Finding value stocks is hard, and it is getting harder now that so many more investors today are searching for them than ever before. Besides, time is always at a premium. Wouldn’t it be wonderful if there was a formula that would spit out profitable undervalued stocks with proven history of outperformance?
Well, there is one, and it is called Magic Formula Investing!
Joel Greenblatt, the hedge fund manager who runs Gotham Asset Management, devised and popularized the Magic Formula as a systematic, proven investment strategy that seeks to identify undervalued stocks with high returns on capital. Greenblatt has helped many investors find hidden values in the stock market through his website Magic Formula Investing. There you can register and then you will be able to run the screener and construct a portfolio based on his formula. Alternatively, like I do, you can also run the Magic Formula Screener in Stock Rover – this is better in my opinion because Stock Rover gives you the ability to run many different screeners, customize them the way you want, and create watchlists and portfolios.
Keep reading to learn how the Magic Formula works, why it works, and what is the magic about this formula.
What is Magic Formula Investing?
Magic Formula is a data-driven approach to finding quality undervalued companies without having to perform deep analysis. It uses a simple rules-based filter to shortlist stocks, and a well-defined process to construct and manage your portfolio that takes the emotion out of the picture. Multiple back-tests have found that Magic Formula outperforms the broader market over time if used consistently.
Joel Greenblatt first outlined the Magic Formula in his book The Little Book that Beats the Market, later revised to The Little Book that Still Beats the Market.
The Magic Formula is a blend of quality and valuation metrics. At its core, it ranks stocks based on their Earnings Yield and Return on Capital metrics. High earnings yield indicates attractively priced stocks while companies with high ROC are considered more profitable and efficient operations.
Earnings Yield: Greenblatt defines earnings yield as Earnings before Income Taxes (EBIT) / Enterprise Value. This is different from traditional definition of earnings yield, which is Earnings/Market Value, or EPS/Price. This metric identifies value stocks.
Return on Capital (ROC): Greenblatt defines Return on Capital as EBIT/(Net Working Capital + Net Fixed Assets). This metric identifies high quality stocks.
Each stock is ranked based on these metrics and the stocks that rank in the top are selected for the portfolio. The entire selection and portfolio management process is mechanical to take the emotion out of the process. This makes for objective stock selection and reduces the errors due to bias.
The Magic Formula Investing, perhaps unintentionally, combines the value and quality factors in one model. We talk about factor investing elsewhere on this site.
How to Use the Magic Formula
The Magic Formula is a rules-based process that makes it simple for investors to use in their investing workflow.
Step 1: Identify the universe of the stocks you will choose from. The general recommendation is to keep to the mid-cap and large-cap asset classes as this ensures that you minimize volatility and are working with stocks that have sufficient liquidity. Greenblatt recommends a minimum market cap of $50 million.
Step 2: Rank each stock first by the earnings yield and then by the return on capital, calculated the way Greenblatt suggests. Sum the 2 rankings to get a composite score.
Step 3: Select the top 20-30 stocks based on this ranking. So you will be picking the stocks with the lowest composite scores.
It is recommended that you perform this process at the beginning of each year, and plan to hold for approximately 1 year. When you are getting closer to the end of the year evaluate the stocks in the portfolio to see if they still fit the Magic Formula criteria. If they do not, sell the stocks that are at loss before the year ends. Hold the stocks with profits until one week after the year ends and then sell them. This way you will take the losses in the current year for tax purposes. Once the next year starts and you have sold all your stocks that do not fit the Magic Formula criteria, you perform the Magic Formula screening again to pick your cohort of stocks for the next year and you will add enough of these stocks to your portfolio to bring your number of holdings back into 20-30 range.
Performance and Track Record
Greenblatt claims that this strategy generates CAGR of around 30% based on his backtesting. The strategy has gained significant followers as it does consistently outperform the market, if followed with discipline. 30% CAGR is not achievable in every time period but the outperformance tends to be persistent.
A Magic Formula portfolio is concentrated in 20-30 stocks, and is therefore not as diversified as a market index. It is likely to be more volatile than the market and you should be able to stomach this volatility.
It does require you to be disciplined and committed to the strategy. This means performing the annual rebalancing without emotion or second guessing. It also means that you stay committed through the periods of market highs and lows.
Long-term investors seeking consistency in process and returns should consider Magic Formula investing. Value investors should also consider Magic Formula Investing as one screen to find possible undervalued stocks. Often you will use other filters on these stocks for finding value stocks, such as margin of safety, or Piotroski f-score. A dividend growth investor may choose the Magic Formula screens to find quality companies at good price, and then apply dividend growth filters to choose from these companies.
How to Screen for Magic Formula Investing Stocks
The simplest way to screen for Magic Formula stocks is to use the tool created by Greenblatt himself at magicformulainvesting.com. You will need to create an account to use this tool.
Alternatively, you can use a stock screener and analysis software such as Stock Rover (that I use). One of the benefits is that this will allow you to add additional filters and criteria to your screen if you so desire. Stock Rover has data for Greenblatt Earnings Yield and Greenblatt ROC, since these are slightly different from the regular earnings yield and return on capital calculation.
You should also consider portfolio diversification and position sizing aspects as you build your portfolio. A tool like Stock Rover shows you the correlations between each stock in your portfolio which comes in handy.
Further Reading and Resources
- The Little Book That Still Beats the Market by Joel Greenblatt
- MagicFormulaInvesting.com (Free stock screening tool)
Photo by Tyler Prahm on Unsplash
