Key takeaways
– Magic Formula Investing is a rules‑based value strategy developed by Joel Greenblatt (described in The Little Book That Beats the Market, 2005).
– It ranks a universe of stocks by two metrics: earnings yield (cheapness) and return on capital (quality) and buys the top-ranked names.
– Typical implementation: screen a defined universe (large caps, exclude financials/utilities/non‑U.S.), rank by the two metrics, combine ranks, buy 30–50 equally weighted names, hold ~1 year, then rebalance annually.
– Historical backtests show outperformance versus the market in many periods, though not always as spectacular as initial claims; performance depends on time frame, transaction costs, taxes, and how many investors follow the strategy.
– The method’s strengths are simplicity and discipline; weaknesses include sensitivity to implementation choices, exclusion of small caps, and potential periods of underperformance.
What is Magic Formula Investing?
Magic Formula Investing is a simple, quantitative value‑investing approach introduced by Joel Greenblatt. It attempts to systematically find “good companies at cheap prices” by using two objective measures:
– Earnings yield (to identify cheap stocks).
– Return on capital (to identify high quality/efficient capital users).
Greenblatt proposed ranking stocks on these two metrics, combining the ranks, and investing in the top-ranked stocks in an equally weighted portfolio that is rebalanced about once per year.
Why use a rules‑based method?
– Removes emotion and ad hoc decision making.
– Makes the investment process repeatable and transparent.
– Accessible to individual investors who don’t conduct deep fundamental analysis.
Key requirements and universe selection
– Market capitalization threshold: Greenblatt’s screener and many implementations start at a minimum market cap (Investopedia notes $50 million as a cutoff used in online tools).
– Exclude: financial companies and utilities (these have balance‑sheet structures that distort the formula’s metrics). Often implementations also exclude non‑U.S. domiciled companies.
– Typical portfolio size: 30–50 stocks (small enough for concentration benefit, large enough for diversification).
– Equal weight each position is common.
The two core metrics (formulas)
1) Earnings yield (EY)
– EY = EBIT / Enterprise Value (EV)
– Interpretation: how much operating profit the company is producing relative to the total value of the business (debt + equity − cash). A higher earnings yield indicates a cheaper company.
2) Return on capital (ROC)
– ROC = EBIT / (Net Fixed Assets + Net Working Capital)
– Interpretation: how efficiently a company turns invested capital into operating profits. Higher ROC indicates a high‑quality, capital‑efficient business.
Ranking and combining the metrics
– For each stock, compute EY and ROC.
– Rank all stocks by EY (best/cheapest = rank 1). Do the same for ROC (best/highest = rank 1).
– Combine the two ranks (often by summing the ranks). The stocks with the lowest combined rank are considered the best picks.
– Select the top N (e.g., 30–50) stocks based on combined rank.
Practical implementation steps (step‑by‑step)
1. Define your universe
– Decide geography (U.S. or global), market cap minimum (e.g., $50M+), and exclusions (financials, utilities, REITs if desired).
2. Gather data
– For each company in the universe collect: EBIT, Enterprise Value, Net Fixed Assets, Net Working Capital. Reliable data sources: financial data providers, your brokerage, or Greenblatt’s screener.
3. Calculate metrics
– Compute EY = EBIT / Enterprise Value.
– Compute ROC = EBIT / (Net Fixed Assets + Net Working Capital).
4. Rank stocks
– Rank by EY (1 = highest EY), rank by ROC (1 = highest ROC).
– Sum the two ranks to get a combined rank.
5. Select positions
– Choose the top 30–50 names by combined rank. (Greenblatt recommended ~30.)
– Allocate equal dollar amounts to each selected stock (equal weight approach).
6. Portfolio sizing and diversification
– With 30 names, each position is roughly 3.3% of the portfolio. Adjust based on your risk tolerance and trading costs.
7. Hold and rebalance
– Hold each position for about one year. Rebalance the whole portfolio annually (sell stocks no longer in the top group and replace with current top-ranked names).
– Tax management: Greenblatt recommended selling losing positions before they reach one year (to realize short‑term losses that can offset gains) and holding winners past one year to get long‑term capital gains rates—this was part of his original implementation.
