Magic Formula Investing Definition and What It Tells You

Magic Formula Investing refers to a rules-based, disciplined investing strategy that teaches a simple and easy-to-understand method for value investing. It relies on quantitative screens of companies and stocks, aiming to beat the average annual returns of the stock market using the S&P 500 as a benchmark. It works by ranking stocks based on their price and returns on capital.

The strategy was developed by Joel Greenblatt, an investor, hedge fund manager, and business professor. Greenblatt’s formula applies to large-cap stocks and excludes small or micro-cap companies.

Key Takeaways:

– 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 was developed by investor and hedge fund manager Joel Greenblatt and published in "The Little Book That Beat the Market" in 2005. It was updated in 2010 as "The Little Book That Still Beats the Market."

– In the original publication, Greenblatt claimed annualized returns of over 30%.

– The magic formula excludes small-cap, foreign, finance, and utility companies.

Understanding Magic Formula Investing:

The magic formula strategy was first described in the best-selling book "The Little Book That Beats the Market" by Joel Greenblatt. Greenblatt outlines two criteria for stock investing: stock price and company cost of capital. Investors use Greenblatt’s online stock screener tool to select the top-ranked companies based on their stock’s earnings, yield, and return on capital.

Investors who use the strategy sell losing stocks before one year to take advantage of the income tax provision. They sell winning stocks after one year to benefit from reduced income tax rates. The strategy aims to help investors buy good companies at cheap prices using a non-emotional approach.

Requirements for Magic Formula Investing:

– Market capitalization greater than $50 million.

– Exclude financial and utility stocks.

– Exclude American Depository Receipts (ADRs).

– Calculate earnings yield and return on capital.

– Rank companies by highest earnings yield and return on capital.

– Buy positions in top-ranked companies monthly.

– Rebalance the portfolio yearly, selling losers before the year term ends and winners after the year mark.

– Repeat the process for at least five to ten years.

According to Greenblatt, his magic formula strategy has generated annual returns of 30%. Independent researchers have found favorable results when backtesting the strategy.

Advantages and Disadvantages of Magic Formula Investing:

Advantages:

– Simple, easy-to-follow rules suitable for every investor.

– Facilitates rational, numbers-based investing without emotion or stress.

– Shows better-than-market returns in multiple backtests.

Disadvantages:

– Returns may not always match the high figures achieved by Greenblatt.

– Some analysts believe the method can be improved by introducing new variables or rebalancing more frequently.

What Does Magic Formula Mean?

Magic formula investing refers to a rules-based strategy that helps identify undervalued or outperforming companies. It was first described by Joel Greenblatt in "The Little Book That Beat the Market" in 2005.

How Do You Use Magic Formula Investing?

Magic formula investing uses quantitative screens to eliminate certain companies and ranks the remainder based on yield and returns. By building and rebalancing the portfolio yearly, it is possible to achieve high returns.

How Do You Calculate the Magic Formula?

The key metrics for the magic formula method are earnings yield and return on capital. Earnings yield is calculated by dividing earnings before interest and taxes by the total value of the enterprise. Return on capital is calculated by dividing EBIT by the sum of net fixed assets and working capital.

Does Magic Formula Investing Work?

The magic formula may not achieve the 30% compound annual growth rate claimed by Greenblatt, but it has shown favorable results in some studies. A backtest between 2003 and 2015 found annualized returns of 11.4% compared to 8.7% from the S&P 500.

The Bottom Line:

The magic formula is a simple, rules-based system designed to bring high returns within reach of the average investor. By following a straightforward, algorithmic approach, the magic formula allows investors to easily identify outperforming or undervalued companies without being influenced by emotions. While returns may be lower than when the formula was first published, the method can still beat the market, especially with modifications.