Did you wish for a magic solution that would make the investment task easier? Well,  your wish has been granted. There is indeed a magic formula to solve your woes as an investor.

We’regoing to talk about the magic formula of investment that is designed to make you a winner always.It is a highly celebrated theory, followed by hedge fund managers and investors.

Joel Greenblatt popularised magic formula investing, which combined the strategies used by successful investors like Warren Buffet and Benjamin Graham to perfect balance to help you ace the game of investing.Without delay, let’s delve deep into the idea and see why it is called the magic formula investing and how you can apply it in your investment strategy to amp up your stock-picking technique.

Knowing The Person Behind The Idea

His colleagues describe him as a genius.  Joel Greenblatt is a successful hedge fund manager and professor atColumbia University. His company Gotham Funds, which Greenblatt runs with his partner, Robert Goldstein, gave an average of 50 percent return for ten years. He described magic formula investing in his second book ‘The Little Book That Beats The Market’. His formulacombined Warren Buffet’s value investing and Benjamin Graham’s deep-value approach to create his winning formula, which he claimed has given him 24 percent returns between 1988-2009. Greenblatt’s formula is designed to beat the market.

What Is Magic Formula Investing?

Magic formula investing is a rule-based disciplined investing strategy to help investors understand value investing theory in a simple manner. He simplified the methodology of stock picking by listing stocks based on their price and return on capital. To make the ranking process easier, he based his theory on two ratio analysis; first is the Return on Capital (ROC) and second is Earing Yield or EBIT.

To use magic formula investing, one needs a thorough understanding of the variable used in describing it.

Return on Capital

It is a measure of a company’s earnings before tax and interest payment (EBIT) as a ratio of tangible capital employed (net working + net fixed).  It is calculated using a simple formula.

ROC= EBIT/(net fixed asset + net working capital)

ROC is a common ratio used to understand companies financial strength against its peers. It avoids the distortion arising from tax and interest payment, and hence, gives a bias-free result. ROC values reflect thecompany’s ability to turn the investment into profit.

Greenblatt mentioned that he used ROC to make it easy for investors to compare stocks.

Earning Yields

The company’s earnings yield measures earning per share against the current stock price or EBIT/enterprise value and, in turn, reflects the investor’s earnings per share. For example, if a company’s earnings yield is 8 percent, it means that the investor will receive Rs 8 for Rs 100 worth of shares.

Investors can apply the earnings yield ratio to compare stocks and different investment instruments to make an informed choice. It tells whether company shares are undervalued or overvalued when you compare company earning yield with peer companies.

Combining the two ratios, investors can list company stocks based on their performance and select the best ones.

Using Magic Formula Of Investing

Instead of conducting fundamental analysis, an investor can list stocks to invest using the magic formula. It is value investing in a simplified form. Greenblatt’s formula helps investors buy good company share at a cheap price using a straight-forward, non-emotional approach. Investors sell loss-making shares before one yearand use the loss to offsetgain to receive a tax advantage. Conversely, they would retain winning stocks to offset the impact of the long-term capital gain tax. Using Joel Greenblatt magic formula, they can screen companies to identify winning and loss-making shares.

Many investors create separate lists of stocks based on return on capital and earnings yield and then in a third list add companies based on the comparative values derived from the first two lists.

Here are the steps to follow to apply the magic formula in investment strategy

  • The first step is to decide the amount to invest and spread it among the stocksin your portfolio. Greenblatt suggests creating a portfolio of 20 to 30 stocks
  • Select companies for your portfolio from large-cap companies
  • Calculate each company’s earnings yield
  • Evaluate return on capital (ROC)
  • Rank companies basis highest earnings yield and ROC
  • Buy 2 to 3 position on the top 20-30 companies every year to create a portfolio. You need to follow the strategy systematically over a period for the formula to work
  • Monitor portfolio performance and regularly rebalance by selling off loss-making shares after 51 weeks of purchasing and the winners on 53 weeks
  • Repeat the process for a period of five to ten years to generate a market-beating return

When Greenblatt proposed his formula in the 80s several fund management companies said to have followed it to generate a significant return. Greenblatt claimed that he was able to generate a 30 percent return using the formula.

General Exclusion

Magic formula investing, however, doesn’t work in all market conditions. It excludes the following

  • The general exclusions to use this formula will set your expectation right. Although called magic formula, it’suseful in evaluating only large-cap companies
  • Financial and banking sector companies also don’t fall under the rule of magic formula investing
  • Greenblatt excluded foreign companies in his magic investing formula

The Closing Thoughts

When describing what magic formula investing is, Greenblatt explained it as “a long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices.”

But does the magic formula investing work? Magic formula investing is a successfully back-tested strategy to improve your chances of outperforming the market overa period of time. The magic formula investing might have lost some of its shine, but no investment formula is foolproof and works in a controlled environment.