Key Takeaways
- Ranks stocks by earnings yield and return on capital.
- Targets undervalued, high-quality companies systematically.
- Portfolio holds 20–30 stocks, rebalanced annually.
- Focuses on long-term gains with tax efficiency.
What is Magic Formula Investing?
Magic Formula Investing is a systematic value investing strategy developed by Joel Greenblatt that ranks stocks based on high earnings yield and high return on capital to find quality companies trading at attractive prices. This approach aims to simplify traditional value investing by using a formulaic method to identify undervalued stocks with strong profitability.
The formula focuses on metrics such as earnings yield and return on capital, which together provide insight into a company's value and operational efficiency. Using these criteria, Magic Formula Investing helps investors build diversified portfolios targeting long-term market outperformance.
Key Characteristics
Magic Formula Investing is defined by a few core principles that distinguish it from other strategies:
- Dual Metric Ranking: Stocks are ranked separately by earnings yield and return on capital, then combined to identify top candidates.
- Focus on Quality and Value: Prioritizes companies with strong profitability and cheap valuations, balancing growth and risk.
- Diversification: Typically involves holding 20–30 stocks to reduce company-specific risk.
- Annual Rebalancing: Portfolios are rebalanced yearly to maintain exposure to the best-ranked stocks.
- Exclusion Criteria: Avoids sectors like utilities and financials to prevent distortions in key metrics.
- Market Capitalization Filter: Often targets mid- and large-cap stocks, similar to those highlighted in best mid-cap stocks and best large-cap stocks guides.
How It Works
The Magic Formula starts by calculating earnings yield, which is EBIT divided by enterprise value, to identify how cheaply a company trades relative to its profits. It then measures return on capital to evaluate how efficiently the company uses its assets to generate earnings.
Stocks are ranked from highest to lowest on each metric, and their ranks are combined to produce a single score. Investors build a portfolio from the top-ranked stocks, adding 2–3 positions monthly until holding 20–30 companies. The portfolio is held for about a year before rebalancing, optimizing for tax efficiency by selling losers before the 1-year mark and winners afterwards.
Examples and Use Cases
Magic Formula Investing can be applied across various industries, with examples illustrating its practical use:
- Airlines: Companies like Delta demonstrate how cyclical industries can appear attractive on earnings yield but require careful analysis of return on capital.
- Value-Oriented Stocks: The strategy often highlights stocks from the best value stocks universe, combining solid fundamentals with reasonable prices.
- Technology and Industrials: Firms with high return on capital but moderate earnings yield may qualify, reflecting quality growth opportunities.
Important Considerations
While Magic Formula Investing offers a disciplined, rules-based approach, you should be aware of its limitations. High portfolio turnover from annual rebalancing can increase transaction costs and tax liabilities, which may reduce net returns.
Additionally, the formula excludes certain sectors and foreign stocks, potentially limiting diversification. Combining this method with broader macroeconomic analysis (macroeconomics) and other factors like the PEG ratio can improve decision-making and risk management.
Final Words
Magic Formula Investing offers a disciplined way to identify undervalued, high-quality stocks by combining earnings yield and return on capital. To get started, run the numbers on a list of mid- to large-cap stocks and build a diversified portfolio of the top-ranked picks.
Frequently Asked Questions
Magic Formula Investing is a value investing strategy developed by Joel Greenblatt that ranks stocks based on high earnings yield and high return on capital to find quality companies trading at bargain prices.
It ranks stocks separately by earnings yield (a measure of value) and return on capital (a measure of quality), then combines these ranks to identify the top 20 to 30 stocks for the portfolio.
The strategy typically excludes utilities, financials, foreign companies like ADRs, and sometimes real estate, because their financial metrics can be distorted and less reliable.
You should rebalance the portfolio annually, gradually building it over 12 months by adding 2 to 3 stocks each month, which helps maintain diversification and capture the strategy's benefits.
Earnings yield identifies undervalued stocks by showing how cheaply a company trades relative to its earnings, while return on capital measures how efficiently the company uses its capital to generate profits, ensuring quality.
The strategy recommends holding stocks for about one year, selling losers just before the one-year mark to claim short-term losses and winners after one year to benefit from lower long-term capital gains taxes.
Yes, Magic Formula Investing simplifies stock selection by using clear, quantitative metrics and provides a free screening tool, making it accessible for beginners to implement systematically.
While past performance doesn't guarantee future results, the strategy aims to outperform the market over a long-term horizon of 5 to 10 years by focusing on high-quality, undervalued stocks.
