Magic Formula Investing
Candlefocus EditorThe primary focus of the magic formula is to find and identify low-priced, high quality companies trading on the stock market. This is achieved by taking two factors – a company’s return on capital (ROC) and its earnings yield (EY) – and combining them into a single metric known as the “magic formula”. The ROC is a measure of the profitability of a company's capital investments while the EY looks at a company’s profit in relation to its enterprise value. Companies are evaluated and screened according to two criteria: their ROC and their EY. The higher the combined total between the two, the more desirable the company is for investment.
The specific rules for a company to qualify for the “magic formula” are as follows:
-The company must have a market capitalization of $50 million or greater. -The company must not be in the finance, utility, or foreign markets. -The company must have a positive prior-year operating income.
The formula, then, is designed to identify companies that meet the criteria and offer both a high ROC and a high EY for their stock.
When the strategy is applied to one’s portfolio of investments, it aims to reduce the volatility and emotional judgment when selecting stocks, and promote sustained and optimal returns over time. The benefits of utilizing the magic formula in one’s strategy are numerous. It is capable of narrowing down a large field of potential investments to a more manageable list of selections and provides an unemotional, risk-managed approach to selecting investments. The strategy allows investors to focus on the core fundamental principles of the investment opportunity.
The strategy is considered to be a very successful back-tested strategy with Greenblatt claiming annualized returns of over 30%. Utilizing the magic formula in one’s portfolio can increase one’s chances of outperforming the stock market and provide an efficient, effective approach to selecting investments.