Magic formula investing is an investment technique outlined by Joel Greenblatt that uses the principles of value investing.
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’ (ISBN 0-471-73306-7), claiming 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%
- Establish a minimum market capitalization (usually greater than $50 million).
- Exclude utility and financial stocks.
- Exclude foreign companies (American Depositary Receipts).
- Determine company’s earnings yield = EBIT / enterprise value.
- Determine company’s return on capital = EBIT / (net fixed assets + working capital).
- Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
- Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
- Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
- Continue over a long-term (5–10+ year) period.
- ^Zen, Brian and Hamai, Garrett. “Joel Greenblatt Speaking at NYSSA”. December 28, 2005.