Magic Formula

What is the Magic Formula?

The Magic Formula is a value investing strategy developed by Joel Greenblatt, a professor at Columbia Business School and successful hedge fund manager. He introduced the strategy in his book The Little Book That Still Beats the Market, where he outlines a systematic approach to identifying stocks that have a good chance of delivering market-beating returns.

The Magic Formula is built on the principles of Benjamin Graham, one of the founding fathers of value investing. The core idea is to identify stocks that are trading at bargain prices relative to their peers while also demonstrating strong business quality. Rather than relying on complex analysis, the formula uses just two quantitative metrics to rank stocks:

• Earnings Yield: A measure of how much earnings a company generates relative to its enterprise value. The higher the earnings yield, the cheaper the stock is relative to its earning power. This is similar in concept to the inverse of the PE ratio but uses enterprise value instead of market cap.
• Return on Capital (ROC): A measure of how efficiently a company uses its capital to generate profits, similar to Return on Capital Employed (ROCE) and Return on Invested Capital (ROIC). The higher the ROC, the better the company is at converting capital into earnings.

The Magic Formula ranks all eligible stocks by both metrics and then combines the rankings to identify companies that score well on both dimensions—stocks that are both cheap and high-quality.

How to Use the Magic Formula

The Magic Formula strategy is relatively simple to implement:

Step 1: Screen and rank stocks. Rank all eligible stocks by their earnings yield (highest to lowest) and by their return on capital (highest to lowest). Each stock receives a rank for each metric.

Step 2: Combine rankings. Add the two rankings together for each stock. The stocks with the lowest combined rank (meaning they score well on both metrics) are the top Magic Formula picks.

Step 3: Build a portfolio. Select the top 20-30 ranked stocks and invest equally in each. Joel Greenblatt recommends buying 5-7 stocks every few months to build up to a full portfolio of 20-30 positions over the course of a year.

Step 4: Rebalance annually. After holding each position for one year, sell it and replace it with the next highest-ranked stock. For tax purposes in the US, Greenblatt suggests selling winners just after the one-year mark (to qualify for long-term capital gains) and losers just before (to claim short-term losses).

Joel Greenblatt even provides a website with a screening and ranking system to help investors find stocks that meet the criteria.

Once you have your list, you can refine it further by examining the company's financial statements, checking its debt-to-equity ratio, and reviewing other financial ratios to confirm the fundamentals support the ranking.

Does the Magic Formula Work?

Multiple academic studies and backtests have examined the performance of the Magic Formula across different markets and time periods:

The evidence from these studies suggests that the Magic Formula has historically outperformed the market across many different regions and time periods. Key findings include:

• The strategy delivered consistent outperformance in US markets over Greenblatt's original study period
• Academic research has validated the strategy across Nordic markets, the Indian stock exchange, and European markets
• The combination of value (earnings yield) and quality (return on capital) factors has been one of the most robust factor combinations in financial research

However, results vary depending on the region, time period, and number of stocks included in the portfolio. The Magic Formula can significantly underperform during certain periods (sometimes for several years), requiring patience and discipline.

Here is an overview of the Magic Formula (MF) return versus the market, also compared with some modified Magic Formulas (source: Magic Formula vs. Traditional Value Investment Strategies):

Why Does the Magic Formula Work?

The Magic Formula works because it systematically exploits two well-documented factors in financial markets:

The value factor: Stocks that are cheap relative to their fundamentals (high earnings yield) tend to outperform expensive stocks over time. This is because the market often overreacts to short-term bad news, pushing prices below fair value and creating buying opportunities.

The quality factor: Companies that generate high returns on capital tend to have durable competitive advantages, or economic moats. These businesses can reinvest their profits at high rates, compounding wealth for shareholders more effectively than average companies.

By combining both factors, the Magic Formula avoids a common trap in value investing: buying stocks that are cheap for good reason (so-called value traps). The return on capital filter ensures that the cheap stocks selected are also genuinely high-quality businesses.

Magic Formula vs Other Value Strategies

The Magic Formula differs from other value investing strategies in its simplicity and dual-factor approach:

• Pure value strategies (like buying the lowest PE ratio stocks) focus only on cheapness without considering business quality. This can lead to portfolios full of struggling companies with declining earnings.
• Quality strategies (like buying the highest ROE stocks) focus only on business quality without considering valuation. This can lead to buying excellent companies at inflated prices.
• The Magic Formula combines both, seeking companies that are both cheap (high earnings yield) and high quality (high return on capital). This dual filter has historically produced better risk-adjusted returns than either factor alone.

Other popular systematic strategies like the Z-Score or PEG ratio screening address different aspects of stock selection. The Magic Formula's strength is its elegant simplicity: just two ratios, transparently calculated, with clear rules for portfolio construction and rebalancing.

Limitations of the Magic Formula

Despite its strong track record, the Magic Formula has important limitations:

• Extended underperformance: The strategy can lag the market for two to three years at a time, which tests investor patience and conviction. Many investors abandon the strategy during drawdowns, missing the subsequent recovery.
• Sector concentration: The ranking system may favor certain sectors at different times, leading to portfolios that are heavily concentrated in specific industries.
• Simplicity trade-off: By using only two metrics, the formula ignores other important factors such as debt levels, management quality, competitive dynamics, and growth prospects.
• Transaction costs: Annual rebalancing of 20-30 positions generates significant trading activity, which can erode returns through commissions and tax implications.
• Accounting quirks: Earnings yield and return on capital can be distorted by one-time items, accounting differences, or cyclical factors, leading to misleading rankings.

For these reasons, many investors use the Magic Formula as a starting point for further research rather than as a fully automated strategy. Combining the formula's quantitative ranking with qualitative analysis of each company's intrinsic value and competitive position can improve results.