How does Magic Formula Investing Work?

Wednesday, Apr 20 2011 by
12
How does Magic Formula Investing Work

In Brief

Magic Formula Investing is a value investing strategy based on buying 20-30 "good, cheap companies" defined as having the best available combined ranking in terms of earnings yield and a return on capital.

Background

A widely respected hedge-fund manager, Joel Greenblatt started as a value purist but was influenced by Warren Buffett's view about growth being part of the value equation. He founded Gotham Capital, a fund which apparently returned over 40% annualized from 1985 to 2005. By 1995, it had returned all money to its outside investors. He has authored two books, You Can Be A Stock Market Genius and New York Times bestsellier,  “The Little Book That Beats the Market”, and is also adjunct professor at Columbia University Business School. Greenblatt espouses MFI as a do-it-yourself version of the approach he has used while amassing his investment track record. With the “Little Book”, Greenblatt wanted to write a book his children could read and learn from. The main point Greenblatt makes is that investors should buy good companies at bargain prices.

Magic Formula Investing uses return on capital and earnings yield as its inputs. Return on capital is seen as the best determinant of whether a business is a good one or not. Companies that can earn a high ROC over time generally have a special advantage that keeps competition from destroying it (e.g. name recognition, a new product that is hard to duplicate or a unique business model).

Earnings yield is the metric that shows whether a company is cheap or not. Greenblatt says that stock prices of a firm can experience “wild” swings even as the value of the company stays relatively constant giving investors opportunities to buy low and sell high. 

Calculation / Definition of the Magic Formula 

  • Define minimum Market Capitalization that meets your liquidity needs. Greenblatt used a market capitalization floor of $50 million, but advised that you can set the minimum as high as $5 billion.
  • Sector Filter: Due to their unique financial structures, all stocks in the financial and utility sectors are excluded. 
  • Calculate Earnings Yield = EBIT / enterprise value.
  • Calculate Return on Capital = EBIT / (Net fixed assets + working capital)
  • EY Rank: Rank the stocks in descending order based on Earnings Yield and assign a rank number to each.
  • ROC Rank: Rank the same stocks in descending order based on Return on Capital…

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Disclaimer:  

As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested. ?>


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10 Comments on this Article show/hide all

general2011 22nd Apr '11 1 of 10
3

If you like Magic Formula, then you'll definitely like a recent find of mine: Edata. Registration is required, but it's free. I've used SharelockHolmes to create my list in the past, but this site looks a better bet.

Here's the top 5 stocks: CPP CPP Group), AZN (AstraZeneca), WMH (William Hill), PIC (Pace), JD. (JD Sports Fashion). Personally, CPP is a tricky one, and I'd be very very wary of investing in it if you wanted to run a concentrated portfolio. It has been floated for just over a year, and recently dived because it "warned on profits following the launch of a Financial Service Authority investigation into one of its products". FT Alphaville

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harryr 24th Apr '11 2 of 10
9

If one wants to make real money on the stockmarket, buy tiny low cap stocks that are growing at the speed of light.

I highlighted NTA that 5 baged last year and IDG that has doubled.

Today take a look at PFO who trade on a pe of 2.!!

The stockmarket is very good at putting the wrong price on a stock, here your have a stock worth in my view 10 times its price TODAY.

Growth, big profits tiny debt and falling.

These are my own views that in the past have done me very well indeed.

Take Zero notice of the crap posted on the Magic formula, its all a case of buying cheap and selling dear.!!

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nicole 24th Apr '11 3 of 10
2

In reply to post #55987

You obviously haven't read the book or the article then. The Magic Formula maintains that you buy cheap stocks - that's the whole point.

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harryr 24th Apr '11 4 of 10
10

No not read the book, never read books.

To my mind you just buy stocks that others price wrong.

Take PFO today on a pe of under 2 when the market trades on a pe of 12.

Then go hunting for the reasons why its on a pe of 2

The only reason ANY stock is on a pe of 2 is if profits are falling or have fallen.

PFO has profits going through the roof, with 80% of shareholders in firm hands.

However do not take my word for it just watch the stock over the next few days/weeks.

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nigelpm 24th Apr '11 5 of 10
4

In reply to post #55987


Today take a look at PFO who trade on a pe of 2.!!

The stockmarket is very good at putting the wrong price on a stock, here your have a stock worth in my view 10 times its price TODAY.

Growth, big profits tiny debt and falling.


PER valuations shouldn't be taken on their own - you need to look at the rest of the business including its historic performance of which PFO has very little.

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Dave Brickell 11th May '11 6 of 10
2

One thing that seems a bit of a mystery with the Magic Formula is how to deal with intangibles in the ROCE calculations. In the Little Book, it's clear that Greenblatt excludes intangibles since he talks about the return on tangible capital. However, the rationale he gives for this is really only related to goodwill, as you can see here.

Does that mean that other more meaningful intangibles like copyrights, patents and customer lists should/could be kept in there? For certain types of companies, intangibles are definitely part of the productive assets of the company, so I don't follow the rationale for always excluding them (if that's what he's saying but I can't really tell). 

Website: Stockopedia PRO
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Mark Carter 20th Aug '11 7 of 10

Should we include or exclude the following components of Net Fixed Assets: investment properties, investments, other financial assets, other non-financial assets?

How about current asset investments?

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seasons 21st Apr '13 8 of 10

In reply to post #56426

Dave,

Have you seen the book "Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors".. I found it on http://greenbackd.com/. I was wondering if I will be able to implement those rules on StockoPedia as they are based on Greenblatt's rules, which are rather rankings!

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Murakami 21st Apr '13 9 of 10
1

In reply to post #72656

Hi, it's a great book/synthesis of the topic - it covers quite a lot of similar ground to what we cover on Stockopedia. I am not sure if we will be modelling it precisely (as we try to focus on primary material by either experienced practitioners or academics) but we already model most, if not all, of the key references it cites, e.g. the Piotroski F-Score or the Novy-Marx Gross Profit to Assets ratio - http://www.stockopedia.com/ratios/gross-profit-to-assets-5365/ . It's also helped to inspire some in-progress work we're doing on Composites Ratios - see: http://help.stockopedia.co.uk/knowledgebase/articles/182732-how-do-you-calculate-the-valuerank-

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MarkLDN 26th Jan 10 of 10
2

In reply to post #55990

PFO - delisted in 2013

So have you found a buyer of those shares yet?

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