Magic Formula Investing
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What is Magic Formula Investing?
Magic Formula Investing is a disciplined investment strategy based on rules. It is a method of value investing designed to increase the likelihood of outperforming the market. It is intended to outperform the average annual returns of the stock market. A Swiss Performance Index (SPI) may be used as a benchmark to measure market performance in the Swiss market, or the S&P 500 Index for the US market. In general, it is advised to purchase 20-30 "good" companies that are low-priced, have a high earnings yield, and provide a high return on investment (ROI).
The formula was developed by Joel Greenblatt. As an investor, hedge fund manager, and professor of economics at Columbia University, he is well-known in the field. It should be noted, however, that the formula excludes certain types of companies, such as small market capitalization companies, financial services companies, and companies in the utility sector (electricity, natural gas, water, etc.).
The Calculation Method
The investor may use Greenblatt's online tool to select 20-30 stocks. In this database, stocks are sorted based on three criteria: earnings yield (EBIT = earnings before interest and taxes), earnings per share (EPS), which represents the stock's return, and return on assets, which indicates the efficiency with which income can be generated from assets.
In general, the strategy proceeds as follows:
- Set a minimum market capitalization (at least $50 million).
- In selecting companies, it is important to exclude public utilities and financial services companies. ADRs (American Depository Receipts) should also be excluded.
- Calculation of the return on earnings of individual companies (EBIT / enterprise value).
- Determine the return on capital for each company [EBIT / (net fixed assets + operating assets)].
- Ranking selected companies according to market capitalization, return on earnings, and return on assets.
- In order to invest in the top 20-30 companies, investments should be made gradually in about 2-3 companies each month.
- Stock portfolios should be rebalanced annually. This will require the price losers to be sold one week before the end of the term (just before the end of the first year), and the price winners to be bought one week after the end of the term (just after the end of the first year).
- It is intended to repeat this process for a period of five to ten years.
Advantages and Disadvantages of Magic Formula Investing
The simplicity of the formula is a clear advantage of the method. The portfolio is constructed according to a set of simple rules. The method also avoids irrational decisions. However, this method does not always produce the expected results. In some cases, this may be the result of a change in market dynamics. In addition, if many people employ this method, the success rate may be lower.
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