Magic Formula Investing

In November, I posted a company profile on the craft store Michaels.  In that post, I mentioned that I was profiling one of Joel Greenblatt’s potential “Magic Formula” stocks.  I want to get back to discussing Joel Greenblatt and his Magic Formula now.  The new year is a good time to consider new ways of investing in stocks. 

To start, I would highly recommend purchasing his book titled, The Little Book that Beats the Market, as it is a short read and he presents the concepts in plain language.  It is very easy to understand no matter what your level of experience is and the book brings together a lot of concepts together in an efficient fashion.

Who is Joel Greenblatt? 

According to Wikipedia, he is an American academic, hedge fund manager, investor and writer.  I think the fact he is a professor at Columbia’s University Graduate School of Business means his writing is clear, succinct and easy for us all to understand.

What is the Magic Formula? 

The Magic Formula is relatively simple – it consists of screening and buying a portfolio of roughly 30 stocks based on their cheapness and the quality of the underlying company as measured by Earnings Yield and Return on Capital.  This may not sound simple but it really is and I would encourage you to check out his website at magicformulainvesting.com as it does most of the heavy lifting on this for you.  The website crunches the numbers behind the scenes for you and spits out what stocks to buy based on the formula. He indicates that you should keep at least 20 stocks at a minimum to properly diversify and manage the risk.  Thirty stocks are likely ideal.  You then proceed to purchase the stocks with the money you have decided to allocate to these investments. The Magic Formula is equally weighted so you should take an equal position in each of the 30 stocks you purchase.  So, if you have $30,000 to invest, you would invest $1,000 in each one. He indicates that if the 30 stocks are going to be part of your long-term investment strategy, and you are using a large percentage of your investment dollars to do this, you may want to buy the stocks over a 12 month period.  This  spreads out the money you need to get going on this strategy. 

The notion is to then hold the stocks you have purchased for one year. After one year is up, see which stocks are no longer in the screen you did one year ago (for example, maybe you screened 30 companies with minimum market capitalization of $50 million). Run that same screen again.  What companies fell of the list and which ones stayed on?  Sell the companies no longer making the screen and take new positions in the ones that stayed on the screen. Then rebalance. So, if the portfolio gained 10% and the entire portfolio is now worth $33,000, each holding in the 30 stocks should be $1,100 now instead of $1,000. Do this each year.  Here is a screenshot from the website for further clarity:  

 Courtesy of magicformulainvesting.com

Courtesy of magicformulainvesting.com

What formulas make up the Magic Formula exactly? 

For those like me that want to dig deeper into exactly what the formula is, keep reading.  If you are content with having the work done for you, skip to my conclusion and then head over to his website and start screening and considering your strategy. As alluded to above, the Magic Formula looks for companies that have a high earnings yield (which suggests the company is undervalued and “cheap”) and a high return on invested capital (this can mean the company is a high-quality operation). Earnings yield for the Magic Formula is taken by dividing the company’s Earnings Before Income Tax (EBIT) by Enterprise Value (Market Capitalization (+) Long Term Debt (-) Total Cash). This results in a percentage value. Let’s say for example, the Earnings Yield figure you get is 8%. What does that mean?  It means that you are purchasing $0.08 of earnings for every dollar invested. You can see why a higher figure is better – a higher percentage means that you are getting more earnings for your dollar invested.

Moving on to Return on Invested Capital, this figure is calculated by taking the EBIT and dividing it by Tangible Capital Employed (Net Working Capital + Net Fixed Assets). Without going further into this ratio, the Return on Invested Capital measures what sort of return a company achieves after investing in its businessA higher return on the capital it invested in its business means a better investment – a higher quality company- with which you may want to consider investing. This number is insight into the profitability of an operation as related to the cost of the assets used to produce those profits.

Conclusion

Joel Greenblatt’s strategy is definitely worth spending some time looking into. In a nutshell, he is using classic value investing strategies. He is looking for undervalued stocks in respect of well run companies. Hard to argue with that approach. The difficult in today's market is finding companies that are still undervalued. That is the difficult part. There is so much written about this value investing strategy and like I say above, I would highly recommend reading his book yourself. This experienced investor and financial expert has done all the work for you and offers his stock screening tool for free on his site. All you need to do is spend a bit of time considering it and learning it!

Top photo by Austin Chan on Unsplash