Magic formula investing is an investment technique outlined by Joel Greenblatt that uses the principles of value investing.
Greenblatt suggests purchasing 30 “good companies”: cheap stocks with a high earnings yield and a high return on capital. He touts the success of his magic formula in his book ‘The Little Book that Beats the Market’ citing that it does, in fact, beat the S&P 500 96% of the time, and has averaged a 17-year annual return of 30.8%.
Greenblatt does not disclose all the necessary details on his implementation, but we assume he achieved such astounding returns by investing in micro-caps and equal-weighting the holdings. In their book “Quantitative Value”, Tobias Carlisle and Wes Grey re-create the Magic Formula but using larger cap stocks and value-weighting the portfolio holdings. They confirm that the Magic Formula beat the market over time, but have not been able to reach Greenblatt’s returns.
Formula:
- Establish a minimum market capitalization (usually greater than $50 million).
- Exclude utility and financial stocks.
- Exclude foreign companies (American Depositary Receipts).
- Determine company’s earnings yield = EBIT / enterprise value.
- Determine company’s return on capital = EBIT / (net fixed assets + working capital).
- Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
- Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
- Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
Continue over a long-term (5–10+ year) period.
The Magic Formula stocks are available for free in Joel Greenblatt’s website, MagicFormulaInvesting.com. In the table below, we copied the top 50 Magic Formula stocks from that website, and broken the magic formula rank into its two components:
- The Quality Rank: EBIT/(net fixed assets + working capital)
- The Valuation Rank: EBIT / enterprise value
The higher the ranks, the better,
Our screener can be helpful as a starting point for stock research. Investors can sort stocks based on their Quality or Valuation or combined Quality and Valuation (the MF Rank).
Magic Formula Stocks with Market Cap of $200M and above
The Terms in the table are defined in the Glossary.