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An Intro to Magic Formula Investing

March 19, 2014 | About:

Over the coming years I will be covering Joel Greenblatt (Trades, Portfolio)’s “magic formula” and the stocks that come up on the magic formula screen. Since its inception in 2006 I have been fascinated that such a simple formula can truly make value investing a whole lot easier.

Since it has been a couple of years since "The Little Book That Beats the Market" has been released, chances are that “newer” value investors might not be familiar with it. So let’s start with the basics and what I hope to accomplish.

The basis of the magic formula comes from Joel Greenblatt (Trades, Portfolio)’s "The Little Book That Beats the Market"(2006) and its sequel "The Little Book That Beats STILL the Market" (2010). The book is a relatively short and entertaining read (as it was written for his children) and could be read in one sitting. But don’t underestimate the information in it. What Greenblatt does is takes Graham’s value investing principles and simplifies it. So what is the magic formula?

What Is the Magic Formula

The magic formula is a quant screen (similar to Gurufocus's magic formula screen) that identifies great companies selling at a discount. The process is simple. To identify great companies Greenblatt screens for companies with a high return on invested capital (ROIC). And to identify companies that are “cheap” Greenblatt uses the company’s earnings yield.

These two metrics are the core of the magic formula and will be something I will go into in further detail in upcoming articles. There are other details that Greenblatt goes into such as ranking the stocks, portfolio management, taxes and which sectors are not included in the magic formula. But for now, I want to focus on the core.

Who Is the Magic Formula Intended For?

The book was written for Greenblatt’s children but in my opinion it is intended for anyone interested in value investing or is looking for a simple process to beat the market over the long run. I say long run because many investors bailed on the magic formula as it underperformed several years following its release. Not to mention, many readers of the book probably thought the strategy was “too easy” and continued to look for the holy grail of investing elsewhere.

But trust me, the foundation of the book is solid and with patience and discipline, you can outperform the market. Which leads me the performance of the magic formula.

Magic formula Performance

Image credit oldschoolvalue.com

Why was the magic formula such a hit? In my view, it’s performance! The formula is simple, makes sense and could be applied immediately.

Wondering if 23% annual returns could be achieved, on June 2012 I decided to start a simulated fund on marketocracy.com. The portfolio selection was as follows.

  • Screen for the top 30 million to 50 million magic formula stocks.

    Screen for the top 30/ 50 million magic formula stocks

  • Allocate 3.33% per position.

    Allocate 3.33% per position

  • Sell all stocks on the last trading day of the year.

    Sell all stocks on the last trading day of the year

  • Run the screen again on the first trading day of the year.

    Run the screen again on the first trading day of the year.

How has this fund performed?

Extraordinary! So far, it has returned 30% on an annualized basis. Keep in mind, I did no security analysis whatsoever. I simply sold all stocks on the last trading day of the year and rebought on the first trading day and sat back. Granted, I missed the the crash of '08 and have been riding a baby bull market but hey, 29% per annum is not bad considering I have seen a number of value managers underperform the major indexes. This performance has made the fund rank in the top 98% of the funds for the year ending in 2013.

Building a Magic Formula Portfolio

In the coming years, it will be my goal to build a magic formula portfolio of 20 magic formula stocks. But because this will be a college fund, I will only invest in magic formula stocks with a market cap greater than $1 billion. My goal is to not only replicate the magic formula results, but to build wealth by slowly saving and investing. I do not need to do this “project” as I’m fine without it. But I see so many people stuck in a vicious cycle where every check earned is owed and not much is saved. But by saving just a little bit and investing it in undervalued securities, you will be amazed how fast money compounds.

"My wealth has come from a combination of living in America, some lucky genes, and compound interest." – Warren Buffett (Trades, Portfolio).

About the author:

Alex Garcia
Alejandro Garcia, B.S. Business Admin-Option in Finance, is a private value investor who uses his blog as a means to write about his experience with Joel Greenblatt's Magic Formula

Visit Alex Garcia's Website


Rating: 5.0/5 (4 votes)

Voters:

Comments

chompinchuck
Chompinchuck - 4 months ago

There are many of these type investment methods that use data to prove their superior returns. The most known is Value Line. Unfortunately actual investing using these themes hasn't worked - not for the Value Line fund or others.

Alex Garcia
Alex Garcia premium member - 4 months ago

Chuck,

I would disagree. Graham, Dreman, and a few others have done great work on portfolios with value characteristics (low P/E, low P/CF. low P/BV, etc..) tend to outperform the market over the long haul.

The key is having the disciplinie to stick with the strategy through the ups and downs

BEL-AIR
BEL-AIR - 4 months ago

I agree with the author, Alex Garcia , just check out aaii to see how well some screeners do..

http://www.aaii.com/stock-screens

SirDuke
SirDuke - 4 months ago

The Magic Formula uses EBIT in the numerator and Tangible Assets (Tangible Working Capital + Net Fixed Assets) in the denominator. It is therefore slightly technically flawed because numerator is the return AFTER debt holders have been paid but the denominator is financed from equity and debt.

So the Magic Formula should really use EBI - i.e. taxed EBIT also known as NOPAT (net operating profit after tax) - in the numerator.

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