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Greenblatt uses EBIT Earnings Before Interest and Taxes as opposed to net income because it puts companies with different debt levels and tax rates on an equal footing when comparing their returns. ROIC Return on Invested Capital is a measure of return on invested capital, either in terms of benchmarking the economic performance of several companies or in terms of value creation by a company.
By comparing the ROIC of different companies, it is possible to identify those that generate the highest return on invested capital. The secret of the magic formula It is not enough to simply apply these two filters to all companies. A few adjustments are necessary before implementing this formula. This amount, set almost 20 years ago, is no longer really relevant. Financial stocks, i. Utilities are also excluded. Among these categories we can count water, gas, electricity or energy suppliers in general.
In other words, these are foreign companies listed in the US. In addition, select companies with pre-tax earnings yields above the average for their sector. Another rule is that one should only buy companies with returns on invested capital ROIC that are higher than the average for their sector.
Keep only the companies with the highest results. Once all these steps are done, it is enough to buy two to three positions each month in the top 20 to 30 companies and sell each position after one year of holding. Some studies have also shown that combining the magic formula with momentum filters greatly improves returns. Source: Backtest Open Source Reddit If this sounds tempting and very simple to reproduce, wise investors will know how to take a step back from these beautiful promises.
In hindsight, it is relatively simple to find a set of criteria that will beat the market. Key Takeaways Magic formula investing is a successfully back-tested strategy that can increase your chances of outperforming the market. The strategy focuses on screening for companies that fit specific criteria and uses a methodical, unemotional process to manage the portfolio over time.
The strategy, which is value-based, was developed by investor and hedge fund manager Joel Greenblatt and published in The Little Book That Beat the Market in The magic formula excludes certain types of companies, such as those with a small market capitalization, foreign companies, finance companies, and utilities. Greenblatt, founder and former fund manager at Gotham Asset Management, is a graduate of the Wharton School at the University of Pennsylvania.
He is an adjunct professor at Columbia University's business school. In the book, Greenblatt outlines two criteria for stock investing: Stock price and company cost of capital. Instead of conducting fundamental analysis of companies and stocks, investors use Greenblatt's online stock screener tool to select the 20 to 30 top-ranked companies in which to invest.
Company rankings are based on: Their stock's earnings which are calculated as earnings before interest and taxes EBIT. Their yield, calculated as earnings per share EPS divided by the current stock price. Their return on capital measures how efficiently they generate earnings from their assets.
Investors who use the strategy sell the losing stocks before they have held them for one year to take advantage of the income tax provision that allows investors to use losses to offset their gains. They sell the winning stocks after the one-year mark, in order to take advantage of reduced income tax rates on long-term capital gains. Then they start the process all over again. Magic formula investing only factors in large cap stocks and doesn't include small cap companies.
The remainder will all be large companies but excludes financial companies , utility companies , and non-U. The following points outline how the formula works: Set a minimum market capitalization for your portfolio companies. Ensure you exclude any financial or utility stocks when you choose your companies. These are stocks in foreign companies. Rank selected companies by highest earnings yields and highest return on capital.
Buy two to three positions each month in the top 20 to 30 companies, over the course of a year. Each year, rebalance the portfolio by selling off losers one week before the year term ends. Sell off winners one week after the year mark. Repeat the process each year for a minimum of five to 10 years or more. Advantages and Disadvantages of Magic Formula Investing The main advantage of the magic formula method is its simplicity: you don't need to be a trained investment specialist or Wall Street prodigy to invest effectively.
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