Magic formula investing is a strategy created by hedge fund manager and Columbia University professor Joel Greenblatt: Buy good companies at a good price.
Learn the basics of Magic Formula Investing, its origin, limitations, and how to make it work for you.
What Is Magic Formula Investing?
When Greenblatt coined the term magic formula investing, his magic formula portfolio from 1998 to 2009 had a return of 24%. So $10,000 invested at 24% for the period would have turned into just over $1 million, while a fund based on the S&P 500 index for the same period would have turned that $10,000 into just under $75,000.
Others who ran their own experiments were not able to duplicate Greenblatt's high returns but still yielded positive results. So there is agreement that the strategy of magic formula investing outperforms the indexes, just not as much as Greenblatt indicated when he introduced the concept in his book "The Little Book That Beats the Market."
How to Calculate the Magic Formula Investing 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.
How Magic Formula Investing Works
The magic formula investing strategy has nine rules to follow:
- Only include stocks with a market capitalization above $50 million, $100 million, or $200 million.
- 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 to 5, rank the results according to earnings yield and return on capital. Rank as percentages.
- Invest in 20 to 30 of the highest-ranked companies, accumulating two to three 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 use the strategy over the long-term. For example, choose to implement it for at least five years.
Limitations of Magic Formula Investing
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. That's why Greenblatt recommends the strategy be implemented for more than five years. It is only over longer periods that buying good companies at good prices pays off.
- Magic formula investing is a strategy of buying good stocks at good prices.
- It was invented by a Columbia University professor Joel Greenblatt.
- The strategy works best if employed for at least five years.
- Roughly 50 stocks at a time ever meet the magic formula criteria.