Magic Formula Investing

The Magic Formula Investing: A Proven Strategy for Stock Market Success

Investing in the stock market can be a daunting task, especially for beginners. With thousands of stocks to choose from and countless investment strategies to consider, it's easy to feel overwhelmed. However, there is one strategy that has gained popularity among investors for its simplicity and proven track record: Magic Formula Investing.

What is Magic Formula Investing?

Magic Formula Investing is an investment strategy developed by Joel Greenblatt, a renowned investor and professor at Columbia Business School. The strategy is based on the idea that investors can achieve above-average returns by investing in high-quality companies at attractive prices.

The Magic Formula consists of two key factors: earnings yield and return on capital. Earnings yield is calculated by dividing a company's earnings before interest and taxes (EBIT) by its enterprise value. Return on capital, on the other hand, measures how efficiently a company generates profits from its invested capital.

By ranking stocks based on these two factors, the Magic Formula identifies companies that are both cheap and profitable. The strategy suggests investing in the top-ranked stocks and holding them for a year before rebalancing the portfolio.

The Performance of Magic Formula Investing

One of the main reasons why Magic Formula Investing has gained popularity is its impressive historical performance. Backtesting the strategy over a 17-year period from 1988 to 2004, Greenblatt found that it generated an average annual return of 30.8%, significantly outperforming the broader market.

Furthermore, a study conducted by the American Association of Individual Investors (AAII) found that a simulated Magic Formula portfolio outperformed the S&P 500 by an average of 13.5% per year from 1999 to 2009. These results demonstrate the potential of the strategy to deliver superior returns over the long term.

Why Does Magic Formula Investing Work?

There are several reasons why Magic Formula Investing has been successful. Firstly, the strategy focuses on buying high-quality companies. By considering both earnings yield and return on capital, it identifies companies that are not only cheap but also have a strong track record of profitability.

Secondly, the Magic Formula strategy takes advantage of market inefficiencies. Greenblatt argues that the market often misprices stocks due to short-term factors or investor biases. By investing in undervalued companies, the strategy aims to capitalize on these mispricings and generate above-average returns.

Lastly, the simplicity of the Magic Formula makes it accessible to individual investors. Unlike complex investment strategies that require extensive financial knowledge, Magic Formula Investing can be implemented by anyone with basic understanding of financial statements and valuation metrics.

Implementing Magic Formula Investing

Implementing the Magic Formula Investing strategy is relatively straightforward. Here are the steps to follow:

Identify a universe of stocks: Start by selecting a universe of stocks to consider for investment. This can be done by using a stock screener or by manually researching companies.
Rank the stocks: Calculate the earnings yield and return on capital for each stock in the universe. Rank the stocks based on these factors, with the highest-ranked stocks being the most attractive.
Construct the portfolio: Invest an equal amount of capital in the top-ranked stocks. The number of stocks to include in the portfolio can vary, but a common approach is to invest in 20 to 30 stocks.
Hold the portfolio: Hold the portfolio for a year before rebalancing. This allows time for the market to recognize the value of the selected stocks.
Repeat the process: After a year, repeat the ranking and portfolio construction process. This ensures that the portfolio remains invested in the most attractive stocks.

Limitations of Magic Formula Investing

While Magic Formula Investing has proven to be a successful strategy, it is not without its limitations. One of the main criticisms of the strategy is its reliance on historical financial data. By focusing solely on past performance, the strategy may overlook companies that are poised for future growth.

Additionally, the Magic Formula does not take into account qualitative factors such as industry dynamics, competitive advantages, or management quality. These factors can have a significant impact on a company's long-term prospects and should be considered alongside the quantitative factors used in the Magic Formula.

In Conclusion

Magic Formula Investing offers a simple yet effective approach to stock market investing. By focusing on high-quality companies at attractive prices, the strategy has consistently outperformed the broader market over the long term. However, it is important to recognize the limitations of the strategy and consider other qualitative factors when making investment decisions.

Whether you are a beginner investor or a seasoned professional, Magic Formula Investing can be a valuable tool in your investment arsenal. By following the steps outlined in this article and conducting thorough research, you can potentially achieve above-average returns and build a successful investment portfolio.