Magic Formula Investing is a term that refers to an investment technique outlined by Joel Greenblatt. Magic Formula Investing is firmly rooted in the principles of value investing. For the lay investor, it is claimed that it offers market-beating returns without the complexity associated with a discounted cash flow analysis.
Methodology
Greenblatt suggests purchasing 30 Good Companies: cheap stocks with a high earnings yield and a high return on capital. He touts the success of his magic formula in his book The Little Book that Beats the Market, citing that it does in fact beat the market 96% of the time, and has averaged a 17-year annual return of 30.8% The comparison index used for "the market" in Greenblatt's research is the S&P 500.
Formula
- Establish a minimum market capitalization (usually greater than $50 million).
- Exclude utility and financial stocks
- Exclude foreign companies (American Depositary Receipts)
- Determine company's earnings yield = EBIT / enterprise value.
- Determine company's return on capital = EBIT / (Net fixed assets + working capital)
- Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
- Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over a 12-month period.
- Re-balance portfolio once per year, selling losers one day before the year-mark and winners one day after the year mark.
- Continue over long-term (3-5 year) period.
