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 tooland then rebalance at the end of the year. Do this and you will beat the market, the book says.
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:
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.
And a better representation.
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.
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.
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.
(click to enlarge)
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.
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 tooland 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
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)
"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.And a better representation.
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.
- Magic Formula that JUST beats the market
- Turnkey Analyst tests the Magic Formula
- Another article suggesting that the Magic Formula beats the market by 4.5%
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)
(click to enlarge)
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
- Gurufocus Magic Formula Newsletter and Screen
- Magic Formula White Paper
- Greenbackd analysis
