Magic Formula Investing

Daniel Penzing
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How the Magic Formula Works

The Magic Formula is the brainchild of Joel Greenblatt, a money manager and writer. He also has a long-running blog and television show called The Little Investment That Could.

To quote the man himself, the magic formula is a bit like:

The formula is based on a strategy of investing in high-quality companies at relatively cheap prices. Because the operating companies had consistently good earnings growth and high returns on capital, Greenblatt believed they would eventually trade at a high rate.

You can check out his original piece on the Magic Formula at Graham and Doddsville here.

Portfolio Selection

The term Magic Formula investing was first brought to the public in an article by Joel Greenblatt in 2004. He called it The Magic Formula Investing, it was published in the New York Times. Since then it has been a very successful investing strategy, and people continue to make good profits every year using it.

The Magic Formula Investing and its calculation is very easy and relatively straight forward. The basis of the Magic Formula Investing is using the EBIT/TEV to come up with valuations of companies. The Earnings before interest and taxes divided by the sum of the EBIT and the tax shields (TEV) of the company. Beware, some companies are not valued the same way all the time. It is a good idea to check all the stocks you are interested in, and see how they are trading.

There are also some stocks that would not show up in the scan. This is mostly because their debt is so high that their net profit is zero. This would still be something you need to look out for, because these companies can affect your overall portfolio.

To read more about the math involved, and how to identify the stocks, read my post on how to calculate the numbers here.

Is It a Workable Strategy?

The magic formula was created by Joel Greenblatt in his book, “The Little Book that Beats the Market.” His thesis was that the market is inefficient and that there is a predictable way to beat it.

The magic formula was created by processing 10 million stocks to find 50, which had the best earnings yield, return on capital, and sales to price ratio. The magic formula is then to invest in those 50 stocks in equal amounts.

Greenblatt’s track record has been validated through replication. It’s the best way in the last 65 years to beat the market. Unfortunately, better performance is available through passive investing. But Greenblatt’s magic formula still has it’s place in the stock and portfolio manager world.

Many professional investors use the formula although they don’t advertise it. Greenblatt believes that there are opportunities in the market’s inefficiency and his magic formula has proven to work.

You don’t have to use the magic formula to make money. But you can if you want to and you choose to.

The magic formula has it’s place in the world of investing. Choosing the magic formula will certainly make you a more active investor.