How Does Magic Formula Investing Work?

Magic Formula investing is a rules-based investing strategy developed by hedge fund manager and professor Joel Greenblatt. First outlined in his book, The Little Book That Beats the Market, the magic formula investing strategy takes a simplified approach to choosing investments.

Magic Formula Investing draws on principles of value investing to create portfolios that seek to outperform the market. For interested investors, knowing the ins and outs of the strategy before applying it is important.

What Is Magic Formula Investing?

At its core, Greenblatt’s Magic Formula Investing strategy focuses on finding good companies to invest in that are trading at attractive prices. Specifically, this strategy focuses on two things: Stock price, and the cost of capital.

The Magic Formula provides a way to help investors find or pinpoint companies that they deem undervalued by the market, and that may potentially offer a high return on their invested capital. It shares some similarities with value investing, which emphasizes finding the “hidden gems” that trade below their intrinsic value.

Value investors often follow a buy-and-hold strategy, in which securities are purchased with the intent to hold them long-term. The idea is that even though the market may have undervalued a company, it could grow in value over time and result in higher returns once an investor decides to sell.

This strategy utilizes fundamental analysis, which involves looking at things like revenue and earnings, and calculating return on equity to measure a company’s financial health.

The difference between a buy and hold strategy and Magic Formula Investing is that fundamental analysis doesn’t come into play. Instead, the formula relies on Greenblatt’s stock-screening method to identify the most promising stocks to invest in.


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What Is the Magic Investing Formula?

Screening stocks using the Magic Formula method is based on a rankings system. As developed by Greenblatt, this system uses three distinct criteria to rank companies:

•   Earnings before interest and taxes (EBIT)

•   Earnings per share

•   Return on capital

Earnings Before Interest and Taxes (EBIT)

This is one way to measure a company’s profitability. This figure represents the net income of a company before income tax expense and interest expenses are deducted. To calculate a company’s EBIT, you’d subtract income tax expense and interest expenses from its revenue.

Earnings Per Share (EPS)

EPS is another measure of profitability, though it’s calculated differently than EBIT. With EPS, you divide a company’s net profit by the total number of common shares of stock it has outstanding. This is also a way to measure a company’s value, since EPS can tell you roughly how much money it makes per share of stock. A higher EPS may suggest higher value and a willingness for investors to pay more for shares of a company’s stock.

Return on Capital

Return on capital measures how well a company is able to allocate its capital to investments that are profitable. To figure out this number, you’d subtract dividends from net income, then divide that by the sum total of the company’s debt and equity.

By applying EBIT, EPS, and return on capital, the Magic Formula method is intended to determine quality companies at an attractive price.

How Magic Formula Investing Works

For investors interested in using the Magic Formula to help build a portfolio, there’s a specific sequence of steps to follow that Greenblatt outlines.

1. Set a Market Capitalization Threshold

Market capitalization (commonly known as market cap) represents the current number of shares of stock a company has outstanding multiplied by the price per share. Companies can be categorized as small-cap, mid-cap or large-cap, based on their market capitalization.

Engaging in Magic Formula Investing, an investor will typically start by excluding any companies with a market capitalization below $100 million. But one could set this number higher or lower, depending on personal preferences. Greenblatt advocates setting the threshold at $1 billion (which means large-cap) to help minimize volatility.

2. Exclude Certain Securities

In Magic Formula Investing, an investor next should eliminate several categories of investments. Those include stocks in the financials and utilities sectors, as well as foreign companies and American Depositary Receipts (ADRs). An ADR offers a way to indirectly own foreign companies that aren’t traded on U.S. stock exchanges.

3. Make the Necessary Calculations

Once an investor has narrowed down their list of companies, they can start running the numbers. Specifically, this means calculating:

•   Earnings before interest and taxes (EBIT)

•   Earnings yield (EBIT divided by enterprise value, which is a company’s total value as measured by its market capitalization plus total debt minus its cash assets)

•   Return on capital (EBIT divided by the sum total of net fixed assets and working capital)

4. Create Your Rankings

After doing the above math, an investor can move on to ranking companies according to the Magic Formula — from highest earnings yield and highest return on capital to lowest. From this point on, one would focus on the top 20 to 30 companies when choosing how to invest.

