How does the Magic Formula work ?

The Magic Formula, developped by Joel Greenblatt, is a value investing strategy that selects companies based on two factors: Return on Capital and Earnings Yield. The formula ranks companies based on these two factors and selects the top 30 companies.

What is the name of the book that Joel Greenblatt wrote ?

Joel Greenblatt wrote the book "The Little Book That Beats the Market" in 2005. The book explains the Magic Formula and how to use it to select stocks.

Magic Formula

by Joel Greenblatt

book

value

quality

Performance

Annualized Return:

YTD Return

2.3%

From January 1st

5 Years Return

-2.6%

/ SP500 + 13.57%

10 Years Return

-0.5%

/ SP500 + 10.52%

15 Years Return

5.9%

/ SP500 + 10.26%

In a Nutshell

In short, the strategy focuses on large capitalization within the United States. The author doesn't look at sensible sectors such as financials and utilities. We look for companies with the higher ROC (Return on Capital) and Earnings Yield.

In a nutshell:

Market Cap.> $100M.
Exclude financial or utility stocks

Performance

Risk

Holding Time

Stock Picks

NEW! Add financial ratios to the screener view

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When to Sell

Magic Formula Sell Strategy

Limit of 20-30 Companies in Portfolio

The magic formula is a balance between 20-30 companies. Start thinking about rebalancing your portfolio when you have more companies.

Re-Balance Every Year

Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.

The Magic Formula is a long-term approach with annual rebalancing. The idea is simple: always have the top 20-30 companies in your portfolio. The Magic Formula doesn't leave room for technical analysis and the selling part is easy. Maybe too simple for bear markets.

All you need to know about Magic Formula

Who is Joel Greenblatt?

Joel Greenblatt, an American money manager, suggests buying 30 "good companies": cheap stocks with high earnings and high returns on capital. He describes it as a simplified version of the strategy used by Warren Buffett and Charlie Munger of Berkshire Hathaway. He touts the success of his magic formula in his book "The Little Book that Beats the Market," claiming it has produced an average annual return of 30.8% over 17 years.

How to use the Magic Formula ?

1. Establish a minimum market capitalization (usually greater than $50 million).
2. Exclude utility and financial stocks.
3. Exclude foreign companies (American Depositary Receipts).
4. Determine company's earnings yield = EBIT / enterprise value.
5. Determine company's return on capital = EBIT /(net fixed assets + working capital).
6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
7. Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
9. Continue over a long-term (5–10+ year) period.

Performances and Study around the Magic Formula

A 2009 study of the Nordic stock markets from 1998 to 2008 found that Greenblatt's formula led to outperformance of the market averages. averages. However, the authors advised that the formula is best used as a screening tool and should not be applied dogmatically, as the outperformance associated with Greenblatt's formula could be explained by data from the Capital Asset Pricing Model and the Fama-French three-factor model.

A 2017 study of Swedish markets found that using the Greenblatt formula resulted in long-term outperformance of market averages in 2005 to 2015 and 2007 to 2017. The authors also found that the "magic formula" was also associated with short-term underperformance in some periods and periods and significantly increased volatility.

Independent Robert Andrew Martin published a backtest analysis of Greenblatt's magic investing formula for the US market in June 2020.He found that from 2003 to 2015 application of Greenblatt's formula to U.S. stocks returned an annualized average 11.4%. This outperformed by a significant margin the S&P 500's annualized return of 8.7%. However, Martin also found Greenblat's formula under-performed the S&P 500 slightly during the 2007-2011 period and actually went negative for a time, and over the entire 2003-2015 period was more volatile overall than the S&P 500. In conclusion, Martin found that the almost 3% outperformance was "surprising", but not as great as the 30% returns Greenblatt's book claimed (though their respective analyses used different years). Martin also noted the strategy had "significant psychological risk" associated with under-performance during the aftermath of the 2007-2008 financial crisis.

Source :

Wikipedia - Magic Formula Investing

The Little Book That Beat the Marker - Joel Greenblatt - 2005