====== Magic Formula Investing ======
Magic Formula Investing is a systematic, rules-based investment strategy popularized by the legendary hedge fund manager and professor [[Joel Greenblatt]] in his bestseller, "The Little Book That Beats the Market." At its heart, the formula is a clever and simple way to automate the core principle of [[Value Investing]]: buying good companies at cheap prices. It achieves this by using a quantitative screen to rank stocks based on just two key factors: how good a business is and how cheap its stock is. The formula's goal is to remove emotion and human bias from the investment process, providing a disciplined method for uncovering potentially undervalued, high-quality companies that the market might be overlooking. It’s a powerful tool designed for the long-term investor, not the short-term speculator.
===== The "Magic" Behind the Formula =====
The genius of the Magic Formula lies in its simplicity. It boils down the complex world of stock analysis to two fundamental questions: "Is this a good business?" and "Am I getting it at a good price?". To answer these, Greenblatt uses two specific financial metrics.
==== The "Good Company" Metric: Return on Capital ====
To find a "good" company, the formula looks for businesses that are highly profitable relative to the amount of capital it takes to run them. The metric used is [[Return on Capital]] (or a variation of it).
A high Return on Capital suggests that the company's management is exceptionally skilled at deploying its assets to generate profits. Think of it like a master chef who can create a gourmet meal using only a few simple ingredients. The formula specifically uses:
**[[EBIT]] / ([[Net Working Capital]] + [[Net Fixed Assets]])**
This version of Return on Capital focuses on the company's core operations, stripping out the effects of debt and taxes to make comparisons between different companies fairer.
==== The "Cheap Price" Metric: Earnings Yield ====
To find a "cheap" company, the formula measures how much profit a business generates relative to its market price. The metric for this is [[Earnings Yield]]. It's essentially the inverse of the more famous [[P/E Ratio]] and tells you what percentage return you would get if you could buy the entire company at its current price.
A high Earnings Yield means you're getting a lot of "bang for your buck." The formula uses a specific version to ensure an apples-to-apples comparison:
**EBIT / [[Enterprise Value]]**
By using EBIT and Enterprise Value, the formula accounts for both a company's debt and its cash on hand. This gives a much more holistic view of the "real" price of the business and its operational earnings, regardless of how the company is financed.
===== Putting the Formula into Practice =====
Applying the formula is a straightforward, step-by-step process designed to be followed mechanically.
==== The Ranking System ====
The core of the process is a simple ranking system:
  - 1. Take a list of stocks (e.g., all companies on the New York Stock Exchange above a certain size).
  - 2. Rank every company by its Return on Capital. The company with the highest Return on Capital gets rank #1, the second-highest gets #2, and so on.
  - 3. Separately, rank every company by its Earnings Yield. The company with the highest Earnings Yield gets rank #1, the second-highest gets #2, etc.
  - 4. Finally, add the two ranks together. The company with the lowest combined score (e.g., a company ranked 5th on quality and 10th on price would have a combined score of 15) is considered the best investment according to the formula.
==== Building Your Portfolio ====
Greenblatt's prescription for building a portfolio using the formula is equally disciplined:
  * **Diversify:** Buy a basket of 20 to 30 of the top-ranked stocks over a period of time. Don't put all your eggs in one basket.
  * **Be Patient:** Hold each stock for approximately one year. This strategy is built for the long haul.
  * **Rebalance:** After a year, sell the stocks and repeat the entire process, replacing them with the new list of top-ranked companies. This ensures your portfolio is always populated with companies that meet the "good and cheap" criteria.
===== Pros and Cons of the Magic Formula =====
Like any investment strategy, the Magic Formula has its strengths and weaknesses. Understanding them is key to using it effectively.
==== The Bright Side ====
  * **Systematic and Disciplined:** It provides a clear, unemotional framework that helps investors avoid common behavioral pitfalls like panic selling or chasing hot stocks.
  * **Based on Sound Principles:** The logic is timeless and aligns with the wisdom of legendary investors like [[Benjamin Graham]] and [[Warren Buffett]].
  * **Historically Strong Performance:** Over long periods, the strategy as outlined in Greenblatt's book has a track record of significantly outperforming major market indices.
==== Words of Caution ====
  * **It Requires Patience:** The formula can—and often does—underperform the market for stretches of time, sometimes for two or three years in a row. This can test an investor's resolve.
  * **It's Not a "Black Box":** The formula is a quantitative //screening tool//, not a substitute for thinking. Some companies that rank highly may be facing temporary issues (good!) or permanent structural decline (bad!).
  * **Data Dependency:** The output is only as good as the input. Different financial data providers can have slightly different numbers, leading to different rankings.
===== Capipedia's Take =====
The Magic Formula is a fantastic and powerful tool for the modern value investor. Its greatest contribution is its ability to systematically surface a list of statistically cheap, high-quality businesses that are prime candidates for further research.
However, we believe it should be used as a //starting point//, not an ending point. The list of top-ranked companies is an incredible hunting ground. The next step for a diligent investor is to take that list and dig deeper. Investigate each company's business model, its management team, and, most importantly, its competitive advantage, or [[moat]]. By combining the quantitative power of the Magic Formula with the qualitative judgment of a thoughtful investor, you can build a truly robust and resilient portfolio. It’s a perfect marriage of man and machine.