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Does the Magic Formula Really Work?

May 22, 2013 | About:
Magic.

That’s what you need to beat the market and that’s what the Magic Formula is supposed to do.

As a result of brilliant marketing, promotion and becoming a New York Times bestseller in 2005, Joel Greenblatt has turned the Magic Formula into a key strategy for many in the value investing and mechanical investing community.

Buy at least 20 stocks from the Magic Formula screening tool and then rebalance at the end of the year. Do this and you will beat the market, the book says.

The Little Book that Beats the Market

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Greenblatt wrote "The Little Book That Beats the Market" for his children who were aged between 6 and 15 at the time.

It’s written in plain English and 6th grade math to make it easy to follow along. This is the strong point of the Magic Formula theme.

Everything is very easy to understand. The concept is simple, the explanation is simple, but most important of all, the execution for investors is simple enough to do on their own.

In its most naked form, the Magic Formula is described by Greenblatt as:
"A long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices."

The Ingredients to the Magic Formula

Here is the formula courtesy of Wikipedia. From beginning to end, it consists of nine steps.

1. Establish a minimum market capitalization (usually greater than $50 million).

2. Exclude utility and financial stocks

3. Exclude foreign companies (American Depositary Receipts)

4. Determine company’s earnings yield = EBIT / enterprise value.

5. Determine company’s return on capital = ebit / (net fixed assets + working capital)

6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).

7. Invest in 20 to 30 highest ranked companies, accumulating two to three positions per month over a 12-month period.

8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.

9. Continue over a long-term (three- to five-year) period.

Pay close attention to step 4 and 5 because they are the key driving formulas for it all to work.

  • Earnings Yield = EBIT / Enterprise Value
  • Return on Capital = EBIT / (Net Fixed Assets + Working Capital)
Earnings yield is used because it targets companies with below-average prices. The idea behind of return on capital is to select good companies that are outperforming. This fits in line with what Greenblatt said:
"A long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices."

The Magical Performance

So how magic is this Magic Formula in terms of performance? This table of values is from the revised 2010 version of the book.

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And a better representation.

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Starting with $10,000, the Magic Formula would have made you a millionaire by 2009.

The Magic Formula is famous for returning a 30% CAGR. From 1988 to 2004, it did achieve a 30.8% return, but the CAGR has declined significantly. No strategy can sustain a CAGR of 30%. Although the backtest in the book only provides data up to 2009, I wouldn’t count on 2010 to 2012 results showing vast out-performance.

The Magic Formula Is a Fraud?

By popular demand, the Magic Formula will soon be added to the list of value stock screens, but the one thing that has held it back is the reliability of the backtest performed by Greenblatt.

I just don’t believe the results are as good as they seem.

What’s more, other blogs have tried to simulate the Magic Formula performance from the book, but none of them have come close.

Backtesting the Magic Formula Using Portfolio123

Portfolio123 has a very good predefined Magic Formula screen which I’m going to use for some more numbers and graphs.

Although the screen uses the same fundamental formula and tries to follow the Little Book, it ends up being slightly different from Greenblatt’s version.

Here is how the screen is constructed.

  • No OTC stocks
  • No ADR’s
  • No financial companies
  • No utilities
  • No real estate companies
  • Market cap greater than $50m
  • 5 year average of ROI ranks in the top 35%
  • Slippage of 2%
  • Carry cost of 1%
  • 100% long
  • Stocks selected based on ranking of Earnings Yield = EBIT / Enterprise Value and Return on Capital = EBIT / (Net Fixed Assets + Working Capital)
To try and compare apples to apples, data from 1999 to 2009 is used as the data only goes back as far as 1999, and 2009 is the latest year provided in Greenblatt’s Book.

(click to enlarge)

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Although the backtest version kills the market over the same period, it doesn’t match or beat the Greenblatt version.

However, if I adjust the slippage to 0%, it comes awfully close. CAGR over the same period then becomes 17.33%, which is oh-so-close to the original 18.57%.

But I’m willing to bet that the original formula does not include factors such as fees and slippage in the results. If it did, it would fall to a level similar to my backtested results.

Either way, there goes my earlier comment about not believing in the results.

Sure it’s not the 30% or higher CAGR that Greenblatt wrote about in the book, but there is magic in the air.

Additional Links

About the author:

Jae Jun
Founder of Old School Value (http://www.oldschoolvalue.com) dedicated to offering the most complete and detailed stock valuation and analysis spreadsheet. Investing made easy by importing 10 years of financials and 5 quarterly statements directly to excel for your analysis needs. Save time, make smarter decisions and make more money.

Visit Jae Jun's Website


Rating: 3.7/5 (23 votes)

Comments

haoafu
Haoafu - 1 year ago
I simplified it to use normalized free cash flow and stick to companies I understand. I don't always use high ROI as long as I'm confident the company is excellant with moat.

Basically I tried to pick good companies at cheap price, and the result is satisfactory to some extent. But I doubt it can work consistently at 30% CAGR over long period of time - this is beyond legendary status.
Matthew Dow
Matthew Dow - 1 year ago
He included $50m and above only.
Stephen Neumeier
Stephen Neumeier premium member - 1 year ago
I think it would be helpful to see a scatterplot chart of all the possible portfolios that can be created using the Magic Formula instead of the average return of all the possible portfolios.

We could then see the best case and worst case scenarios and see if the results are clustered around the average.

Please leave your comment:


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