Magic Formula Investing is a disciplined investment strategy designed by Joel Greenblatt that simplifies the process of value investing. It advocates for purchasing quality stocks at bargain prices through a systematic and easy-to-understand approach.
Origins and Development
Introduced by Joel Greenblatt in his 2005 book, “The Little Book That Still Beats the Market,” the Magic Formula revises traditional value investing principles into a straightforward method.
Key Components of Magic Formula Investing
Metrics
Two primary metrics form the backbone of Magic Formula Investing:
- Earnings Yield: Calculated as EBIT/Enterprise Value (EV), this metric indicates how much a company earns relative to its value.
- Return on Capital: Measured by EBIT/(Net Working Capital + Net Fixed Assets), this assesses how efficiently a company generates earnings from its operational assets.
Ranking System
Stocks are evaluated and ranked based on these two metrics. The system prioritizes companies with the highest earnings yield and best return on capital.
Implementation Process
Step-by-Step Guide
- List Companies: Choose a universe of stocks, typically those with a market capitalization above a certain threshold.
- Calculate Metrics: Determine the earnings yield and return on capital for each company in the list.
- Rank Stocks: Assign ranks based on both metrics, summing up the ranks to find the best combination of high earnings yield and return on capital.
- Select Top Stocks: Identify the top 20-30 companies with the best combined ranks.
- Rebalance Annually: Reassess and adjust the portfolio every year to maintain the strategy’s principles.
Examples and Case Studies
To illustrate, let’s consider Company A and Company B. Assume Company A has an EBIT of $2 million and an EV of $20 million, yielding an earnings yield of 10%. Company B, with an EBIT of $5 million and EV of $50 million, also delivers an earnings yield of 10%. However, if Company A has a return on capital of 15% compared to Company B’s 12%, under Magic Formula Investing, Company A is considered a better investment opportunity.
Historical Performance and Applicability
Historically, portfolios constructed using Magic Formula Investing have often outperformed market indices. However, performance can vary, and it’s essential to consider market conditions and individual financial goals.
Special Considerations
Limitations
- Market Conditions: The strategy may underperform in certain market environments, particularly when growth stocks outperform value stocks.
- Selection Criteria: Not all stocks may fit the predefined criteria, potentially limiting diversification.
Advantages
- Simplicity: Its straightforward approach makes it accessible to both novice and experienced investors.
- Disciplined Framework: Reduces emotional decision-making by adhering to a systematic process.
Comparisons with Other Strategies
Magic Formula vs. Traditional Value Investing
While traditional value investing relies on thorough qualitative and quantitative analysis, Magic Formula Investing streamlines decision-making through a quantitative ranking system.
Magic Formula vs. Growth Investing
Unlike growth investing, which focuses on companies with high growth potential, Magic Formula Investing targets fundamentally strong companies available at attractive valuations.
Related Terms
- Value Investing: An investment strategy focusing on undervalued stocks with strong fundamentals.
- Earnings Yield: A financial metric comparing earnings to company valuation.
- Return on Capital: Indicates the efficiency of a company’s use of its capital.
FAQs
What is the minimum investment capital required for Magic Formula Investing?
Are there any sectors or industries where Magic Formula Investing is particularly effective?
How often should the portfolio be rebalanced?
References
- Greenblatt, J. (2005). The Little Book That Still Beats the Market. Wiley Finance.
- Other references and academic papers discussing value investing principles.
Summary
Magic Formula Investing offers a disciplined and accessible approach to value investing by focusing on fundamental metrics and systematic ranking. By combining high earnings yield and robust return on capital, it aims to identify quality investment opportunities with inherent value, providing an effective investment framework for long-term gain.
