What Is Magic Formula Investing?

Magic formula investing refers to a rules-based, disciplined investing strategy that teaches people a relatively simple and easy-to-understand method for value investing. It relies on quantitative screens of companies and stocks, and is designed to beat the stock market's average annual returns using the S&P 500 to represent the market return. Put simply, it works by ranking stocks based on their price and returns on capital.

Magic formula investing tells you how to approach value investing from a methodical and unemotional perspective. Developed by Joel Greenblatt—an investor, hedge fund manager, and business professor—the formula applies to large-cap stocks but doesn't include any small or micro-cap companies.

Understanding Magic Formula Investing

The magic formula strategy was first described in the 2005 best-selling book The Little Book That Beats the Market and in the 2010 follow-up, The Little Book That Still Beats the Market by investor Joel Greenblatt. Greenblatt, founder and former fund manager at Gotham Asset Management, is a graduate of the Wharton School at the University of Pennsylvania. He is an adjunct professor at Columbia University's business school.

In the book, Greenblatt outlines two criteria for stock investing: Stock price and company cost of capital. Instead of conducting fundamental analysis of companies and stocks, investors use Greenblatt's online stock screener tool to select the 30 to 50 top-ranked companies in which to invest. Company rankings are based on:

• Their stock's earnings which are calculated as earnings before interest and taxes (EBIT).
• Their yield, calculated as earnings per share (EPS) divided by the current stock price.
• Their return on capital measures how efficiently they generate earnings from their assets.

Investors who use the strategy sell the losing stocks before they have held them for one year to take advantage of the income tax provision that allows investors to use losses to offset their gains. They sell the winning stocks after the one-year mark, in order to take advantage of reduced income tax rates on long-term capital gains. Then they start the process all over again.

As Greenblatt stated in a 2006 interview with Barron's, the magic formula is designed to help investors with “buying good companies, on average, at cheap prices, on average.” Using this straightforward, non-emotional approach, investors screen for companies that are good prospects from a value investing perspective.

Requirements for Magic Formula Investing

Since Greenblatt’s magic formula only applies to companies with market capitalizations greater than $50 million, it excludes small-cap stocks. The remainder will all be large companies but excludes financial companies, utility companies, and non-U.S. companies.

The following points outline how the formula works:

1. Set a minimum market capitalization for your portfolio companies. This should be typically higher than $100 million.
2. Ensure you exclude any financial or utility stocks when you choose your companies.
3. Exclude American Depository Receipts (ADRs). These are stocks in foreign companies.
4. Calculate each company's earnings yield (EBIT ÷ Enterprise Value).
5. Calculate each company's return on capital [EBIT ÷ (Net Fixed Assets + Working Capital)].
6. Rank selected companies by highest earnings yields and highest return on capital.
7. Buy two to three positions each month in the top 20 to 30 companies, over the course of a year.
8. Each year, rebalance the portfolio by selling off losers one week before the year term ends. Sell off winners one week after the year mark.
9. Repeat the process each year for a minimum of five to 10 years or more.

According to Greenblatt, his magic formula investing strategy has generated annual returns of 30%. Though they differ in their calculation of returns from the strategy, a number of independent researchers have found that the magical formula investing approach has appeared to show good results when backtested compared to the S&P 500.

Advantages and Disadvantages of Magic Formula Investing

The main advantage of the magic formula method is its simplicity: you don't need to be a trained investment specialist or Wall Street prodigy to invest effectively. All it takes is a few simple rules to find a basket of reliable investments. It also reduces emotional or irrational decision-making. However, contrary to its name, there's nothing magical about the magic formula, and it may not always be the best strategy. Some market tests of the formula have found lower-than-expected returns, possibly due to changing market dynamics or the increased number of investors following Greenblatt's method. In addition, some analysts to have improved the method by introducing additional variables, such as debt/equity ratios or dividend yields.

The Bottom Line

The magic formula is a simple, rules-based system designed to bring high returns within reach of the average investor. By following a simple, algorithmic approach, the magic formula allows investors to easily identify outperforming or undervalued companies, without letting emotions or instinct cloud their judgment. While returns are now far lower than when the magic formula was first published, the method can still beat the market, especially with a few modifications.

Correction—Feb, 1, 2023: A previous version of this article incorrectly stated the market capitalization and the number of companies investors can select in Greenblatt’s online stock screener. It has been edited to reflect that the market capitalization starts at $50 million and investors can select 30 to 50 companies.