Table of Contents
- What Is Magic Formula Investing?
- Key Takeaways
- Understanding Magic Formula Investing
- Requirements for Magic Formula Investing
- Advantages and Disadvantages of Magic Formula Investing
- What Does Magic Formula Mean?
- How Do You Use Magic Formula Investing?
- How Do You Calculate Magic Formula?
- Does Magic Formula Investing Work?
- The Bottom Line
What Is Magic Formula Investing?
Let me explain what magic formula investing is. It's a rules-based, disciplined strategy that gives you a simple way to do value investing. You rely on quantitative screens to pick companies and stocks, aiming to beat the average annual returns of the stock market, using the S&P 500 as the benchmark. Basically, it ranks stocks by their price and returns on capital.
This approach teaches you to handle value investing methodically and without emotion. Joel Greenblatt, an investor, hedge fund manager, and business professor, developed it. The formula focuses on large-cap stocks and skips small or micro-cap companies entirely.
Key Takeaways
Here's what you need to know: Magic formula investing is a back-tested strategy that boosts your odds of beating the market. It screens for companies meeting specific criteria and manages your portfolio methodically over time without emotional interference. This value-based method comes from Joel Greenblatt's 2005 book The Little Book That Beats the Market, updated in 2010. He claimed over 30% annualized returns in the original. Remember, it excludes small-cap companies, foreign ones, finance companies, and utilities.
Understanding Magic Formula Investing
The strategy first appeared in Joel Greenblatt's 2005 bestseller The Little Book That Beats the Market, with a follow-up in 2010. Greenblatt founded Gotham Asset Management and graduated from Wharton; he also teaches at Columbia's business school.
In his book, he focuses on two criteria: stock price and the company's cost of capital. Instead of deep fundamental analysis, you can use his online stock screener to pick the top 30 to 50 ranked companies. Rankings come from the stock's earnings (EBIT), yield (EPS divided by current price), and return on capital, which shows how efficiently earnings come from assets.
If you're using this, sell losing stocks before the one-year mark to offset gains with losses for tax purposes. Sell winners after one year to get lower long-term capital gains taxes. Then repeat the process. As Greenblatt said in a 2006 Barron's interview, it's about buying good companies at cheap prices on average, using a non-emotional screen for value prospects.
Keep in mind, it only includes large-cap stocks, not small caps.
Requirements for Magic Formula Investing
Greenblatt's formula applies to companies with market caps over $50 million, so no small caps. It covers large companies but skips financials, utilities, and non-U.S. firms.
Here's how it works: Set a minimum market cap, usually over $100 million. Exclude financial and utility stocks, and avoid ADRs from foreign companies. Calculate earnings yield as EBIT divided by enterprise value. Figure return on capital as EBIT divided by net fixed assets plus working capital. Rank companies by highest earnings yields and return on capital. Buy two to three positions monthly in the top 20 to 30 companies over a year. Rebalance each year by selling losers a week before the year ends and winners a week after. Do this for at least five to 10 years.
Greenblatt says this generates 30% annual returns, and independent backtests show it beats the S&P 500, though calculations vary.
Advantages and Disadvantages of Magic Formula Investing
The big advantage is simplicity—you don't need to be a Wall Street expert. Just follow a few rules to build a solid portfolio, cutting out emotional decisions.
But it's not truly magical and might not always work best. Some tests show lower returns due to market changes or more people using it. Analysts suggest improvements like adding debt/equity ratios or dividend yields.
Magic Formula Investing Pros and Cons
- Pros: Simple rules for any investor; promotes rational, data-driven choices without emotion; backtests show market-beating returns.
- Cons: Returns may not hit Greenblatt's highs; could improve with extra variables or more frequent rebalancing.
What Does Magic Formula Mean?
Magic formula investing is a rules-based strategy letting everyday people spot undervalued or outperforming companies. Joel Greenblatt described it in his 2005 book.
How Do You Use Magic Formula Investing?
You use quantitative screens to filter out companies, then rank the rest by highest yield and returns. Build and rebalance your portfolio yearly for solid returns.
How Do You Calculate Magic Formula?
Key metrics are earnings yield (EBIT divided by enterprise value) and return on capital (EBIT divided by net fixed assets plus working capital).
Does Magic Formula Investing Work?
It doesn't guarantee 30% CAGR anymore, but studies show positive results. A 2003-2015 backtest gave 11.4% annualized returns vs. 8.7% for the S&P 500—outperformance, but not as claimed in the book.
The Bottom Line
This is a straightforward system to achieve high returns as an average investor. It helps you find outperforming or undervalued companies without emotions getting in the way. Returns are lower now than originally published, but it can still beat the market with tweaks.
Correction—Feb 1, 2023: Earlier versions misstated market cap starting at $50 million and selection of 30 to 50 companies; this has been corrected.
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