Magic Formula Investing

What Is Magic Formula Investing?

Magic Formula Investing is an investment strategy developed by Joel Greenblatt, a renowned investor and hedge fund manager. The plan aims to identify undervalued and high-performing stocks by combining two key financial metrics: return on capital (ROC) and earnings yield.

It also aims to identify financially strong companies (high return on capital) and undervalued ones (high earnings yield). By focusing on these factors, the strategy seeks to uncover stocks with the potential for significant future appreciation.

• Magic Formula Investing provides a systematic and disciplined approach to stock selection, reducing emotional bias and promoting a consistent investment strategy.
• The strategy emphasizes fundamental financial metrics, such as earnings yield and returns on capital, to identify potentially undervalued stocks with strong financial performance.
• Targeting undervalued stocks with solid financials aims to generate market-beating returns over the long term.

How Does Magic Formula Investing Work?

Magic Formula Investing applies a systematic and quantitative approach to selecting stocks based on their financial metrics. Here's how it works:

1. Stock Universe: Begin with a predetermined universe of stocks. This universe can be based on specific criteria like market capitalization or liquidity.
2. Calculate Financial Metrics: Two vital financial metrics for each stock in the universe are earnings yield and return on capital (ROC).
   • Earnings Yield: Earnings yield is calculated by dividing earnings per share (EPS) by the stock price. This metric indicates how much return an investor can expect from a stock based on its current earnings.
   • Return on Capital (ROC): ROC is calculated by dividing earnings before interest and taxes (EBIT) by the sum of net working capital (current assets minus current liabilities) and net fixed assets. ROC measures how effectively a company is utilizing its money to generate profits.
3. Rank Stocks: Rank all the stocks in the universe based on their earnings yield and ROC. Stocks with higher earnings yields and ROC will receive better rankings.
4. Combine Rankings: Add the earnings yield and ROC rankings for each stock. According to the Magic Formula, stocks with the lowest combined rankings are the most attractive.
5. Select Portfolio: Choose a predetermined number of stocks with the lowest combined rankings, typically around 30. These stocks form the portfolio for investment.
6. Rebalance: Once a year or at a predetermined interval, rebalance the portfolio by selling stocks that no longer meet the criteria and replacing them with new stocks that rank highly based on the Magic Formula.

Requirements

To implement Magic Formula Investing, specific requirements need to be considered:

1. Access to Stock Universe: One needs access to a comprehensive stock universe or database that provides the necessary financial information for calculating earnings yield and return on capital. This can be obtained through financial data providers, online platforms, or investment research tools.
2. Financial Statement Data: To calculate the earnings yield and return on capital, one requires accurate financial statement data for each stock in one’s universe. This includes earnings per share, stock prices, EBIT, net working capital, and net fixed assets.
3. Regular Rebalancing: It requires periodic portfolio rebalancing, preferably annually. This involves reviewing the rankings of stocks in the portfolio and making necessary adjustments by selling underperforming stocks and replacing them with top-ranked stocks that meet the criteria.
4. Discipline and Patience: Any investment strategy requires discipline and patience. It involves sticking to the predetermined criteria and not being swayed by short-term market fluctuations or emotional biases.
5. Risk Management: Proper risk management, including it, is crucial in any investment strategy. Diversification within the portfolio can help mitigate risk. Additionally, investors should consider sector exposure, liquidity, and company-specific risks to manage their overall risk exposure effectively.
6. Understanding Limitations: It's essential to recognize the limitations of any investment strategy, including it. The system relies solely on quantitative factors and does not consider qualitative aspects like industry dynamics, competitive advantage, management quality, or external factors.

How To Calculate?

To calculate the Magic Formula rankings for stocks, one will need the following financial data for each stock:

1. Earnings Per Share (EPS): This information can be found in the company's financial statements. EPS represents the company's profit divided by the number of outstanding shares.
2. Stock Price: Obtain the current stock price for each stock. This information is readily available through financial data providers or online stock market platforms.
3. Earnings Before Interest and Taxes (EBIT): EBIT measures a company's operating profit before deducting interest and taxes. This information is found in the company's income statement or financial reports.
4. Net Working Capital: Calculate the net working capital by subtracting the current liabilities from the company's assets. This information is available on the company's balance sheet.
5. Net Fixed Assets: Obtain the net fixed assets by subtracting accumulated depreciation from the gross fixed assets. This data can be found in the company's balance sheet or financial reports.

After gathering the necessary financial data, follow these steps to calculate the Magic Formula rankings:

Step 1 : Calculate Earnings Yield

• Divide the EPS by the stock price to calculate the earnings yield.
• Earnings Yield = EPS / Stock Price

Step 2: Calculate Return on Capital (ROC)

• Divide the EBIT by the sum of net working capital and net fixed assets to calculate the return on capital.
• ROC = EBIT / (Net Working Capital + Net Fixed Assets)

Step 3: Rank Stocks

• Rank all stocks separately based on their earnings yield and ROC, from highest to lowest. The stock with the highest earnings yield will receive a rank of 1, while the stock with the lowest will receive the highest level. Repeat the same ranking process for ROC.

