Magic Formula Investing: How to Use It

Looking for a simple way to find undervalued stocks with strong growth potential? 

Magic formula investing, created by Joel Greenblatt, offers an easy-to-follow strategy for identifying companies that are both profitable and attractively priced. By focusing on businesses with high earnings yield and strong returns on capital, this method helps investors filter out weaker options and zero in on quality stocks. 

Introduced in Greenblatt’s book The Little Book That Still Beats the Market, the magic formula provides a clear, systematic approach to building a winning portfolio, making it a practical tool for those looking to outperform the market.

Decoding Magic Formula Investing 

Magic formula investing uses a set of specific criteria to evaluate and rank companies based on those criteria, in hopes of finding companies that are undervalued, but still show solid financial performance. For this strategy, two key metrics are used which are Earnings Before Interest and Taxes (EBIT) and Return on Capital Employed (ROCE).

EBIT is a company’s profitability before adding interest and taxes and helps provide a greater understanding of its operating performance. Focusing on EBIT means that the formula does not account for distortions to the company’s earning power arising from financial leverage or tax considerations. This is especially important when you want to sieve out companies that may look profitable on the surface but are loaded with debt.

Another is Return on Capital Employed (ROCE). This measures how efficiently a company is using its capital to generate returns. A high ROCE means the business is doing best with its resources and making good use of them, which is a sign of operational efficiency. ROCE measures how well a company converts investments into profits, and companies with higher ROCE are considered attractive long-term value candidates.

Together, these metrics are a means of ranking companies by their earnings yield and return on capital. The magic formula is a combination of both profitability (EBIT) and efficiency (ROCE) that shrinks the universe of possible stocks to those that are profitable and efficient, and could achieve very good returns. This is a systematic approach that allows only profitable and capital efficient companies into the portfolio in line with value investing principles. 

Step-by-Step Guide to the Magic Formula Process

The magic formula simply takes a clear process to identify undervalued companies with strong financial performance. First, it sets a minimum market capitalization (often $50 million) to weed out smaller, more volatile firms in favor of more established businesses with sufficient liquidity. The threshold can be set based on the investor’s risk tolerance and focus on the market.

Second, some industries (e.g. financials, utilities) are excluded since their different regulatory and capital structures could distort the effectiveness of the formula. This allows the strategy to focus on operational efficiency, as opposed to external factors particular to these sectors.

After filtering by market cap and industry, companies are ranked based on two critical metrics: Return on capital and earnings yield. Earnings yield is a profitability measure calculated as EBIT divided by enterprise value, which tells us how much we’re getting for our money. Return on capital is a measure of how well the company uses its assets to earn a profit. These metrics are ranked separately for each company and the resulting rankings are combined to produce a final list of top performing businesses.

The rankings are complete and the investor selects the 20-30 highest ranked stocks to build a portfolio. It offers enough diversification to keep the downside risks at bay, while keeping the strategy of the formula focused. The portfolio is rebalanced on an annual basis, replacing underperforming stocks with new ranked opportunities in order for the portfolio to remain in line with the formula’s principles. Additionally, this annual review allows investors to take advantage of new undervalued stocks as they come into view with the changing market conditions to ensure that the strategy remains as relevant and adaptable as possible. 

Eligibility and Stock Selection Criteria 

The magic formula strategy uses criteria to pick stocks that fit the value investing principles. Market capitalization is an essential requirement, with a typical minimum of $50 million, but some investors modify this concerning their risk tolerance. Focusing on larger companies reduces volatility, and there is sufficient liquidity to buy or sell positions.

The strategy also excludes certain industries, including financials, utilities and real estate, because of their distinct regulatory environments and capital intensive structure. These factors can distort key metrics such as earnings and return on capital. Excluding such sectors allows the magic formula to concentrate on sectors that are driven by operational performance rather than by regulatory or structural influences on profitability.

In short, stocks must be of the right size, financially sound, and in the right industry to qualify. The strategy is designed to keep these filters in place to ensure that the strategy focuses on finding companies that have strong operational efficiency and a high value potential. 

Analyzing the Effectiveness of Magic Formula Investing 

Magic formula investing has achieved strong long term performance, frequently outperforming the broader market benchmarks such as the S&P 500. Joel Greenblatt’s research demonstrates that the formula produced annual returns of about 30 percent over a 17 year period, far greater than the S&P 500’s average return of about 10 percent over this same period. These results show that if applied consistently, the formula could produce higher returns.

