The Magic Formula: A Simple Value Investing Approach

The “Magic Formula,” popularized by Joel Greenblatt in his book The Little Book That Beats the Market, is a stock-picking strategy designed to identify undervalued companies and outperform the market over the long term. It’s based on the principle of buying good companies at bargain prices, using two key financial metrics: Return on Capital (ROC) and Earnings Yield (EY).

Understanding the Components

The formula revolves around ranking companies based on ROC and EY and then combining those rankings to create an overall ranking. Let’s break down each component:

• Return on Capital (ROC): This metric measures how efficiently a company uses its capital to generate profits. Greenblatt specifically defines ROC as Earnings Before Interest and Taxes (EBIT) divided by (Net Working Capital + Net Fixed Assets). A higher ROC indicates better capital allocation and profitability. The formula prioritizes companies that are adept at generating profits from their investments.
• Earnings Yield (EY): This metric represents a company’s earnings relative to its price. Greenblatt calculates it as EBIT divided by Enterprise Value (EV). Enterprise Value accounts for both the company’s market capitalization and its debt, providing a more comprehensive picture of its total value. A higher EY suggests that a company’s earnings are high relative to its price, implying potential undervaluation.

How the Magic Formula Works

1. Calculate ROC and EY: For a given universe of stocks (Greenblatt typically uses the largest 3,500 US companies, excluding utilities and financial firms), calculate the ROC and EY for each company.
2. Rank the Companies: Rank the companies separately based on ROC and EY, from highest to lowest. The company with the highest ROC receives a rank of 1, the second highest receives a rank of 2, and so on. Do the same for EY.
3. Combine the Ranks: For each company, add its ROC rank to its EY rank. The company with the lowest combined rank is considered the most attractive.
4. Select the Top Stocks: Choose a set number of top-ranked companies based on their combined rank. Greenblatt suggests buying 20-30 stocks.
5. Rebalance Annually: Sell the oldest stocks in the portfolio after one year and replace them with newly identified top-ranked stocks. This process is repeated annually to maintain a portfolio of undervalued, high-performing companies.

Pros and Cons

The Magic Formula is a relatively simple and systematic approach that can be implemented even by novice investors. Its objective nature removes emotional biases from investment decisions. However, it’s important to acknowledge its limitations.

Pros:

• Simple and easy to understand.
• Systematic and removes emotion.
• Potentially high returns over the long term (historically).

Cons:

• Can underperform in short periods.
• Requires discipline and patience.
• Focuses solely on quantitative factors, ignoring qualitative aspects of businesses.
• May not be suitable for all market environments.

Important Considerations

While the Magic Formula has shown promising results in backtests, it’s crucial to remember that past performance is not indicative of future returns. The formula relies on quantitative data and doesn’t account for qualitative factors like management quality, competitive advantages, or industry trends. Investors should conduct their own due diligence and consider the Magic Formula as just one tool in their investment toolkit. Diversification is also essential to mitigate risk.