Magic formula investing is a tried-and-true approach that can boost your chances of outperforming the market.
The technique focuses on screening for firms that meet specified criteria and managing the portfolio over time using a rigorous, unemotional methodology.
The value-based strategy was devised by investor and hedge fund manager Joel Greenblatt and published in 2005 in The Little Book That Beats the Market. It was republished in 2010 as The Little Book That Still Bits the Market.
Greenblatt promised yearly returns of more than 30% in the initial article.
The magic formula does not include certain categories of firms, such as those with a modest market capitalization, foreign corporations, financial companies, and utilities.
The Magic Formula investing ratios
The magic formula has two ratios. The first is the earnings yield, expressed as EBIT/EV. We calculate it by dividing profits before interest and taxes by the enterprise value:
Earnings Before Interest and Taxes (EBIT) / Enterprise Value =
Earnings Yield
Earnings/price is a simpler and more typical variant of this ratio. Greenblatt favors EBIT over profits because EBIT compares firms with different tax rates more effectively. EV is favored over share price since it takes into account the company’s debt. As a result, EBIT/EV offers a more accurate depiction of overall results than earnings/price.
EBIT / (Net Fixed Assets + Working Capital) = Return on Capital
The first of these ratios compares profits before interest and taxes to enterprise value. The second ratio examines earnings in relation to tangible assets. Many balance-sheet assets degrade over time as their usefulness wears out. These are referred to as “fixed assets.”
Net fixed assets are fixed assets less any depreciation and liabilities connected with the asset. When compared to simply looking at the overall asset figure on the balance sheet, this provides a more accurate understanding of the true worth of a company’s assets. Working capital is also included in this ratio and is calculated as current assets minus current liabilities. This indicates whether the firm will be able to maintain operations in the short future.
There is a lot of data in the “magic”
While the two ratios in the magic formula appear to be minor, they really compute a lot of data about a company’s inner workings, including:
Earnings
Earnings are the profits generated by a corporation during a specified time period, which is commonly defined as a quarter or a year. Analysts wait for the results of the firms they watch to be announced after the end of each quarter. Earnings are researched because they are directly related to firm performance.
Interest
Interest expenditure is incurred when a firm borrows money to finance its operations. Different firms’ capital arrangements result in differing interest expenses.
Taxation rates
A corporate tax is a tax that a business has to pay on its profits. Taxes are paid on a company’s taxable income, which is its revenue minus the cost of goods sold (COGS), general and administrative (G&A) expenses, selling and marketing, research and development, depreciation, and other operating costs.
Corporate tax rates vary a lot from country to country. Some countries with low rates are known as “tax havens.”
Share price
A share price, often known as a stock price, is the cost of purchasing one share of a corporation. A share’s price is not set and varies according on market conditions. It will most likely rise if the firm is regarded to be doing well, and fall if the company fails to meet expectations.
Debt
In addition to loans and credit card debt, businesses that need to borrow money have access to additional debt options. Common forms of corporate debt that are inaccessible to individuals are bonds and commercial paper.
Asset depreciation
Depreciation is an accounting method for allocating the cost of a tangible or physical item over its useful life. Depreciation is a measure of how much of an asset’s value has been consumed. It enables businesses to generate money from assets they own by paying for them over time.
Current assets
The Current Assets account is a balance sheet line item in the Assets section that accounts for all company-owned assets that may be converted to cash in less than a year. Current assets are assets whose value is reflected in the Current Assets account. Cash, cash equivalents, accounts receivable, stock inventories, marketable securities, pre-paid obligations, and other liquid assets are examples of current assets.
Current liabilities
Current liabilities are the short-term financial commitments of a corporation that are due within one year or during a regular operational cycle. Accounts payable, short-term debt, dividends, and notes payable, as well as income taxes owed, are examples of current obligations.
How does the Magic Formula works?
The following sections explain how the formula works:
1. Establish a minimum market capitalisation for each of your portfolio firms. This should be greater than $100 million.
2. When selecting your firms, make sure to exclude any banking or utility stocks.
3. Do not include American Depository Receipts (ADRs). These are shares in overseas corporations.
4. Determine the earnings yield (EBIT / Enterprise Value) for each firm.
5. Determine the return on capital for each firm [EBIT / (Net Fixed Assets + Working Capital)].
6. Sort the firms based on their best earnings yields and highest return on capital.
7. Over the course of a year, buy two to three positions every month in the top 20 to 30 firms.
8. Rebalance the portfolio once a year by selling losers one week before the fiscal year finishes. One week after the year’s end, sell off the winners.
9. Repeat the process every year for at least five to ten years, if not more.
Is the Magic Formula investing truly effective?
Greenblatt claims that his magic formula investment method has produced yearly returns of 30%. The magic formula can no longer guarantee returns of 30% compound yearly growth, although certain research show promising outcomes. A backtest of market performance from 2003 to 2015 revealed that the magic formula approach achieved annualized returns of 11.4%, compared to 8.7% for the S&P500.
The benefits and drawbacks of Magic Formula investing
The magic formula method’s key benefit is its simplicity: you don’t need to be a qualified investment professional or Wall Street prodigy to invest well. A few basic guidelines are all that is required to identify a basket of dependable assets. It also decreases illogical or emotional decision-making.
However, contrary to its name, the magic formula is not magical, and it may not always be the optimal plan. Some market testing of the formula have revealed lower-than-expected returns, which might be attributed to changing market dynamics or an increase in the number of investors using Greenblatt’s technique. Furthermore, some analysts claim to have enhanced the approach by incorporating new factors like as debt/equity ratios and dividend yields.
The bottom line
The magic formula is a simple, rules-based strategy that makes high returns accessible to the average investor. The magic formula helps investors to readily uncover outperforming or undervalued firms by using a straightforward, quantitative technique, without allowing emotions or instinct to distort their judgment. While returns are currently far lower than when the magic formula was initially published, the strategy may still outperform the market with a few tweaks.
