Magic Formula Investing Explained: Simple Strategy for Value Investing

What Is Magic Formula Investing?

Magic formula investing refers to a rules-based, disciplined investing strategy that teaches people a relatively simple and easy-to-understand method for value investing. It relies on quantitative screens of companies and stocks, and is designed to beat the stock market’s average annual returns using the S&P 500 to represent the market return.  In simple terms, stocks are ranked based on their price and return on capital.

Magic formula investing is a strategy developed by Joel Greenblatt aimed at simplifying value investing. Its goal is to outperform the stock market by using specific quantitative screens. It ranks stocks based on earnings yield and return on capital. However, this only applies to large-cap stocks and excludes certain industries like finance or utilities. Magic formula investing offers a systematic, unemotional approach that reduces decision-making stress for investors.

Deep Dive into Magic Formula Investing

The magic formula strategy was first described in the 2005 best-selling book The Little Book That Beats the Market and in the 2010 follow-up, The Little Book That Still Beats the Market by investor Joel Greenblatt. Greenblatt, founder and former fund manager at Gotham Asset Management, is a graduate of the Wharton School at the University of Pennsylvania. He is an adjunct professor at Columbia University’s business school.

In the book, Greenblatt outlines two criteria for stock investing: Stock price and company cost of capital. Investors use Greenblatt’s online stock screener to choose 30 to 50 top companies, rather than doing a fundamental analysis. Company rankings are based on:

• Their stock’s earnings which are calculated as earnings before interest and taxes (EBIT).
• Their yield, calculated as earnings per share (EPS) divided by the current stock price.
• Their return on capital measures how efficiently they generate earnings from their assets.

Investors sell losing stocks before a year to use losses for tax advantages and offset gains. They sell the winning stocks after the one-year mark, in order to take advantage of reduced income tax rates on long-term capital gains. Then they start the process all over again.

As Greenblatt stated in a 2006 interview with Barron’s, the magic formula is designed to help investors with “buying good companies, on average, at cheap prices, on average.” Using this straightforward, non-emotional approach, investors screen for companies that are good prospects from a value investing perspective.

Criteria for Implementing Magic Formula Investing

Since Greenblatt’s magic formula only applies to companies with market capitalizations greater than $50 million, it excludes small-cap stocks. The remainder will all be large companies but excludes financial companies, utility companies, and non-U.S. companies.

The following points outline how the formula works:

1. Set a minimum market capitalization for your portfolio companies. This should be typically higher than $100 million.
2. Ensure you exclude any financial or utility stocks when you choose your companies.
3. Exclude American Depository Receipts (ADRs). These are stocks in foreign companies.
4. Calculate each company’s earnings yield (EBIT ÷ Enterprise Value).
5. Calculate each company’s return on capital [EBIT ÷ (Net Fixed Assets + Working Capital)].
6. Rank selected companies by highest earnings yields and highest return on capital.
7. Buy two to three positions each month in the top 20 to 30 companies, over the course of a year.
8. Each year, rebalance the portfolio by selling off losers one week before the year term ends. Sell off winners one week after the year mark.
9. Repeat the process each year for a minimum of five to 10 years or more.

According to Greenblatt, his magic formula investing strategy has generated annual returns of 30%. Though they differ in their calculation of returns from the strategy, a number of independent researchers have found that the magical formula investing approach has appeared to show good results when backtested compared to the S&P 500.

Pros and Cons of the Magic Formula Strategy

The main advantage of the magic formula method is its simplicity: you don’t need to be a trained investment specialist or Wall Street prodigy to invest effectively. All it takes is a few simple rules to find a basket of reliable investments. It also reduces emotional or irrational decision-making.

Despite its name, the magic formula isn’t magical and may not always be the best strategy. Some tests show lower returns, possibly because of changing market dynamics or more investors using this method. Some analysts say adding variables like debt/equity ratios or dividend yields can improve the method.

The Bottom Line

Developed by Joel Greenblatt, an investor, hedge fund manager, and business professor, the magic formula investing strategy is simple and accessible for average investors, thanks in part to its rules-based structure. At its core, the strategy screens stocks by earnings yield and return on capital. Based on historical data, this method is a backtested success with the potential to outperform the market compared to the S&P 500.

Even though recent returns may not match early claims but there have been adaptations and modifications made by investors to adapt to changing dynamics of the market conditions. The strategy’s focus on rational, unemotional decision-making empower investors and reduces decision-making stress.

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.