Magical Formula Investing (Origin, Principles, Formula)

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Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.
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Magical Formula Investing is an investment strategy developed by Joel Greenblatt, a well-respected finance professor and fund manager.

This method combines two key financial metrics:

  • earnings yield and
  • return on capital

The goal is to systematically identify high-quality companies at bargain prices.

 


Key Takeaways – Magical Formula Investing

  • Value and Quality Focus
    • Magical Formula Investing prioritizes undervalued, high-quality companies.
    • It uses earnings yield and return on capital as metrics.
  • Systematic Approach
    • It employs a disciplined, rule-based strategy to select and rotate stocks annually (help reduce emotional biases).
  • Long-term Strategy
    • Designed for long-term investment.
    • Emphasizes patience and consistency over quick gains.

 

The Origin and Principles

Joel Greenblatt introduced this strategy in his book, “The Little Book That Beats the Market.”

The formula is designed to be straightforward and enable investors of all skill levels to apply it.

It emphasizes long-term investment over frequent trading.

This aligns with the philosophy of value investing.

This isn’t to say that day trading isn’t valid; it’s just that Magical Formula Investing has a different focus.

 

Core Components of the Formula

Earnings Yield

Earnings yield may be calculated by dividing a company’s earnings before interest and taxes (EBIT) by its enterprise value (EV).

Sometimes it’s simply earnings per share (EPS) divided by the share price (if debt is ignored).

This metric helps in identifying undervalued stocks.

It provides a comparative measure of a company’s profitability against its current market price.

Return on Capital

Return on Capital (ROC) is another element.

It’s determined by dividing EBIT by the total capital employed (tangible assets minus current liabilities).

A high ROC indicates a company’s efficiency in generating profits from its capital.

This highlights businesses with a competitive advantage.

Application of the Formula

Investors using the Magical Formula rank stocks based on earnings yield and return on capital.

They typically select the top-ranked companies to create a diversified portfolio.

The formula suggests re-evaluating the portfolio annually – i.e., selling off the underperformers that no longer fit the threshold, and reinvesting in newly ranked top companies.

 

Performance and Critiques

Performance Analysis

The Magical Formula has demonstrated commendable performance in backtested scenarios, often outperforming market averages.

Its simplicity and systematic nature reduce behavioral biases and decision-making errors.

Critiques and Limitations

Some critics argue that the formula oversimplifies complex market dynamics.

Past Data

For one, it’s based on looking at past data.

So, this strategy tends to apply more effectively to staid businesses – e.g., consumer staples, utilities – rather than tech companies or those where trends and growth are most applicable.

Earnings Yields & ROC Differ Based on Sector

It also may not recognize sector-specific nuances.

Bear Markets

Additionally, its performance in volatile or bear markets may vary.

When the environment is bad for stocks more generally, they all tend to decline, though it’s a matter of degree.

 

Conclusion

Magical Formula Investing offers a disciplined approach to value investing.

It focuses on specific company fundamentals – earning yield and return on capital.

While it has its limitations, it serves as a practical tool for investors seeking a structured, data-driven investment strategy.

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