Magic Formula Investing: How It Works and Real-World Examples
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Summary:
Magic Formula Investing is a disciplined investment strategy developed by Joel Greenblatt. This article explores the key aspects of this strategy, its advantages, disadvantages, and how it can be utilized for value investing. Discover the magic formula’s requirements, historical performance, and whether it’s a suitable approach for your investment portfolio.
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Magic Formula Investing: a valuable approach to wealth building
Magic Formula Investing, often referred to as the “magic formula,” is a time-tested, rules-based investment strategy that can help individuals increase their chances of outperforming the stock market. This strategy is designed to simplify value investing and was created by Joel Greenblatt, an accomplished investor, hedge fund manager, and business professor. In this comprehensive guide, we will delve into the world of Magic Formula Investing, discussing its definition, history, key principles, and its pros and cons.
Understanding the Magic Formula Investing
The magic formula strategy was first introduced in the best-selling book “The Little Book That Beats the Market” in 2005, with an updated version published in 2010. Joel Greenblatt, an alumnus of the Wharton School at the University of Pennsylvania and an adjunct professor at Columbia University’s business school, outlined this unique approach to investing.
This strategy stands apart from traditional stock analysis methods by focusing on just two crucial criteria for stock selection: stock price and a company’s cost of capital. Rather than engaging in time-consuming fundamental analysis, investors can employ Greenblatt’s online stock screener tool to identify the top-ranked companies in which to invest. These companies are ranked based on three key factors:
1. Earnings Yield: Calculated as earnings before interest and taxes (EBIT) divided by the enterprise value.
2. Yield: Calculated as earnings per share (EPS) divided by the current stock price.
3. Return on Capital: Measures how efficiently companies generate earnings from their assets.
Investors following the magic formula approach aim to sell losing stocks before holding them for a year to benefit from tax provisions. They then sell winning stocks after a year, taking advantage of reduced income tax rates on long-term capital gains, before repeating the process.
As Joel Greenblatt explained in an interview with Barron’s, the magic formula strategy is all about “buying good companies, on average, at cheap prices, on average.” This straightforward and emotion-free approach helps investors identify promising prospects from a value investing perspective.
Magic Formula Investing requirements
To effectively implement the magic formula strategy, there are specific requirements to consider:
1. Minimum market capitalization: The strategy applies to companies with market capitalizations greater than $50 million. This filters out small-cap stocks.
2. Exclusion of certain companies: The magic formula excludes financial and utility companies, as well as non-U.S. companies.
3. Calculating earnings yield and return on capital: Investors must calculate each company’s earnings yield and return on capital to rank them. This involves dividing EBIT by the enterprise value and EBIT by the sum of net fixed assets and working capital, respectively.
4. Regular rebalancing: The portfolio must be rebalanced every year by selling off losing stocks before the one-year mark and selling winning stocks after a year. This annual rebalancing is a crucial component of the strategy.
5. Long-term commitment: To truly harness the power of the magic formula, investors should be prepared to adhere to the strategy for a minimum of five to ten years or more.
Historical performance of the Magic Formula Investing
Joel Greenblatt’s original claim of annualized returns exceeding 30% with the magic formula garnered significant attention. While the methodology for calculating returns might vary among different studies, several independent researchers have found that the magic formula investing approach consistently demonstrated strong results in backtesting compared to the S&P 500.
An important aspect to note is that the magic formula primarily focuses on large-cap stocks, excluding smaller companies. It also does not include financial and utility companies, making it a more selective strategy.
Advantages and Disadvantages of Magic Formula Investing
How to implement Magic Formula Investing
Magic Formula Investing provides a structured framework for identifying and investing in promising companies. Let’s explore how to implement this strategy effectively and some real-world examples.
Steps to implement Magic Formula Investing
Implementing the magic formula involves several steps to ensure that your investment portfolio is well-balanced and optimized for success:
- Initial screening: Begin by filtering out companies with a market capitalization below $50 million. This step automatically excludes small-cap stocks, which are not part of the magic formula approach.
- Exclusion criteria: Exclude financial and utility companies, as well as non-U.S. companies, from your selection. This helps narrow down your options to a manageable list of potential investments.
- Ranking companies: Calculate each company’s earnings yield and return on capital. These metrics play a crucial role in ranking the companies. The magic formula focuses on selecting companies with the highest earnings yields and the most efficient use of capital.
- Portfolio building: Over the course of a year, invest in the top 20 to 30 ranked companies. This gradual approach helps spread your investments and manage your risk effectively.
