Magic formula investing

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Magic formula investing is a term referring to an investment technique outlined by Joel Greenblatt that uses the principles of value investing.

Methodology[edit]

In his book, Greenblatt presents a “Magic Formula” for buying good companies at good prices. These concepts – good company and good price – are represented by two ratios from companies’ financial statements: Return on Invested Capital (ROIC) represents “good company” & Earnings Yield represents “good price".

Greenblatt’s Magic Formula gives these two ratios equal weight when selecting investments. The Formula ranks all companies in the investable universe by Good Company (ROIC) and also by Good Price (Earnings Yield). Then, each company’s ROIC and Earnings Yield ranks are added together. Greenblatt’s Formula has an investor buy companies with the best combined rankings, hold each company for a year, and then move funds into new highly ranked companies. [1]

Greenblatt suggests purchasing 30 "good companies": cheap stocks with a high earnings yield and a high return on capital. He touts the success of his magic formula in his book 'The Little Book that Beats the Market ', Joel Greenblatt ISBN 0-471-73306-7, citing that it does in fact beat the S&P 500 96% of the time, and has averaged a 17-year annual return of 30.8%[2]


Formula[edit]

  1. Establish a minimum market capitalization (usually greater than $50 million).
  2. Exclude utility and financial stocks.
  3. Exclude foreign companies (American Depositary Receipts).
  4. Determine company's earnings yield = EBIT / enterprise value.
  5. Determine company's return on capital = EBIT / (net fixed assets + working capital).
  6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
  7. Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
  8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
  9. Continue over a long-term (5–10+ year) period.

References[edit]

  1. ^ "Euclidean Technologies, The Little Book That Beats the Market Review, Quotes, & Lessons Learned."
  2. ^ Zen, Brian and Hamai, Garrett. "Joel Greenblatt Speaking at NYSSA". December 28, 2005.

External links[edit]