5. Start Building Your Portfolio

Greenblatt suggests buying the stocks that rank in that top 20-30 list on a rolling basis. For instance, an investor may consider buying two to three positions per month for one year, eventually owning 24 to 36 of the top ranking companies. According to Greenblatt’s formula, owning at least 20 different companies will help to maintain diversification.

At the end of the 12-month period, the Magic Formula dictates that investors would sell off the losing stocks and the winners, being mindful of capital gains taxes rules. Then they’d start the cycle over again, using the Magic Formula rules to select a new crop of stocks to invest in.

Holding stocks for a year before selling at a gain or loss is intended to help maximize potential after-tax returns. When you sell stocks at a profit that you’ve held longer than one year you’d be subject to the more favorable long-term capital gains tax rate.


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Magic Formula Investing Results

Any time one is considering an investment strategy, it’s important to understand how it works and how it aligns with your goals and risk tolerance. Greenblatt’s approach is intended to help investors choose companies whose performance can potentially beat the market. Magic Formula is considered to be a tool for long-term investors seeking a disciplined, value-oriented strategy and has historically demonstrated strong outperformance of markets such as the S&P 500.

There’s no guarantee, however, that investors will see a positive return utilizing the strategy for any given year and, as with any investing strategy, there is also the risk of seeing losses.

Whether investors can replicate those Magic Formula Investing results for themselves can depend on different variables. For example, an individual portfolio may produce a very different return profile if an investor adjusts the market capitalization threshold up or down. Or if a company has an above-average year for revenue and profits, that could affect how the ranking calculations shake out.

Pros and Cons of Magic Formula Investing

The main idea behind the Magic Formula method is that it may be an option for even beginner investors to use. The idea is that by following the formula, an investor can eliminate some of the noise when making investment decisions.

That includes not giving in to investment biases that could prompt an investor to buy or sell at the wrong time. By focusing on the rankings and sticking with a one-year rolling schedule of buying and then selling, an investor can potentially remove their emotions from the equation. This can help avoid selling off stocks in a panic if the market becomes more volatile.

Downsides of Magic Formula Investing

While this formula can help an investor create a diversified portfolio, it’s still exclusionary in that it doesn’t include investing in foreign companies or companies in the financials and utilities sectors.

Beyond that, there’s no certainty that an investor will see positive results in the form of above-average returns — as noted. Greenblatt himself says that there’s nothing “magical” about the formula and that it shouldn’t be considered a guarantee of investment returns or performance. As with any investing strategy, it isn’t foolproof.

Finally, the Magic Formula Investing strategy is meant to be a long-term one. For investors more interested in seeing quick results versus adopting a buy and hold mindset, day trading might be an option to consider, though it is higher-risk.

The Takeaway

Hedge fund manager and professor Joel Greenblatt devised his Magic Formula Investing strategy as a way to invest in a curated group of good companies with high potential for returns. The system ranks companies according to three criteria: earnings before interest and taxes (EBIT), earnings per share, and return on capital. The system is intended for anyone from first-time investors to more seasoned investors.

But as with any investment strategy, there is no guarantee that the magic formula investing results will be positive every time. There is a potential for both gains and losses.

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FAQ

What is the Magic Formula Investing strategy’s formula?

Magic Formula Investing is a strategy to choose specific stocks, and it utilizes a ranking system, developed by Joel Greenblatt, that uses three distinct criteria to rank companies: Earnings before interest and taxes (EBIT), earnings per share, and return on capital.

What returns does the Magic Formula Investing method supply?

The Magic Formula was designed to help investors outperform the market over a long period of time. But depending on the specifics of an investor’s portfolio, returns can vary wildly, and it’s possible the strategy could lead to losses as well.

What is the “magic” in Magic Formula Investing?

Magic Formula Investing is a stock-screening method used to identify companies that might be undervalued. Unfortunately, there is no magic in the formula or strategy, and there’s no guarantee that it will yield returns for investors.

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