The strategy usually performs well in bull markets and in recovery phases as undervalued stocks usually rebound sharply. While it works, however, its effectiveness wanes in bear markets or prolonged down cycles, when value stocks may stay depressed for longer than anticipated. Due to this, magic formula investing is more suited towards long term investors, as short term market volatility can result in periods of underperformance.

The magic formula stands out because it is simple and systematic about value investing. Unlike other value strategies that rely on subjective analysis, it focuses on two clear metrics: Capital return and earnings yield. In doing so, investors do not need to do extensive research or have any expertise to identify high quality undervalued stocks. Its effectiveness, however, depends on market cycles, and it needs discipline to stick to it through the difficult periods.

The magic formula is a relatively straightforward way to take advantage of value opportunities compared with other strategies like growth investing or passive index tracking. But it’s not a one-size-fits-all solution, and investors need to be committed to the strategy’s principles, even when market conditions are challenging the strategy’s short-term performance. 

Comparative Analysis with Other Investment Strategies

The magic formula differs from other value and growth investing in its simplicity and systematic approach. While value investing typically involves analyzing metrics like price-to-earnings (P/E) ratios, price-to-book (P/B) ratios, or intrinsic value, the magic formula focuses solely on two metrics: The two measures of return are return on capital (ROC) and earnings yield. This streamlined approach enables investors to spot undervalued stocks without having to go through the rigors of fundamental analysis.

While growth investors focus on companies that have great future earnings potential, the magic formula looks for companies with great current value and profitability. Stocks that growth investors expect to grow earnings, revenue, or market share rapidly usually have higher P/E ratios and more volatility, because growth investors often pay a premium for stocks. On the other hand, the magic formula looks for companies that are already making good returns on capital, but are undervalued (based on low earnings yields), providing a value angle.

The magic formula is one of the most simple methods out there. Value and growth strategies are generally time consuming and require significant research, analysis of market conditions and subjective judgment. The magic formula automates much of the stock selection process by using a mechanical ranking system, making it available to individual investors who don’t have the resources or expertise to do detailed analysis. Yet this simplicity can be a disadvantage, as it fails to take into account some qualitative elements that conventional strategies do include, for example, industry trends, management quality, or innovation.

The magic formula is, at its core, a structured middle ground between value investing principles and a mechanical process. It offers a practical solution for investors who want to be somewhere in between very analytically based strategies and more passive, hands off strategies. 

Practical Considerations for Investors 

Portfolio diversification and risk management are key when implementing magic formula investing. The strategy makes stock selection easier, but it can also result in the portfolio being overly concentrated in certain sectors, and thus susceptible to sector specific down turns. For example, in 2015 the energy sector was hit hard with declines as a result of plummeting oil prices that hit investors heavily invested in the energy sector hard. To help offset such risks, make sure your portfolio includes stocks from different industries, which will help diversify your exposure.

Another key aspect is rebalancing. The magic formula recommends an annual rebalancing of the portfolio to reflect the latest rankings of companies by earnings yield and return on capital. The portfolio is adjusted to reflect changes in market valuations, financial performance, and price action through regular rebalancing. Excessive trading, however, can raise the cost of transactions and diminish overall returns. Keeping to a disciplined, long-term approach reduces these costs and keeps the strategy intact.

The need for risk management is still there. The magic formula finds undervalued stocks, but it doesn’t eliminate the risk of a bad economy or company. For instance, several retail companies had poor stock performance in 2016 as a result of a shift in consumer behavior toward e-commerce. 

As such, use the formula as part of a larger investment strategy. Protect yourself from surprises in your portfolio by monitoring market conditions and individual stock risks, such as falling financial health or industry disruptions. Sound risk management and diversification practices, combined with the magic formula, can help increase stability and long-term results.

The Upsides of Using Magic Formula Investing

Magic formula investing has a lot of advantages for individual investors looking for a simple value investing approach. That simplicity is one of its greatest strengths. The formula, developed by Joel Greenblatt, uses earnings yield and return on capital, as the selection criteria of stocks, thereby removing the emotional biases from the process of selecting stocks, which otherwise result in poor investment decisions. This is accessible even to beginners with no experience.

