What is magic formula investing?

What is magic formula investing?

Magic formula investing is a rules-based strategy from Joel Greenblatt. You rank stocks by earnings yield and return on capital. You buy the top 30 names. It's a simple screen for beating the market. The goal is cheap, high-quality companies.

Greenblatt introduced the idea in his 2005 book The Little Book That Beats the Market. He wanted a simple way to find good companies at bargain prices. He calls it a simplified version of the Buffett-Munger approach. The formula sorts the whole market with two numbers.

How does the magic formula work?

The first factor is earnings yield. You take earnings before interest and taxes, or EBIT, and divide by enterprise value. That tells you how cheap a company is. Higher is better. Cheap companies rank higher.

The second factor is return on capital. You take EBIT and divide it by net fixed assets plus working capital. That shows how efficient the business is. A high number means the company earns a lot from what it owns.

You set a minimum market cap, usually above $50 million. You exclude utilities, financials, and foreign companies. You buy the top 20 to 30 names and rebalance once a year. Greenblatt suggests buying 2 to 3 positions per month.

You build the portfolio gradually, adding two or three names each month. You rebalance once a year. The strategy needs a five to ten year horizon to work. Short-term it looks unremarkable, so most people quit before it pays.

Does magic formula investing beat the market?

Backtests show it can. One study of U.S. stocks from 2003 to 2015 found an annualized return of 11.4%. The S&P 500 returned 8.7% over the same period. That's about 2.7% extra per year.

Studies in the Nordic countries, India, France, and Hong Kong also found outperformance. But each flags higher volatility and short bursts of underperformance. A Norwegian study measured a 21.56% annual gain from 2003 to 2022. Real-world costs trim that.

What are the risks of magic formula investing?

The biggest risk is psychological. Many investors see big losses early and quit before the strategy pays off. The formula can go negative for years. Those who quit early lock in the loss and miss the eventual rebound. Discipline is what matters.

Transaction costs can eat returns, and small-cap stocks may be hard to trade. The formula is not a guarantee. Use it as a screening tool and add your own research. Never treat it as a blind buy signal.

Skeptics question the edge. Studies note the outperformance may simply reflect factors in the capital asset pricing model and the Fama-French three-factor model. The gains may be earned risk, not hidden genius. Treat them as such.

Greenblatt's book hinted at far bigger gains than real backtests deliver. Independent tests found about 3% a year above the market, not 30%. Compounding that edge over a decade is still sizable. Just do not expect a miracle.

Can you see the magic formula in action?

Take three companies with no debt. A earns 10% on capital, B earns 20%, C earns 25%. C is the most efficient, so it ranks first on return on capital. Yet your buying decision also weighs how cheap each one is.

Say A trades at 12x earnings, B at 15x, and C at 30x. Ranked by earnings yield, A is cheapest, C is priciest. Add the ranks: C is 1 plus 3, A is 3 plus 1, B is 2 plus 2, so B sits tied in the middle.

The lowest combined score wins. In this toy market that puts the efficient-but-priced-for-it C and the cheap-but-average A ahead of the middle-of-the-road B. The formula buys the names that best balance quality and price, not just one or the other.

Real screens run these rankings across thousands of stocks, then buy the top 20 to 30 with the lowest combined scores. Hold a year, sell, and repeat. The two-number sort is the whole strategy distilled to something you can run on a spreadsheet.

How can you improve the magic formula?

The formula is a starting point, not a straitjacket. You can bolt other factors on top. The most tested is price momentum. Greenblatt never claimed the two ranks were the only ones that matter.

Add momentum and the history improves. European tests from 1999 to 2011 found that combining the formula with six-month price momentum lifted a 12-year return from 182.8% to 783.3%. That is more than triple the gain from the same screen alone.

You can add a debt-to-equity cap to keep out heavily borrowed firms. Some screeners add a dividend yield filter for income. Greenblatt's own tool lets you set the minimum market cap and pick either 30 or 50 stocks. The two core ranks stay the same.

Taxes matter more than people think. Sell a losing position before it turns one year old to harvest the loss and offset gains. Hold winners past the twelve-month mark for a lower long-term capital gains rate. Small timing moves like these keep more of your return.