Magic Formula Investing

Magic Formula Investing is a term that refers to an investment technique outlined by Joel Greenblatt that uses the principles of value investing.

Contents

Methodology

Greenblatt suggests purchasing 30 "good companies": cheap stocks with a high earnings yield and a high return on capital. He touts the success of his magic formula in his book The Little Book that Beats the Market,[1] citing that it does in fact beat the S&P 500 96% of the time, and has averaged a 17-year annual return of 30.8%[2]

Formula

  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 20-30 highest ranked companies, accumulating 2-3 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 (3-5+ year) period.

Risks

The 17-year annual return of 30.8% is a theoretical average based on purchasing all stocks that show up on the screen every year for 17 years.[3] In practice investors do not do this, rather accumulating 2-3 positions per month over a 12-month period. Historically many stocks that show up on the screen are duds, for example Crocs (CROX), a Magic Formula stock in early 2008 at $21, which subsequently dropped 94% over the next 12 months;[3] or Heely's (HLYS), which in the same period fell from $4.50 to $1.50, a 73% decline.[3] If investors had picked these stocks, for example, their performance would have been significantly worse than the theoretical average of 30.8%.[3] Thus timing when to buy, and which stocks, plays a role in the performance of the strategy.

References

  1. ^ The Little Book That Beats The Market, Joel Greenblatt ISBN 0-471-73306-7
  2. ^ Zen, Brian and Hamai, Garrett. "Joel Greenblatt Speaking at NYSSA". December 28, 2005.
  3. ^ a b c d The Best Magic Formula Stocks, Magic Diligence. Last accessed April 16, 2011.

External links


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