- Annual rebalancing: Rebalance your portfolio every year. One week before the one-year mark, sell off underperforming stocks, and one week after the one-year mark, sell winning stocks. This disciplined rebalancing ensures that your portfolio is always optimized for potential growth.
- Long-term commitment: For the best results, stick to the strategy for a minimum of five to ten years or more. The magic formula’s power is most apparent when used as a long-term investment strategy.
Real-world examples of Magic Formula Investing
Let’s take a closer look at a couple of real-world examples to illustrate how the magic formula works in practice:
Example 1: XYZ Corporation
– Market capitalization: $75 million
– Earnings yield: 12%
– Return on capital: 15%
– Earnings yield: 12%
– Return on capital: 15%
In this scenario, XYZ Corporation meets the criteria for market capitalization and is not in the excluded sectors. With a strong earnings yield and an efficient use of capital, XYZ Corporation ranks high in the magic formula. An investor using this strategy might consider adding XYZ Corporation to their portfolio.
Example 2: ABC Inc.
– Market capitalization: $30 million
– Earnings yield: 9%
– Return on capital: 12%
– Earnings yield: 9%
– Return on capital: 12%
ABC Inc. falls short of the required market capitalization, making it unsuitable for the magic formula approach. This illustrates how the initial screening process can help investors focus on companies with the potential for better returns.
Enhancements and variations of the Magic Formula
While the magic formula is a robust strategy in itself, some investors and analysts have explored enhancements and variations to adapt to changing market conditions and individual preferences.
Adding additional variables
To potentially improve the magic formula’s performance, some investors consider introducing extra variables into the selection criteria. For example, incorporating debt/equity ratios or dividend yields can provide a more comprehensive view of a company’s financial health.
Frequent rebalancing
While the standard magic formula recommends annual rebalancing, some investors prefer more frequent adjustments, such as quarterly rebalancing. This approach aims to capture market fluctuations more effectively.
These enhancements and variations allow investors to customize the magic formula to better align with their specific goals and risk tolerance.
The bottom line
The magic formula is a simple, rules-based investment system that brings the possibility of high returns within reach for average investors. This strategy’s strength lies in its ability to identify outperforming or undervalued companies using a systematic, algorithmic approach. Although the returns may not match the lofty figures from the initial publication, with some modifications, the method can still beat the market.
Correction—Feb, 1, 2023: A previous version of this article incorrectly stated the market capitalization and the number of companies investors can select in Greenblatt’s online stock screener. It has been edited to reflect that the market capitalization starts at $50 million, and investors can select 30 to 50 companies.
Frequently asked questions
What is the history of Magic Formula Investing?
Magic Formula Investing was first introduced in the best-selling book “The Little Book That Beats the Market” by Joel Greenblatt in 2005. It was updated in 2010 with “The Little Book That Still Beats the Market.” Joel Greenblatt, an accomplished investor and professor, outlined this unique approach to investing in these publications.
How does Magic Formula Investing differ from traditional stock analysis methods?
Magic Formula Investing simplifies stock selection by focusing on just two crucial criteria: stock price and a company’s cost of capital. Instead of engaging in time-consuming fundamental analysis, investors use Greenblatt’s online stock screener tool to identify top-ranked companies based on earnings yield, yield, and return on capital.
What are the requirements for implementing the Magic Formula Investing strategy?
To effectively implement the Magic Formula Investing strategy, investors should consider factors like minimum market capitalization, exclusion of certain companies, calculations for earnings yield and return on capital, regular rebalancing, and long-term commitment to the strategy. These requirements are essential for success.
What are some real-world examples of companies suitable for Magic Formula Investing?
Real-world examples can illustrate how the strategy works. Companies with market capitalizations greater than $50 million, strong earnings yields, and efficient use of capital are typically suitable for Magic Formula Investing. On the other hand, smaller companies or those in excluded sectors may not meet the criteria.
Are there variations or enhancements to the Magic Formula Investing strategy?
While the standard Magic Formula Investing strategy is robust, some investors and analysts have explored variations. These can include adding extra variables such as debt/equity ratios or dividend yields and opting for more frequent rebalancing, like quarterly adjustments. These enhancements allow customization to better align with specific goals and risk tolerance.
Key takeaways
- Magic Formula Investing is a rules-based, value investing strategy created by Joel Greenblatt to simplify stock selection.
- The strategy focuses on two key criteria: stock price and a company’s cost of capital, using quantitative screens.
- To implement the strategy effectively, investors should adhere to requirements like minimum market capitalization and annual rebalancing.
- The strategy has historical backtested returns that outperformed the S&P 500, although actual results may vary.
- Investors can customize the strategy with enhancements and variations, such as adding extra variables or adjusting the rebalancing frequency.
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