Step 4: Combine Rankings

• Add the rankings of earnings yield and ROC for each stock. According to the Magic Formula, the stock with the lowest combined order is considered the most attractive.

Step 5: Select Portfolio

• Choose a predetermined number of stocks with the lowest combined rankings, typically around 30, to form an investment portfolio.

Step 6: Rebalancing

• Periodically, usually, on an annual basis, review the rankings and rebalance the portfolio by selling stocks that no longer meet the criteria and replacing them with new top-ranked stocks.

Examples

Let us understand it better with a few examples:

Example #1

Let's consider an imaginary stock universe with three companies: Company A, Company B, and Company C.

Financial Data:

• Company A: EPS = $2, Stock Price = $20, EBIT = $10 million, Net Working Capital = $5 million, Net Fixed Assets = $15 million
• Company B: EPS = $3, Stock Price = $30, EBIT = $12 million, Net Working Capital = $6 million, Net Fixed Assets = $18 million
• Company C: EPS = $4, Stock Price = $25, EBIT = $9 million, Net Working Capital = $4 million, Net Fixed Assets = $16 million

Calculation:

1. Earnings Yield:
   • Company A: Earnings Yield = $2 / $20 = 0.1 (or 10%)
   • Company B: Earnings Yield = $3 / $30 = 0.1 (or 10%)
   • Company C: Earnings Yield = $4 / $25 = 0.16 (or 16%)
2. Return on Capital (ROC):
   • Company A: ROC = $10 million / ($5 million + $15 million) = 0.5 (or 50%)
   • Company B: ROC = $12 million / ($6 million + $18 million) = 0.48 (or 48%)
   • Company C: ROC = $9 million / ($4 million + $16 million) = 0.45 (or 45%)
3. Rankings:
   • Based on earnings yield: Company A (rank 1), Company B (rank 2), Company C (rank 3)
   • Based on ROC: Company A (rank 1), Company B (rank 2), Company C (rank 3)
4. Combined Rankings:
   • Company A: Combined Ranking = 1 + 1 = 2
   • Company B: Combined Ranking = 2 + 2 = 4
   • Company C: Combined Ranking = 3 + 3 = 6

In this example, according to the Magic Formula Investing strategy, Company A would have the lowest combined ranking (2), indicating it as the most attractive stock to consider for investment.

Example #2

Another example of Magic Formula Investing that was widely covered in finance news is the case of the investment firm, Gotham Capital, run by Joel Greenblatt, the creator of the Magic Formula.

Gotham Capital implemented the Magic Formula Investing strategy with notable success. One of the most well-known instances was from 1985 to 1994 when Joel Greenblatt managed the hedge fund. According to various reports and Greenblatt's account, the fund achieved an average annualized return of over 50% during that time, significantly outperforming the broader market.

The success of Gotham Capital and the remarkable returns generated by applying the Magic Formula garnered attention in finance news and investment circles. It highlighted the potential of a systematic approach to stock selection and the ability to achieve exceptional performance over the long term.

Advantages And Disadvantages

Some of the advantages and disadvantages of Magic Formula Investing are:

Benefits of Magic Formula Investing:

Advantages	Explanation
Systematic Approach	Magic Formula Investing provides a systematic and disciplined approach to stock selection, reducing emotional bias in decision-making.
Focus on Fundamental Metrics	The strategy has demonstrated success, with notable investors and funds achieving impressive returns by implementing the Magic Formula.
Potential for Long-Term Outperformance	The formula is relatively straightforward, making it accessible to individual investors without extensive financial expertise.
Simplicity and Ease of Implementation	The formula itself is relatively straightforward, making it accessible to individual investors without extensive financial expertise.

Disadvantages of Magic Formula Investing:

Disadvantages	Explanation
Reliance on Quantitative Factors	While the strategy aims to exploit market inefficiencies, it assumes that the market consistently misprices stocks, which may not always be accurate. Market efficiency can impact the strategy's effectiveness.
Lack of Real-Time Adaptability	While the strategy aims to exploit market inefficiencies, it assumes that the market consistently misprices stocks, which may not always be true. Market efficiency can impact the strategy's effectiveness.
Potential for Value Traps	The strategy's focus on undervalued stocks carries the risk of investing in companies that may be undervalued for valid reasons, such as declining business prospects or poor management. Thorough research is needed to avoid potential value traps.
Limited Market Efficiency	While the strategy aims to exploit market inefficiencies, it assumes that the market consistently misprices stocks, which may not always be accurate. Market efficiency can impact the strategy's effectiveness.

Frequently Asked Questions (FAQs)

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