Magic Formula Investing
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, 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%
- Establish a minimum market capitalization (usually greater than $50 million).
- Exclude utility and financial stocks
- Exclude foreign companies (American Depositary Receipts)
- Determine company's earnings yield = EBIT / enterprise value.
- Determine company's return on capital = EBIT / (Net fixed assets + working capital)
- Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
- Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over a 12-month period.
- Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
- Continue over a long-term (3-5+ year) period.
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. 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; or Heely's (HLYS), which in the same period fell from $4.50 to $1.50, a 73% decline. If investors had picked these stocks, for example, their performance would have been significantly worse than the theoretical average of 30.8%. Thus timing when to buy, and which stocks, plays a role in the performance of the strategy.
- ^ The Little Book That Beats The Market, Joel Greenblatt ISBN 0-471-73306-7
- ^ Zen, Brian and Hamai, Garrett. "Joel Greenblatt Speaking at NYSSA". December 28, 2005.
- ^ a b c d The Best Magic Formula Stocks, Magic Diligence. Last accessed April 16, 2011.
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