Magic Formula Investing
The Magic Formula Investing is an investment strategy developed by Joel Greenblatt, a renowned investor and hedge fund manager. The magic formula draws on principles of value investing to create portfolios with the potential to outperform the market. The formula aims to identify undervalued and high-performing stocks by combining two key financial metrics: return on capital and earnings yield. It also provides a systematic and disciplined approach to stock selection, reducing emotional bias and promoting a consistent investment strategy. 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.”
ABOUT THE FORMULA
Magic Formula Investing tells you how to approach value investing from a methodical and unemotional perspective.
The formula 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.
This strategy utilizes fundamental analysis, which involves looking at things like revenue and earnings, and calculating return on equity to measure a company’s financial health.
FORMULA CRITERIA
This is one way to measure a company’s profitability. This figure represents the net income of a company before income tax expense and interest expenses are deducted.
Earnings Per Share (EPS).
EPS is another measure of profitability. With EPS, you divide a company’s net profit by the total number of common shares of stock it has outstanding.
Return on capital measures how well a company is able to allocate its capital to investments that are profitable. To figure out this number, you’d subtract dividends from net income, then divide that by the sum total of the company’s debt and equity.
HOW IT WORKS
Set a Market Capitalization Threshold.
For magic formula investing, an investor will typically start by excluding any companies with a market capitalization below $100 million. One could set this number higher or lower, depending on personal preferences.
Exclude Certain Securities.
The investor next needs to eliminate several categories of investments. Those include stocks in the financials and utilities sectors, as well as foreign companies and American Depositary Receipts (ADRs).
Make the Necessary Calculations.
Once an investor has narrowed down their list of companies, they can start running the numbers. Calculate Earnings before interest and taxes (EBIT), Earnings Yield, and Return on Capital.
Create Your Rankings.
After doing the maths, you can move on to ranking companies according to the magic formula — from highest earnings yield and highest return on capital to lowest.
Start Building Your Portfolio.
Greenblatt suggests buying the stocks that rank in that top 20-30 list on a rolling basis. According to Greenblatt’s formula, owning at least 20 different companies will help to maintain diversification.