What Is Magic Formula Investing?
Magic formula investing is 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.
How to Put Magic Formula Investing to Work
- Set a minimum market capitalization for your portfolio companies (typically higher than $100 million).
- Exclude any financial or utility stocks.
- Exclude American depository receipts, which 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 and selling off winners one week after the year mark.
- Repeat the process each year for a minimum of five to 10 years or more.
What Does Magic Formula Investing Tell You?
The formula tells you how to approach value investing from a methodical and unemotional perspective. The magic formula strategy was first described in the best-selling book "The Little Book That Beats the Market" (1980) and in the 2010 follow-up, "The Little Book That Still Beats the Market” by investor Joel Greenblatt. Founder and former fund manager at Gotham Asset Management, Greenblatt is a graduate of Wharton and an adjunct professor at Columbia University.
Greenblatt's magic formula is designed to help investors in, as he put it in a 2006 interview with Barron’s, “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.
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), yield (calculated as earnings per share divided by the current stock price), and return on capital (which measures how efficiently they generate earnings from their assets).
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, and no financial companies, utility companies or non-U.S. companies will be included.
Investors using 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.
- 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.
Does the Magic Formula Work?
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 compared to the S&P 500 when backtested.