The stock selection is consistent because the strategy is systematic. It does this by looking at metrics such as Earnings before Interest and Taxes (EBIT) and Return on Capital Employed (ROCE) to find undervalued companies with solid fundamentals. This approach increases the likelihood of finding stocks trading below their intrinsic value, while minimizing overpayment driven by extrinsic value factors like market sentiment. This makes it a powerful tool for value-focused investors.

One of its biggest advantages is its long-term orientation. The magic formula is designed for annual rebalancing and holding positions for a long time, which is what investors want to build wealth slowly over time. It also reduces the need for frequent trading and helps investors avoid the pitfalls of market timing, which makes it easier to remain disciplined in volatile market conditions.

Secondly, the formula provides a structured means to capture market inefficiencies. The strategy consistently applies its criteria to uncover opportunities that traditional or momentum-driven approaches may overlook. This allows individual investors to benefit from a proven investment framework, offering a practical and disciplined way to handle an actively managed portfolio without requiring extensive financial knowledge or complex analysis.

Potential Pitfalls of Magic Formula Investing

Magic formula investing is a systematic approach, but it is not without its limitations and risks. The problem is that it depends on proprietary metrics such as earnings yield and return on capital, which don’t capture everything there is to know about a company’s financial health. However, in some market conditions, these metrics can ignore the bigger economic picture, or the changing outlook for the company, and send investors into attractive stocks that are actually hiding risk.

The formula also underperforms in short term or highly volatile markets. It was designed for long term use, but it can struggle when the economy is down or the market is extremely volatile. In periods of further decline in stocks identified as undervalued, the strategy’s ability to produce profitable investments is diminished.

Another limitation is excluding qualitative factors such as management quality, industry trends, or competitive advantages. Therefore, the formula can choose companies with great metrics but significant long-term problems that don’t show up in the numbers.

Finally, the strategy can lead to sector concentration, increasing risk if many portfolio stocks are in similar industries. This can hurt performance if the sector underperforms. To address this, investors should complement the magic formula with other research, diversify across sectors, and use tools like trade alerts to monitor market and sector conditions, enhancing risk management.

Conclusion

Magic formula investing provides a simple, systematic method of locating undervalued stocks using certain financial metrics. Joel Greenblatt created this strategy to enable individual investors to follow a disciplined, rules-based process for building a portfolio. The magic formula narrows down the selection process to companies with high earnings yield and high return on capital.

Like any strategy, however, it’s important to understand its limitations. The formula can be effective in some market conditions but may struggle in highly volatile markets or when used without additional qualitative analysis. Investors should never forget the broader context and must not make investment decisions only based on the formula.

Magic formula investing can be incorporated into a broader, diversified strategy to help improve the risk and reward profile. Used with proper care and consideration of market conditions, the magic formula can be a valuable tool for long term portfolio growth. 

Decoding Magic Formula Investing: FAQs

How Often Should I Rebalance My Portfolio When Using Magic Formula Investing?

The standard advice is to rebalance annually by selling stocks held for a year and replacing them with new picks, according to the formula’s latest ranking. Annual rebalancing captures fresh opportunities and manages risk. Quarterly rebalancing is possible, but it will likely result in more frequent transactions and, therefore, higher transaction costs and taxes.

Is Magic Formula Investing Suitable for All Types of Investors?

Long-term value investors with moderate risk tolerance should use magic formula investing. The strategy’s simplicity makes it accessible to individual investors who want a systematic, rules-based approach. Yet, this strategy may not be ideal for conservative investors or those looking for short-term gains, as it requires patience and commitment during market volatility.

How Does the Magic Formula Handle Downturns in the Stock Market?

Value stocks can be more volatile in bear markets and therefore magic formula investing may underperform in downturns. Nevertheless, its concentration on top quality, mispriced companies can set up portfolios to rebound faster in market rallies. Short term volatility should be expected and investors should stick to the strategy’s long term approach.

Can Magic Formula Investing Be Applied to International Stocks?

If you can get data like earnings yield and return on capital, the strategy works for international stocks too. When applying the formula globally, investors should also take into account differences in market conditions, regulations, and currency fluctuations.

What Tools Can Help an Investor Implement the Magic Formula?

There are tools like the official magic formula website, which pre-screens stock lists according to the strategy. Stock screeners, portfolio management software, and brokerage tools themselves are financial platforms that can help you track, select, and rebalance stocks in accordance with the formula.