8. Monitor costs and slippage
– Account for commissions, bid/ask spreads, and taxes. Frequent rebalancing or trading in illiquid names increases these costs.
Example calculation
– Company A: EBIT = $200M; Enterprise Value = $1.6B → EY = 200 / 1,600 = 0.125 = 12.5%
– Company A: Net Fixed Assets + Net Working Capital = $800M → ROC = 200 / 800 = 0.25 = 25%
– Repeat for every company, rank EY and ROC, sum ranks, and pick the lowest combined ranks.
Portfolio management details and calendar
– Annual calendar example:
– Day 0: Run screen, build portfolio, buy top 30.
– Month 12: Re-run screen, sell names that no longer rank in top 30, buy replacements; rebalance equal weights.
– Throughout year: monitor for delisting/mergers or dramatic fundamentals changes that warrant earlier action.
Performance — does the Magic Formula work?
– Greenblatt reported very high returns (he cited ~30% annual in his book). Independent studies and later backtests generally find outperformance versus broad market indices, but typically much smaller than Greenblatt’s initial claim.
– Example cited in Investopedia: a 2003–2015 backtest found annualized returns of ~11.4% for the magic formula vs. 8.7% for the S&P 500. This shows outperformance but not the extreme returns originally promoted. (Performance will vary by time period, implementation, transaction costs, taxes, and how widely the strategy is followed.)
Advantages
– Simple, transparent, repeatable rules.
– Removes much emotional and discretionary bias from stock selection.
– Historically has produced outperformance in many backtests and academic tests.
– Works as a practical value‑investing approach for nonprofessionals.
Disadvantages and caveats
– Not truly “magic”—no guarantee of continued outperformance. Periods of prolonged underperformance occur.
– Excludes many stock types (small caps, financials, utilities) that might offer opportunities.
– Sensitive to input definitions (e.g., how you compute working capital, how you handle special items). Small changes in implementation can materially affect results.
– Transaction costs and taxes can erode returns, especially for smaller accounts or frequent rebalancers.
– As more investors adopt the method, the edge may shrink. Some analysts add additional filters (debt/equity, dividend yield, liquidity screens) which changes the strategy substantially.
Variations and common modifications
– Use different portfolio sizes (20–100 stocks) to adjust concentration.
– Add filters: minimum liquidity, maximum debt/equity, dividend yield floors, or adjust for accounting distortions.
– Rebalance more often (quarterly) or less often (multi‑year hold) — each choice changes tax and turnover profiles.
– Include smaller caps (with added liquidity and risk controls) to potentially boost returns but increase volatility and implementation complexity.
Practical tips before you start
– Test the method on historical data or a paper portfolio to understand turnover and tax effects.
– Ensure you have a data source for accurate EBIT, EV, and balance sheet items. Spreadsheet implementations are possible; many brokerages and data sites offer screeners.
– Use equal weighting to follow the intended diversification effect. Avoid concentration unless you have a specific reason.
– Keep an eye on trading costs—use limit orders for illiquid names and batch your trades if possible.
– Be prepared for stretches of underperformance; the strategy is long‑term and systematic.
Tools and resources
– Joel Greenblatt, The Little Book That Beats the Market (2005) and The Little Book That Still Beats the Market (2010).
– Online screeners (some allow you to replicate Greenblatt’s universe and rankings).
– Spreadsheet templates to compute EBIT, EV, ROC, rank, and combined rank.
– Portfolio tracking software for periodic rebalancing and tax tracking.
The bottom line
Magic Formula Investing is a disciplined, quantitative value strategy that combines a cheapness metric (earnings yield) with a quality metric (return on capital) to identify attractive stocks. It’s straightforward and designed for individual investors who want a rules‑based approach to value investing. Historical results show the strategy can outperform over long time frames, but returns are sensitive to implementation, costs, and market conditions—there is no guaranteed “magic.” Careful execution, sensible portfolio sizing, and a long-term mindset are essential.
Sources
– Joel Greenblatt, The Little Book That Beats the Market (2005); The Little Book That Still Beats the Market (2010).
– Investopedia, “Magic Formula Investing” (https://www.investopedia.com/terms/m/magic-formula-investing.asp).