Are you tired of complex investment strategies that leave you feeling overwhelmed? Look no further than magic formula investing, a straightforward approach that has consistently outperformed the market. In this comprehensive guide, we'll explore how to harness the power of this strategy to potentially boost your investment returns.
What is Magic Formula Investing and How Does It Work?
Magic formula investing strategy is a rules-based, disciplined approach developed by Joel Greenblatt, a renowned investor, hedge fund manager, and business professor. This strategy aims to beat the stock market’s average annual returns using the S&P 500 as a benchmark.
At its core, magic formula investing is a contrarian strategy that focuses on identifying undervalued, high-quality companies. It’s essentially a simplified version of Warren Buffett’s investment philosophy, involving the purchase of about 30 “good companies” with two key characteristics:
- A high earnings yield
- A high return on capital
The Magic Behind the Formula
The magic formula uses two primary criteria for stock selection:
- Stock price: Represented by the earnings yield
- Company cost of capital: Measured by the return on capital
These metrics are calculated as follows:
- Earnings Yield = EBIT / Enterprise Value
- Return on Capital = EBIT / (Net Fixed Assets + Working Capital), where invested capital is the sum of Net Fixed Assets and Working Capital
Where EBIT stands for Earnings Before Interest and Taxes.
By focusing on these two factors, the magic formula aims to identify companies that are both profitable (high return on invested capital) and undervalued (high earnings yield).
Building Your Magic Formula Portfolio: A Step-by-Step Approach
Now that we understand the basics, let’s dive into how you can create your own magic formula portfolio by setting criteria such as minimum market capitalization.
Step 1: Define Your Investment Universe
The magic formula only applies to companies with market capitalizations greater than $50 million. It excludes:
- Small-cap stocks
- Financial companies
- Utility companies
- Non-U.S. companies, including foreign companies
Step 2: Calculate and Rank
Using Greenblatt’s online stock screener tool or your own calculations:
- Calculate the earnings yield and return on capital for each company in your universe.
- Rank all companies based on their earnings yield (highest to lowest), giving the top rank to the company with the highest earnings yield.
- Rank all companies based on their return on capital (highest to lowest).
- Combine these rankings to create a final score for each company.
Step 3: Select Your Stocks
Choose the top-ranked companies based on their combined score. The typical magic formula portfolio consists of 20-30 stocks.
Step 4: Build Your Portfolio
Invest in your selected stocks using the following approach:
- Buy 5-7 of the top-ranked companies.
- Invest 20% to 33% of your allocated funds.
- Repeat this process every 2-3 months until you've invested all your money.
Step 5: Rebalance and Repeat
- Hold each stock for one year.
- After one year, sell the stocks that no longer meet the criteria.
- Replace sold stocks with new ones identified by the formula.
- Rebalance your portfolio annually to ensure you always hold the top-ranked companies.
Why Magic Formula Investing Works: Understanding the Strategy's Success
The magic formula has consistently outperformed the S&P 500 in backtests and real-world applications. But what makes it so effective? Joel Greenblatt's magic formula investing strategy emphasizes selecting stocks that combine a high company's earnings yield with a strong return on capital. This approach is positioned as a simplified method for value investing, aimed at identifying undervalued companies to outperform market averages over the long term.
1. Grounded in Economic Intuition
The strategy focuses on two fundamental aspects of a good investment:
- Buying at a good price (high earnings yield)
- Investing in quality businesses (high return on capital)
2. Market Inefficiencies
The magic formula works because markets aren't always efficient. It capitalizes on temporary mispricing of quality companies.
3. Disciplined Approach
By following a set of rules, the strategy removes emotional decision-making from the investment process.
4. Focus on Quality
The formula is adept at identifying quality businesses that are more likely to trade at a discount to their intrinsic value.
5. Contrarian Nature
The strategy often leads to investing in temporarily unpopular or overlooked companies, which can result in significant returns when the market recognizes their value.
Common Pitfalls to Avoid When Implementing Magic Formula Investing
While the magic formula is straightforward, there are some common mistakes investors should be wary of:
- Ignoring market cap requirements: Stick to the $50 million minimum market cap to ensure sufficient liquidity.
- Neglecting regular rebalancing: Annual portfolio review is crucial for maintaining the strategy’s effectiveness.
- Emotional decision-making: Trust the process and avoid making changes based on short-term market fluctuations.
- Overlooking diversification: While the strategy provides some built-in diversification, consider your overall portfolio allocation.
- Expecting immediate results: The magic formula is a long-term strategy. Patience is key.
Real-World Applications and Performance of Magic Formula Investing
The magic formula has been put to the test in various stock markets worldwide, consistently demonstrating its effectiveness.
U.S. Stock Market Performance
In his book, Greenblatt reported that from 1988 to 2004, the magic formula strategy returned an average of 30.8% per year, compared to the S&P 500's 12.4% return.
International Markets
Studies have shown the effectiveness of Greenblatt's magic formula in other markets:
- Finnish Stock Market: A study found that the magic formula outperformed the market index by 7.5% annually from 1991 to 2006.
- London Stock Exchange: Research indicated significant outperformance of the FTSE All-Share index from 2000 to 2006.
Adaptations and Variations
Some investors have successfully adapted the magic formula by:
- Adding additional quality metrics
- Adjusting for industry-specific factors
- Combining with other value investing strategies
Frequently Asked Questions About Magic Formula Investing
Is magic formula investing suitable for beginner investors?
Yes, the strategy's simplicity makes it accessible to beginners. However, it's crucial to understand the principles behind it and commit to the long-term approach.
How often should I update my magic formula portfolio?
Annually. Greenblatt recommends holding stocks for one year and rebalancing the portfolio every 12 months.
Can I use magic formula investing for my entire portfolio?
It's not recommended. While effective, it's wise to maintain a diversified investment approach. Consider allocating a portion of your portfolio to magic formula investing.
Does magic formula investing work in all market conditions?
No strategy works all the time. The magic formula may underperform during strong bull markets or periods favoring growth stocks. However, it has shown resilience over full market cycles.
How can I find magic formula stocks without using Greenblatt's screener?
Several options exist:
- Use financial websites with stock screening tools
- Create your own spreadsheet using financial data from reliable sources
- Consider paid stock screening services that include magic formula criteria
Conclusion: Harnessing the Magic for Long-Term Investment Success
Magic formula investing offers a compelling approach for investors seeking a systematic, value-oriented strategy. By focusing on high-quality companies trading at attractive prices, this method has demonstrated its potential to outperform the market over the long term.
Remember, successful implementation requires discipline, patience, and a commitment to following the rules. While no investment strategy is foolproof, the magic formula's track record and logical foundation make it a valuable tool in any investor's arsenal.
Are you ready to add a touch of magic to your investment portfolio? Start by researching and creating your initial magic formula stock list today. Your future self may thank you for embracing this powerful, yet simple, investment strategy.
