Magic Formula Investing
Encyclopedia
Magic Formula Investing is a term that refers to an investment technique outlined by Joel Greenblatt
that uses the principles of value investing
.
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%
Joel Greenblatt
Joel Greenblatt is a value investor, and adjunct professor at the Columbia University Graduate School of Business...
that uses the principles of value investing
Value investing
Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...
.
Methodology
Greenblatt suggests purchasing 30 "good companies": cheap stocks with a high earnings yieldEarnings yield
Earnings yield is the quotient of earnings per share divided by the share price. It is the reciprocal of the P/E ratio.The earnings yield is quoted as a percentage, allowing an easy comparison to going bond rates.-Applications:...
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
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
96% of the time, and has averaged a 17-year annual return of 30.8%
Formula
- Establish a minimum market capitalizationMarket capitalizationMarket capitalization is a measurement of the value of the ownership interest that shareholders hold in a business enterprise. It is equal to the share price times the number of shares outstanding of a publicly traded company...
(usually greater than $50 million). - Exclude utilityPublic utilityA public utility is an organization that maintains the infrastructure for a public service . Public utilities are subject to forms of public control and regulation ranging from local community-based groups to state-wide government monopolies...
and financialFINANCIALFINANCIAL is the weekly English-language newspaper with offices in Tbilisi, Georgia and Kiev, Ukraine. Published by Intelligence Group LLC, FINANCIAL is focused on opinion leaders and top business decision-makers; It's about world’s largest companies, investing, careers, and small business. It is...
stocks - Exclude foreign companies (American Depositary ReceiptAmerican Depositary ReceiptAn American depositary receipt is a negotiable security that represents the underlying securities of a non-U.S. company that trades in the US financial markets...
s) - Determine company's earnings yieldEarnings yieldEarnings yield is the quotient of earnings per share divided by the share price. It is the reciprocal of the P/E ratio.The earnings yield is quoted as a percentage, allowing an easy comparison to going bond rates.-Applications:...
= EBITEarnings before interest and taxesIn accounting and finance, earnings before interest and taxes is a measure of a firm's profit that excludes interest and income tax expenses. Operating income is the difference between operating revenues and operating expenses...
/ enterprise valueEnterprise valueEnterprise value , Total enterprise value , or Firm value is an economic measure reflecting the market value of a whole business. It is a sum of claims of all the security-holders: debtholders, preferred shareholders, minority shareholders, common equity holders, and others...
. - Determine company's return on capital = EBITEarnings before interest and taxesIn accounting and finance, earnings before interest and taxes is a measure of a firm's profit that excludes interest and income tax expenses. Operating income is the difference between operating revenues and operating expenses...
/ (Net fixed assets + working capitalWorking capitalWorking capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is...
) - Rank all companies above chosen market capitalizationMarket capitalizationMarket capitalization is a measurement of the value of the ownership interest that shareholders hold in a business enterprise. It is equal to the share price times the number of shares outstanding of a publicly traded company...
by highest earnings yield and highest return on capital (ranked as percentagePercentageIn mathematics, a percentage is a way of expressing a number as a fraction of 100 . It is often denoted using the percent sign, “%”, or the abbreviation “pct”. For example, 45% is equal to 45/100, or 0.45.Percentages are used to express how large/small one quantity is, relative to another quantity...
s). - Invest in 20-30 highest ranked companies, accumulating 2-3 positions per month over a 12-month period.
- Re-balance portfolioPortfolio (finance)Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
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.