Magic Formula

The Magic Formula is a quantitative investment strategy popularized by hedge fund manager Joel Greenblatt in his best-selling book, “The Little Book That Beats the Market.” Don't let the whimsical name fool you; it's a disciplined approach rooted firmly in the principles of value investing. The core idea is brilliantly simple: buy good companies at cheap prices. To achieve this, the formula uses a systematic stock screening process to identify companies that score highly on two specific metrics: Return on Capital, which measures how “good” a company is at generating profits from its assets, and Earnings Yield, which measures how “cheap” a company's stock is relative to its earnings. By ranking and combining these two factors, the formula aims to create a portfolio of high-quality, undervalued businesses poised for long-term growth, providing a structured method for investors to bypass emotional decision-making and focus on fundamental value.

At its heart, the Magic Formula is a two-part recipe for finding investment treasures. It mechanizes the process of looking for the two things every value investor wants: a great business and a bargain price.

How do you tell if a business is a high-quality operation? You look at how effectively it makes money. That's what Return on Capital (ROC) does. It measures how much profit a company generates for every dollar of capital it employs. A high ROC suggests the company has a strong competitive advantage, or what Warren Buffett would call a “moat“—something that protects it from competitors and allows it to earn consistently high profits. Greenblatt uses a specific formula to calculate this:

• ROC = EBIT / (Net Working Capital + Net Fixed Assets)

Where:

• EBIT (Earnings Before Interest and Taxes) represents the company's operating profit.
• Net Working Capital + Net Fixed Assets represents the tangible capital needed to run the business.

A company that can consistently generate a high ROC is like a star student who always gets top grades with minimal effort—it's just really good at what it does.

Finding a great company is only half the battle; you don't want to overpay for it. This is where Earnings Yield comes in. It's a simple way to gauge if a stock is a bargain. Think of it as the inverse of the famous P/E ratio. A higher yield means you're getting more earnings for your money. Greenblatt's formula for this is:

• Earnings Yield = EBIT / Enterprise Value

Where:

• Enterprise Value (EV) is a more comprehensive measure of a company's total value than just its market capitalization. It includes debt and excludes cash, giving a truer picture of what it would cost to buy the entire company.

By using EBIT/EV, the formula compares a company's operating earnings to its total price tag, allowing for a fair comparison between companies with different debt levels and tax rates. A high earnings yield is a strong signal that the company might be on sale in the stock market.

The “magic” isn't just in the metrics themselves, but in how they are systematically combined and applied. It’s a disciplined, multi-step process.

The process is straightforward and mechanical, designed to remove human bias:

1. Step 1: Start with a list of stocks, typically excluding financial and utility companies, and focusing on those above a certain minimum market capitalization (e.g., $50 million) to ensure you're dealing with reasonably established businesses.
2. Step 2: Calculate the Return on Capital for every company on the list. Rank them from best (highest ROC) to worst (lowest ROC).
3. Step 3: Calculate the Earnings Yield for every company. Rank them from best (highest yield) to worst (lowest yield).
4. Step 4: Add the two ranks together for each company. For example, a company that is 10th in ROC and 25th in Earnings Yield gets a combined score of 35.
5. Step 5: The companies with the lowest combined scores are your “Magic Formula” stocks. These are the ones that, according to the system, offer the best combination of quality and value.

Greenblatt provides clear instructions for building a portfolio based on these rankings:

• Diversify: Buy a basket of 20 to 30 of the top-ranked stocks over the course of a year. Buying a few every month helps average out your purchase prices.
• Be Patient: Hold each stock for approximately one year. This long-term horizon is crucial, as it gives the market time to recognize the value you've identified.
• Systematically Rebalance: After a year, sell your stocks and repeat the entire process, replacing them with the new list of top-ranked companies. Greenblatt suggests selling winners just after the one-year mark and losers just before it for potential tax benefits.

While the formula's historical performance has been impressive, it's essential to understand its limitations.

• It's Not Actually Magic: The name is catchy, but the strategy is not a foolproof spell for instant riches. It can, and often does, underperform the market for stretches of one, two, or even three years. Success requires immense patience and the discipline to stick with the system even when it's not working.
• Back-testing Isn't Prophecy: While the formula performed well in historical simulations, past performance is no guarantee of future results. Market dynamics can change, and as a strategy becomes more popular, its effectiveness can diminish—a core idea in the Efficient Market Hypothesis.
• Data Quality is Key: The rankings are only as good as the financial data used to generate them. Different financial data providers can have slight variations in how they calculate metrics like EBIT or capital, leading to different lists of top stocks.
• Sector Blind Spots: The formula naturally avoids certain industries, like banking and insurance, where the standard metrics for capital and earnings don't apply well. This can lead to a less diversified portfolio than one constructed by a human manager.