Magic formula investing

Magic formula investing

Last Updated by WikiWealth

Summary

Magic formula investing is a term that refers to an investment technique outlined by Joel Greenblatt that uses the principles of value investing.

Methodology

Greenblatt suggests purchasing 30 "good companies": cheap stocks with a high earnings yield 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%

Formula

Establish a minimum market capitalization (usually greater than $50 million).
Exclude utility and financial stocks
Exclude foreign companies (American Depositary Receipts)
Determine company's earnings yield = EBIT / enterprise value.
Determine company's return on capital = ebit / (net fixed assets + working capital)
Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
Re-balance portfolio 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.

Risks

The 17-year annual return of 30.8% is a theoretical average based on purchasing all stocks that show up on the screen every year for 17 years. In practice investors do not do this, rather accumulating 2–3 positions per month over a 12-month period. Historically many stocks that show up on the screen are duds, for example Crocs (CROX), a magic formula stock in early 2008 at $21, which subsequently dropped 94% over the next 12 months; or Heely's (HLYS), which in the same period fell from $4.50 to $1.50, a 73% decline. If investors had picked these stocks, for example, their performance would have been significantly worse than the theoretical average of 30.8%. Thus timing when to buy, and which stocks, plays a role in the performance of the strategy.

Interview with Joel Greenblatt

References

The Little Book That Beats The Market, Joel Greenblatt ISBN 0-471-73306-7
Zen, Brian and Hamai, Garrett. "Joel Greenblatt Speaking at NYSSA". December 28, 2005.
The best magic formula stocks, Magic Diligence. Last accessed April 16, 2011.

Source: https://en.wikipedia.org/wiki/Magic_formula_investing