Magic Formula Investing

Magic formula investing is a very stringent method for value investing. Made popular by Joel Greenblatt, the magic formula is a combination of valuation metrics to find good stocks.

How the Magic Formula Works

The Magic Formula described by Joel Greenblatt looks for undervalued companies based on earnings yield and returns on capital.

Here are the steps to implement this strategy:

1. Throw out the tiniest of companies. The market cap requirement is up to the individual, though many throw out all companies with market caps of less than $100 million.
2. Throw out utilities, financial companies, and foreign companies listed on American stock exchanges. Utilities, financial firms, and international companies have their own unique risks. Utilities offer high earnings yields with minimal growth but with high and irregular capital expenditures. Financial firms use substantial leverage.
3. Calculate an earnings yield. Greenblatt uses EBIT divided by enterprise value.
4. Calculate a return on capital rate for all companies. Return on capital is simply EBIT divided by the sum of net fixed assets plus working capital.
5. Rank all companies by highest earnings yield and return on capital.

Portfolio Selection

Joel Greenblatt suggests that investors should pick 2-3 new companies each month for a 12-month period to eventually build a portfolio of 24-36 companies. These companies should be sold at the end of the rolling 12-month period; ideally you would sell one day after a full year has lapsed, so as to maximize the benefit by holding long enough to enter the long-term capital gains tax requirements.

Rolling positions monthly removes some market timing influence on total returns. Because you’re buying new positions each month, you’re adding to your portfolio twelve times per year, which gives you positions at any price for the total market. In effect, you remove the chance that you pick great stocks, but purchase them at the worst time.

Backtested results tend to vary based on who you ask. Joel Greenblatt said in the Little Book that Beats the Market that investors who used the strategy would earn a compound annual return of30.8% from 1988 to 2004 versus a 12.4% return for the S&P500. Others show a much smaller edge for the Magic Formula strategy over the market because of practical liquidity issues and more restrictive, large market cap requirements.

The difference comes down to market capitalization. As the minimum market capitalization is pushed down to smaller and smaller companies, the returns increase substantially.

Is It a Workable Strategy?

I do think so. Screening for companies based on earnings yield and return on capital is a great way to find undervalued securities that are simply selling for prices much lower than what you would expect given a company’s underlying fundamentals.

I use a similar method to find undervalued companies, but unlike Greenblatt, I don’t purchase all of the names that appear in the results from a stock screener. Instead, I use it as a starting point and begin to remove companies that are “cheap for a reason,” so to speak.

Investors who do not want to dedicate time to managing the strategy themselves have a few choices. A brand of mutual funds by the name of Formula Investing uses several strategies similar to the Magic Formula to provide investors to hands-off Magic Formula investing. Joel Greenblatt manages the funds as an adviser.

The funds are still young, so history is thin. However, the purest form of the Magic Formula strategy can be found in the Formula Investing US Value Select A (FNSAX) fund, which in the nearly two years since inception, has beat the S&P500 index despite its hefty 1.35% annual expense. The fund is also ranked in the top 1% in its category at Mornigstar for the last year, a remarkable achievement.

But will outperformance be a regular thing for Formula Investing’s funds? I tend to think that it will. Searching for the best stocks by earnings yield and returns on capital is the most basic starting point in any value investing strategy – and it has been value investors that have most regularly beat the market averages.