Magic Formula Investing – What it is and How to do it?

If you are investor who wants to consider a money-making strategy that could help you in value investing, the Magic Formula Investing is a wicked strategy that can actually yield impressive results.

Joel Greenblatt, a Columbian professor and a fund manager, introduced the “magic formula” in his 2005 book, The Little Book That Beats the Market, and since has remained a common strategy in the stock investment market.

The formula relies on the quantitative screening of stocks and companies thereby highlighting the annual returns of a particular market.

What is in the Magic Formula?

a crazy scientist

The magic formula was designed to help all investors like you to “buy good companies on an averagely fair price.” With this non-emotional, straightforward approach, you will be able to screen companies that have high investment value and make the right investment decisions.

Instead of carrying out a comprehensive analysis of stocks and companies, you are able to use the formula to obtain top 30 ranked companies which you are able to invest.

The magic formula utilises the earnings yield of stocks and capital returns to make company rankings as these two factors can be used to efficiently measure how the companies generate their earnings based on asset values.

Since the magic formula is commonly incorporated among companies whose capitalisation value is worth $100 million and above, it would not be advisable to apply it if you intend to invest in small cap stocks.

With the strategy, you are able to sell your losing stocks to benefit from the income tax provision as well as sell your winning stocks to take advantage of the low income tax rates.

How do you use the Magic Formula to make investments?

The easy way:

Joel Greenblatt has actually put together a website where he does all the calculations for you for free. You can choose 30-50 stocks from the list. Buy them, wait for one year and then rebalance your portfolio. It’s as simple as that.

homepage of magic formula investing

The website is: https://www.magicformulainvesting.com/

The hard way:

Choosing a company or stock to invest in using the formula involves simple steps. First, you will have to master the rules of the formula application. The investment approach has nine specific rules that you must follow:

  1. Only consider stocks that have market capitalization value of $100 and above.
  2. Do not include utility or financial stocks
  3. Exclude any American Depositary Receipts (ADRs) or foreign companies
  4. Understand the earning yield of the company of interest; this is known as EBIT/EV
  5. Identify the return on capital of the company i.e. EBIT/(working capital + net fixed assets)
  6. Based on the above 5 steps rank your findings based on the capital returns and earnings yield. Rank your findings using percentages
  7. Over a period of 12 months, invest in top 20 to 30 ranked companies as you accumulate 3 positions every month
  8. Rebalance and compare their portfolios every year, selling your winners after a period of 53 weeks from the purchase date while selling your losers 51 weeks later. This step is important to allow you take advantage of the tax shifts.
  9. You are required to utilize this formula only for long term i.e. you should be willing to invest to up to a minimum of 5 years

After mastering the rules, the second step is to implement the formula by yourself. In order to pick the “magic” stock or company, you will need to screen the stocks with the least market capitalisation value. After this, you will need to exclude the financial and utility stocks due to the fact that they have different business models as well as the ways through which they make money.

The next step involves determining the earning yield (EBIT/Enterprise Value) of the company you have chosen keeping in mind that all non-USA companies are excluded.

You will then determine the Return on Capital of the companies then rank them based on the Return on Capital and Earnings Yield values. You can now invest in the top 20 or 30 companies by taking stocks after every 2 to 3 months over a period of one year; this is followed by a continuous re-balance of the portfolio annually.

Implementation and expectations

Individuals always observe variable returns amidst the fact that they are following the same steps. The two key determinants of your returns include the type of stock you buy and the time at which you buy the stock. Keep in mind that the screener might produce variable results in different days as stocks exchange in the top identified companies.

Thus, Greenblatt had recommended that investors implement the formula for at least a period of five years. A short period of one or two years may result in the underperformance of the indexes. It is only over a long period that you will be able to purchase good companies at a favorable price.

Understanding the two ratios in the formula

After going through the magic formula, you are able to see two financial ratios that Greenblatt had included:

EBIT/EV—this ratio represents the earnings before taxes or interests divided by the value of enterprise. Although earnings/price is a simpler version of the ratio, Greenblatt considered EBIT more preferable since it accurately measures companies with different rates of taxation. EV is more applicable in comparing share prices since it factors in the debts of a company.

EBIT/(working capital + net fixed assets)—this ratio focuses on the earnings in relation to tangible assets. Net fixed assets refer to the fixed assets (such as machinery) minus all liabilities and accumulated lifetime depreciation associated with that identified assets. Rather than considering fixed assets, net fixed assets provide an accurate real value of the assets that a company owns.

Do not underestimate the relevance of these two ratios. They are actually giving the computations of different data reflecting the inner functioning of the companies. They reflect: the actual earnings, tax rates, interests, debt, price of equity, asset depreciation rates, and current liabilities and assets.

Does the Magic Formula work?

Based on past studies and Greenblatt’s calculations, it is evident that the magic formula works. According to Greenblatt, the investing strategy is able to generate up to 30% of annual returns.

Similarly, one study tested the formula between 1999 and 2009, and found that there is an average return of 13.7% every year.

Another study conducted between 1993 and 2005 also found that the formula outperformed the market index of the United States by 3.6% while in the UK and Japan, the index rates were outperformed by 7.3% and 10.8% respectively.

Although the values differ, they all show a positive investment return of the magic formula.