Magical Formula Investing (Origin, Principles, Formula)
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 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
The Magical Formula has demonstrated commendable performance in backtested scenarios, often outperforming market averages.
Critiques and Limitations
Some critics argue that the formula oversimplifies complex market dynamics.
For one, it’s based on looking at past data.
Earnings Yields & ROC Differ Based on Sector
It also may not recognize sector-specific nuances.
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.
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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