What Is Magic Formula Investing?
A Fund Manager's Strategy That Outperforms the Indexes
Joel Greenblatt, a hedge fund manager and professor at Columbia University, introduced the "magic formula" investing strategy in The Little Book That Beats the Market, and in 2010, a follow-up, The Little Book That Still Beats the Market, was published with updated statistics. Greenblatt also wrote You Can Be a Stock Market Genius.
He called the formula "magic" because, according to his testing, the strategy averaged 24% returns per year between 1988–2009. If you invested in an index fund during that period, the return would have been 9.55%. The percentage difference becomes more noticeable when put into dollar terms. If $10,000 were invested at 24% and $10,000 invested at 9.55% over that timeframe, the magic formula would have turned $10,000 into just over $1 million, whereas the S&P 500 index would have turned $10,000 into just under $75,000. Bigger returns matter, especially over long periods, due to the power of compounding. Below we look at what the strategy is, how to implement it, as well as whether the strategy lives up to Greenblatt's claim.
Another Look at the Returns
Before delving into the strategy, some other people have run tests on the strategy, and their findings are different than Greenblatt's—yet still positive. One study ran a test from 1999–2009 and found the strategy returned 13.7% per year on average. Another study found that between 1993–2005, the strategy outperformed the US index by 3.6%, the UK index by 7.3%, and the Japan index by 10.8%. For example, if the UK index returned 9%, the magic strategy returned 16.3%.
Several other tests conclude the same thing: the strategy outperforms the indexes, although not by quite as much as Greenblatt indicates in his book.
The Magic Formula Strategy Basics
The magic formula investing approach can be summarized in one sentence: Buy good companies at a good price. The strategy has nine rules to follow.
- Only include stocks with a market capitalization above $50 million, $100 million, or $200 million. The investor chooses which, and guidance on which to choose is provided below.
- Exclude financial and utility stocks.
- Exclude foreign companies or American Depositary Receipts (ADRs).
- Determine the company’s earnings yield, which is EBIT/EV.
- Determine the company’s return on capital, which is EBIT/(net fixed assets + working capital).
- Based on Steps 1–5, rank the results according to earnings yield and return on capital. Rank as percentages.
- Invest in 20–30 of the highest-ranked companies, accumulating 2–3 positions per month over a 12-month period.
- Rebalance the portfolio once per year, selling losers 51 weeks after purchase and selling winners 53 weeks after purchase. This is for tax purposes, as losers are held for less than a year, and winners are held for longer than a year.
- Only utilize the strategy over the long-term. For example, choose to implement it for at least five years.
Some steps may sound daunting, especially 4–6. Steps 4 and 5 are looking at what type of returns the company gets relative to its enterprise value and assets. The more earnings an investor receives, for the dollars invested, the better. Step 6 is about finding the best 20–30 stocks that meet these criteria.
Greenblatt has created a website that does all these calculations for you and provides some guidance on why these ratios are used. MagicFormulaInvesting.com ranks all the stocks that meet the criteria, calculating Steps 2–6. You select the minimum market capitalization you want the website to use, and how many stocks you want it to find. If you input $50 million and select 30 stocks, the website will produce a list of the 30 top-ranked stocks with a market capitalization greater than $50 million.
Market capitalization is the share price multiplied by how many shares are outstanding. If you don't mind trading smaller companies that may not have a long track record and are somewhat speculative, then set the market capitalization limit at $50 million. If you only want to invest in bigger, more established companies, set the minimum market capitalization at $500 million or $1 billion. Big companies still face risks, and small companies may have a big upside if they grow quickly. There is no perfect solution; it comes down to a personal choice.
The 30 or 50 stocks produced are not ranked, they are listed in alphabetical order. This is because the strategy calls for investing in 20–30 stocks, and over the course of the year, many of the stocks on the list need to be purchased anyway. The list will change over time, though. If the screen is run each month, a few different stocks would be purchased from the list each month.
Although the website makes it easy to see stocks that meet the criteria, it is recommended that investors have some background in reading financial statements and understanding what Steps 4 and 5 mean. Reading a basic book on understanding financial statements and fundamental analysis is well worth the small time investment.
Implementation and Expectations
Individuals could see great variability in returns from one another, even if they are all following the strategy steps. When a stock is bought and which stocks are bought will all play a role in determining the return for that individual. Remember, the screener could produce different results on different days, as some stocks move out of or into the top 30/50 stocks that meet the criteria. It's for this reason that Greenblatt recommends the strategy is implemented for more than five years. It is only over longer periods that buying good companies at good prices pays off.
Adjust the Holding Period
The strategy calls for selling losers and winners just before and just after the one-year mark. This creates an implementation question. If you just sold a stock, and it is still on the list, do you buy it again? This is a personal decision, and if you want to utilize the strategy over the long-term, consider these types of questions before embarking. There is also the option of holding onto winners for longer than 53 weeks. If you have some fundamental and technical analysis experience, and a trade is performing very well, consider holding onto it for further gains.
Purchase Times and Seasonality
The strategy recommends buying two or three stocks each month over the course of a year. This spreads out purchases and avoids buying all the stocks right before a possible big drop, but it also avoids the possibility of buying all the stocks before a big rise in the market.
Spreading purchases out is fine, but another consideration is to look at how stocks tend to perform during the year—called seasonality. Based on market tendencies over the last 20 years, January is typically a poor month for stocks, and June–September also usually sees stocks decline. This chart shows this, and the number at the bottom of the column is the percentage gain or loss, on average, for that month.
Those who want to accumulate more stocks at once may wish to make more stock purchases toward the end of January or early February, or June through the end of September, taking advantage of the depressed prices, which are more typical at these times of the year.
Commissions and Account Size
Greenblatt's results don't take into account commissions. Buying and selling 30 stocks in a year (60 commission payments) can be a big hit to returns on a small account.
While not expressly stated in the book, it would be advantageous if investors had at least $30,000 in investable capital. That way, $1,000 or more can be invested in each trade, and $10–$20 in commissions to get in and out doesn't sting as much.
If you're only investing $100 in each stock, paying up to $20 in commissions to get in and out means the stock needs to move favorably by more than 20% just to break even. The more capital, the fewer commissions affect the account. Even $1,000 in each stock isn't ideal; more capital is better, as it reduces the negative effect of commissions. Small accounts should avoid this strategy.
Understanding the Formula's Ratios
There are two ratios in the magic formula, with the first being the earnings yield: EBIT/EV. This is earnings before interest and taxes divided by enterprise value. A simpler and more common version of this ratio is earnings/price. Greenblatt prefers EBIT over earnings because EBIT more accurately compares companies with different tax rates. EV is preferred to share price because EV also factors in the company's debt. Therefore, EBIT/EV provides a better picture of overall earnings than earnings/price.
The second ratio is return on capital, which is EBIT/(net fixed assets + working capital). While the first ratio looked at earnings before interest and taxes compared to enterprise value, this ratio focuses more on the earnings relative to tangible assets. Many assets listed on the balance sheet aren't worth what it says, because assets like machinery depreciate over time as the usefulness is used up. These types of assets are called fixed assets. Net fixed assets are fixed assets minus all the accumulated depreciation and any liabilities associated with the asset. This gives a more accurate sense of the real value of a company's assets, compared to just looking at the total asset number on the balance sheet. Working capital is also part of this ratio and is current assets minus current liabilities. This gives a picture of whether the company is likely able to continue operations in the short-term.
While the two ratios in the magic formula look small, they actually are computing a lot of data about the inner workings of a company. Earnings, interest, tax rates, equity price, debt, depreciation of assets, current assets, and current liabilities are all being factored in.