There’s never been a shortage of successful or popular ways to make money from the stock market, whether it be through growth investing on the one hand or momentum investing on the other.
However, several of these techniques necessitate a considerable measure of proficiency, scrutiny, and inquiry to be executed efficiently.
But if you don’t have sufficient resources or expertise for such endeavors, there’s an uncomplicated investment strategy that banks on a couple of critical metrics to identify potentially solid additions to your portfolio.
This straightforward approach – known as Magic Formula Investing – has gained a formidable reputation and is renowned today for its ease of use and market-busting returns.
We explore this system in-depth, investigating its history and appropriateness for those who prefer a low-maintenance investing set-up.
How Does the Magic Formula Work?
Joel Greenblatt isn’t just a respected hedge fund manager and business professor. The famed Wall Street money man also created the Magic Formula Investing protocol, a technique that screens for high-performing and extremely profitable stock picks.
Indeed, the plan aims to pinpoint firms with appealing valuations, relying primarily on two economic indicators: earnings yield and return on capital.
Refreshingly, the underlying concept of the Magic Formula is decidedly straightforward. For instance, Greenblatt believes that companies exhibiting high earnings in proportion to their market value – and which generate substantial profits with the capital they possess – are likely undervalued by the market. Therefore, by detecting these firms and including them in your stock holdings, investors can earn greater returns than the overall market.
The Magic Formula is a rules-based mechanism that aims to eliminate emotion and prejudice from the investment process. The plan is intended to identify undervalued stocks – regardless of industry or particular market environment – by relying exclusively on just two critical yardsticks.
Pros and Cons of Using the Magic Formula
Like any other investment tool, the Magic Formula has its advantages and drawbacks.
For instance, since it is based on two standards only, one of its most appealing features is its simple, under-friendly design.
Additionally, backtesting has shown it has surpassed and outplayed the broader market over extended periods, providing higher returns with lower volatility. The Magic Formula strategy is also based on the honored principles of value investing, which has a noble and storied history of success.
However, there are several potential downsides to consider too. It relies solely on numeric analysis and does not consider other factors such as industry trends or company management.
As a result, Magic Formula investing can be volatile in the short term, as companies with high earnings yields and returns on capital may experience unforeseen fluctuations in stock price based on market conditions.
That said, if too many investors adopt the Magic Formula, it could lead to the overvaluation of stocks, thus reducing its effectiveness over time.
It’s important to note that the Magic Formula isn’t intended to screen all types of stock. Small-cap companies do not fare well when analyzed with this procedure, nor do those businesses categorized as belonging to the utility or financial sectors either. Moreover, your portfolio should be rebalanced every twelve months, with poorly performing assets sold off before the end of the year to benefit from specific income tax provisions.
Does Magic Formula Investing Work?
In their book, “Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors,” Wesley Gray and Tobias Carlisle provide a comprehensive overview of Joel Greenblatt’s Magic Formula investing blueprint.
Having analyzed the most pertinent data from 1964 to the end of 2011, the two authors found that the Magic Formula produced an average return of 12.79% per year, outperforming the S&P 500 index by an impressive margin.
While this fell short of the 30.8% Greenblatt claimed in his magnum opus, “The Little Book that Beats the Market,” it’s still a significant achievement.
However, Gray and Carlisle’s book identified the shortcomings of the Magic Formula approach, such as its tendency to focus on shorter-term performance and neglecting other important factors like business quality, management expertise, and growth prospects.
Despite these limitations, the authors concluded that the Magic Formula is a good policy that can be used to identify undervalued stocks with robust fundamentals and strong returns.
How To Use The Magic Formula For Best Results
There are several options for investors to implement Magic Formula investing outside the traditional practice of selecting individual stocks.
For instance, one way would be to expand the criteria beyond Greenblatt’s earnings yield and capital returns, adding other fundamental factors to the screening process instead. These could include things such as the price-to-earnings ratio or the dividend yield and would allow investors to tailor the strategy to their specific needs while adding some redundancy to what can be a blunt instrument.
Quantitative investment strategies, such as factor investing or smart beta, can also incorporate Magic Formula benchmarks as one of several considerations in the stock selection process.
Finally, Magic Formula protocols can be as adept at unearthing alternative investment opportunities with asset categories such as fixed-income securities and real estate. For instance, the Magic Formula can help investors choose bonds with high yields and robust credit ratings or real estate investment trusts with high rental returns and minimal leverage ratio. This enables investors to expand their portfolios while still following the principles of the Magic Formula technique.
Conclusion: Does Magic Formula Investing Work?
Joel Greenblatt’s simple but powerful investing framework has passed the harshest of tests.
While it may not have the apparent sophistication of other more fancy stock market systems, if properly executed, it should surely deliver the same returns it’s given thousands of other investors over the decades.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.