Magic formula investing refers to a rules-based, disciplined strategy that provides people with a relatively simple method for value investing. This strategy relies on quantitative screens of companies and is designed to beat the average annual returns of the stock market, often using the S&P 500 as a benchmark. Simply put, it ranks stocks based on their price and returns on capital, making stock selection straightforward.
Magic formula investing offers a methodical and unemotional approach to value investing. Developed by Joel Greenblatt, an investor, hedge fund manager, and business professor, the technique focuses on large-cap stocks, deliberately excluding small or micro-cap companies.
Key Takeaways
- Proven Success: Magic formula investing is a successfully back-tested strategy that can increase your chances of outperforming the market.
- Methodical Approach: The strategy screens for companies that meet specific criteria and employs a methodical, unemotional process to manage portfolios over time.
- Founded by Joel Greenblatt: The strategy was established by investor and hedge fund manager Joel Greenblatt and detailed in his 2005 book The Little Book That Beat the Market, updated in 2010.
- High Returns: Initially, Greenblatt claimed annualized returns exceeding 30%.
- Selective Criteria: Excludes small-market-cap companies, foreign companies, finance companies, and utilities.
Understanding Magic Formula Investing
First described in Joel Greenblatt’s best-selling book The Little Book That Beats the Market and updated in The Little Book That Still Beats the Market, the magic formula emphasizes two main criteria: stock price and company cost of capital. Instead of conducting traditional fundamental analysis, investors use an online stock screener to select the 30 to 50 top-ranked companies based on:
- Earnings Yield (EBIT): Determined by dividing a company’s earnings before interest and taxes (EBIT) by its enterprise value.
- Return on Capital: Calculated by dividing EBIT by the sum of net fixed assets and working capital.
Investors typically sell losing stocks just before the one-year mark to offset gains with losses and sell winning stocks after one year to benefit from reduced income tax rates on long-term capital gains. This process is repeated each year.
Requirements for Magic Formula Investing
To adhere to Greenblatt’s magic formula, follow these steps:
- Set a minimum market capitalization, usually above $100 million.
- Exclude financial and utility companies.
- Omit American Depository Receipts (ADRs).
- Calculate each company’s earnings yield (EBIT ÷ Enterprise Value) and return on capital (EBIT ÷ [Net Fixed Assets + Working Capital]).
- Rank companies by highest earnings yield and return on capital.
- Buy two to three positions in the top 20 to 30 companies each month.
- Annually rebalance by selling losing stocks before the year’s end and winning stocks after one year.
- Repeat this process annually for at least five to ten years.
While Greenblatt’s magic formula has shown notable annual returns, ongoing market tests have yielded varied results due to changing market dynamics and the increased number of investors following this strategy.
Advantages and Disadvantages of Magic Formula Investing
Pros
- Simple Rules: Easy for any investor to follow, eliminating the need for specialized training or expertise.
- Rational Investing: Bypasses emotional decision-making and focuses on a numbers-based approach.
- Proven Results: Has shown better-than-market returns in multiple backtests.
Cons
- Inconsistent Returns: Actual returns may differ from Greenblatt’s reported figures.
- Potential for Improvement: Some analysts suggest incorporating additional variables, such as debt/equity ratios or dividend yields, to enhance results.
Frequently Asked Questions
What Does Magic Formula Mean?
Magic formula investing is a rules-based strategy aimed at helping ordinary individuals identify undervalued or outperforming companies, first described by Joel Greenblatt in 2005.
How Do You Use Magic Formula Investing?
By following quantitative screens to eliminate certain companies, the remainder are ranked by highest yield and returns. This step-by-step approach helps build and rebalance a successful portfolio each year.
How Do You Calculate Magic Formula?
The key metrics involve earnings yield (EBIT ÷ Enterprise Value) and return on capital (EBIT ÷ [Net Fixed Assets + Working Capital]).
Does Magic Formula Investing Work?
Though it no longer boasts a 30% compound annual growth rate, backtests from 2003 to 2015 revealed annualized returns of 11.4%, which outperformed the S&P 500’s 8.7% return during the same period.
The Bottom Line
The magic formula is a straightforward, rules-based system designed to make high returns attainable for the average investor. By following a simple, algorithmic approach, the magic formula helps investors identify promising stocks without emotional interference. Despite modern returns being lower than initial claims, the strategy can still outperform the market, especially with thoughtful modifications.
Related Terms: value investing, quantitative analysis, hedge fund, large-cap stocks.
