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 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.

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.

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.

Applying the formula is a straightforward, step-by-step process designed to be followed mechanically.

The core of the process is a simple ranking system:

1. 1. Take a list of stocks (e.g., all companies on the New York Stock Exchange above a certain size).
2. 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. 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. 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.

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.

Like any investment strategy, the Magic Formula has its strengths and weaknesses. Understanding them is key to using it effectively.

• 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.

• 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.

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.