What Is Magic Formula Investing?

What Is Magic Formula Investing?

The magic formula is an investing strategy created by Joel Greenblatt that focuses on finding the best price to buy certain companies in order to maximize returns. When Greenblatt coined the term magic formula investing, his portfolio had a return of 24% from 1998 to 2009.

This means that $10,000 invested at 24% for the period would have turned into just over $1 million. A fund based on the S&P 500 index for the same period would have turned that $10,000 into just under $75,000.

Others who ran their own experiments were not able to duplicate Greenblatt's high returns but still yielded positive results. As a result, investing experts agree that the strategy of magic formula investing outperforms the indexes. In most cases, though, it doesn't seem to beat indexes by as much as Greenblatt indicated when he introduced the concept in his book, The Little Book That Beats the Market.

How Do You Calculate Magic Formula Investing Ratios?

There are two ratios in the magic formula. The first is the earnings yield: EBIT/EV. This is earnings before interest and taxes divided by enterprise value:

A simpler and more common version of this ratio is earnings/price. Greenblatt prefers EBIT over earnings, because EBIT more accurately compares companies with different tax rates. EV is preferred to share price because EV also factors in the company's debt. Therefore, EBIT/EV provides a better picture of overall earnings than earnings/price. 

The second ratio is return on capital, which is EBIT/(Net Fixed Assets + Working Capital):

The first ratio looks at earnings before interest and taxes compared to enterprise value. The second ratio focuses on the earnings relative to tangible assets. Many assets listed on the balance sheet depreciate over time as their usefulness is used up. These types of assets are called "fixed assets."

Net fixed assets are fixed assets minus all the accumulated depreciation and any liabilities associated with the asset. This gives a more accurate sense of the real value of a company's assets, compared to just looking at the total asset number on the balance sheet. Working capital is also part of this ratio and is current assets minus current liabilities. This gives a picture of whether the company is likely able to continue operations in the short term. 

While the two ratios in the magic formula look small, they actually are computing a lot of data about the inner workings of a company, including:

• Earnings
• Interest
• Tax rates
• Equity price
• Debt
• Depreciation of assets
• Current assets
• Current liabilities

How Magic Formula Investing Works

The magic formula investing strategy has nine rules to follow:

1. Only include stocks with a market capitalization above $50 million, $100 million, or $200 million.
2. Exclude financial and utility stocks.
3. Exclude foreign companies or American Depositary Receipts (ADRs).
4. Determine the company’s earnings yield, which is EBIT / EV.
5. Determine the company’s return on capital, which is EBIT / (Net Fixed Assets + Working Capital).
6. Based on Steps 1 through 5, rank the results according to earnings yield and return on capital. Rank as percentages.
7. Invest in 20 to 30 of the highest-ranked companies, accumulating two to three positions per month over a 12-month period.
8. Rebalance the portfolio once per year, selling losers 51 weeks after purchase, and selling winners 53 weeks after purchase. This is for tax purposes, as losers are held for less than a year, and winners are held for longer than a year.
9. Only use the strategy over the long term. For example, choose to implement it for at least five years.

Limitations of Magic Formula Investing

You could see great variability in returns from another investor, even if you are both following the same strategy. When you buy stocks and which stocks you buy will play roles in determining your returns. For example, the initial formula calculations could produce different results on different days, as some stocks move out of or into the top 30 to 50 stocks that meet the criteria.

This variability is one reason that Greenblatt recommends that the strategy be used for more than five years. Due to short-term market fluctuations, you will see better returns over long periods of time from buying good companies at good prices.