What Is Magic Formula Investing?
Magic formula investing refers to a rules-based, disciplined investing strategy that teaches people a relatively simple and easy-to-understand method for value investing. It relies on quantitative screens of companies and stocks, and is designed to beat the stock market's average annual returns using the S&P 500 to represent the market return. Put simply, it works by ranking stocks based on their price and returns on capital.
Magic formula investing tells you how to approach value investing from a methodical and unemotional perspective. Developed by Joel Greenblatt—an investor, hedge fund manager, and business professor—the formula applies to large cap stocks, but doesn't include any small or micro cap companies.
Magic formula investing only factors in large cap stocks and doesn't include small cap companies.
Understanding Magic Formula Investing
The magic formula strategy was first described in the 1980 best-selling book "The Little Book That Beats the Market" and in the 2010 follow-up, "The Little Book That Still Beats the Market” by investor Joel Greenblatt. Greenblatt, founder and former fund manager at Gotham Asset Management, is a graduate of the Wharton School at the University of Pennsylvania. He is an adjunct professor at Columbia University's business school.
In the book, Greenblatt outlines two criteria for stock investing: Stock price and company cost of capital. Instead of conducting fundamental analysis of companies and stocks, investors use Greenblatt's online stock screener tool to select the 20 to 30 top-ranked companies in which to invest. Company rankings are based on:
- Their stock's earnings which are calculated as earnings before interest and taxes (EBIT)
- Their yield which is calculated as earnings per share (EPS) divided by the current stock price
- Their return on capital which measures how efficiently they generate earnings from their assets.
Investors who use the strategy sell the losing stocks before they have held them for one year to take advantage of the income tax provision that allows investors to use losses to offset their gains. They sell the winning stocks after the one-year mark, in order to take advantage of reduced income tax rates on long-term capital gains. Then they start the process all over again.
As Greenblatt stated in a 2006 interview with Barron's, the magic formula is designed to help investors with “buying good companies, on average, at cheap prices, on average.” Using this straightforward, non-emotional approach, investors screen for companies that are good prospects from a value investing perspective.
- Magic formula investing is a successfully back-tested strategy that can increase your chances of outperforming the market.
- The strategy focuses on screening for companies that fit specific criteria and uses a methodical, unemotional process to manage the portfolio over time.
- The strategy, which is value-based, was developed by investor and hedge fund manager Joel Greenblatt.
Since Greenblatt’s magic formula only applies to companies with market capitalizations greater than $100 million, it excludes small cap stocks. The remainder will all be large companies, but excludes financial companies, utility companies, and non-U.S. companies.
The following points outline how the formula works:
- Set a minimum market capitalization for your portfolio companies. This should be typically higher than $100 million.
- Ensure you exclude any financial or utility stocks when you choose your companies.
- Exclude American Depository Receipts (ADRs). These are stocks in foreign companies.
- Calculate each company's earnings yield (EBIT ÷ Enterprise Value).
- Calculate each company's return on capital [EBIT ÷ (Net Fixed Assets + Working Capital)].
- Rank selected companies by highest earnings yields and highest return on capital.
- Buy two to three positions each month in the top 20 to 30 companies, over the course of a year.
- Each year, rebalance the portfolio by selling off losers one week before the year-term ends. Sell off winners one week after the year mark.
- Repeat the process each year for a minimum of five to 10 years or more.
According to Greenblatt, his magic formula investing strategy has generated annual returns of 30%. Though they differ in their calculation of returns from the strategy, a number of independent researchers have found that the magical formula investing approach has appeared to show good results when backtested compared to the S&P 500.