors, the new process architecture of gate-all-around, and 3D packaging), which requires more inspection for defaults/defects. The design and manufacturing complexity is such that if one part of these chips fail, then the whole chip (or system-on-a-chip) fails, which drives demand (and pricing power) for process control (imaging and inspection) equipment.