How Does Magic Formula Investing Work?

December 17, 2020 · 7 minute read

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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”, this strategy takes a simplified approach to choosing investments that virtually any investor can apply. It draws on principles of value investing to create portfolios with the potential to outperform the market.

What Is Magic Formula Investing?

At its core, Greenblatt’s magic investing formula is all about finding good companies to invest in that are trading at attractive prices. Specifically, this strategy focuses on two things:

•  Stock price
•  Cost of capital

The magic formula helps investors pinpoint companies that are undervalued by the market and are likely to 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 typically follow a buy and hold strategy, in which securities are purchased at a discount 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 uses 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 with 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.

What Is the Magic Investing Formula?

Screening stocks using the magic formula method is based on the idea of 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, and 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 Earnings Per Share 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 the best quality companies at the best price.

How Magic Formula Investing Works

For investors interested in using the magic investing formula to 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.

For 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 minimize volatility.

2. Exclude Certain Securities

In magic formula investing, an investor next needs to 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 where 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 would buy 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 your 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.

Magic Formula Investing Results

Any time one is considering an investment strategy, it’s important to look at how well it works when it comes to generating returns. Greenblatt’s approach is intended to help investors choose companies whose performance can potentially beat the market. And according to him, it has helped generate a 30% annual rate of return for investors who use the strategy, which is well above the typical return generated by the S&P 500.

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’s a simple enough strategy for even beginner investors to use. In other words, one doesn’t need to be an investment guru to see magic formula investing results. The idea is that by following the formula, an investor can eliminate some of the white 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 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 magic formula investing results in the form of above-average returns. 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 more appropriate.

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.

His system ranks companies according to three criteria: earnings before interest and taxes (EBIT), earnings per share, and return on capital. The system is simple enough that it’s 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.

For investors looking for a low cost online brokerage, SoFi offers a platform and resources to help members build a portfolio using the magic formula or any other investing approach without sacrificing part of your returns to high fees.

Find out how to open a SoFi Invest account today.

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