Introduction
Magic formula investing is an investment strategy modelled by Joel Greenblatt. He is an American academic, investor, hedge fund manager, and writer. The formula was described in his book, "The Little Book That Beats the Market".
This formula is based on certain rules and methodologies that provide a simple yet disciplined approach to investing in companies which fit the specified criteria.
He suggests investing in cheap stocks, which have a high return on capital, as well as a high earnings yield. The goal is to surpass the average market return. The book claims that it does beat the S&P 500 index, 96% of the time.
Magic Formula
The magic formula works as follows:
- Establish a minimum market capitalisation, typically higher than $50 million
- Exclude finance and utility stocks while investing
- Exclude all foreign companies (for example, American Depositary Receipts)
- Calculate the company's earnings yield (EBIT/enterprise value)
- Calculate the company's return on capital (EBIT/(net fixed assets + working capital))
- Rank the selected companies by the highest earnings yield and the highest return on capital
- Over the course of a year, invest in 2 or 3 positions, in the 20–30 highest ranked companies
- Rebalance the portfolio every year by selling losers a week before the year-end mark, and selling winners one week after the year-end mark
- Continue this process over a long-term (i.e. a 5–10 year period or longer)
Understanding the Magic Formula
Market capitalisation refers to the share price multiplied by the number of outstanding shares. The minimum market capitalisation varies from investor to investor, and need not be set at $50 million, but could be set higher, at $100 million or even $200 million. It is all about personal choice.
The two ratios in the formula involve the computation of EBIT. This is the company's earnings before interest and tax. The first ratio looks at a company's earnings relative to enterprise value. The second ratio looks at a return on capital, or in other words, earnings relative to tangible assets.
