If you found this article you most likely have heard of the Magic Formula investment strategy developed, tested and described by Joel Greenblatt in his great book The Little Book That Still Beats the Market.
It's a straightforward and effective method for selecting stocks that offer strong returns, especially in developed markets.
In this post, I'll explain how you can tailor and apply this strategy to various developed markets to maximize your investment success. Whether you’re a seasoned investor or just starting out, grasping these principles can significantly enhance your investment returns.
Core Principles of the Magic Formula
The Magic Formula is based on two main principles: finding companies with high return on invested capital (ROIC) and high earnings yield. These metrics help identify companies that use their money wisely and offer good value for your money.
By focusing on these principles, you can sift through the market to spot the top-performing yet undervalued companies, making your investment choices smarter.
Key Point: The Magic Formula looks at ROIC and earnings yield to find high-performing, undervalued companies, especially useful in data-rich developed markets.
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Historical Success in Developed Markets
The Magic Formula has shown a consistent ability to outperform the market in various developed regions, using robust back-testing data from both the US and Europe.
This proves the Magic Formula isn't about random stock selection; it’s about systematically identifying stocks that are financially sound and undervalued.
Europe from 1999 to 2011
In Europe, detailed back-testing from June 1999 to June 2011 shows that the Magic Formula significantly outperformed general market indices.
The top-ranked Magic Formula companies, classified in quintile 1 (top 20%), achieved returns substantially higher than the overall market, with the best Magic Formula companies improving market performance by up to 152.3% over this period. The complete analysis and results of this extensive study are documented here: Magic Formula returns in Europe from June 1999 to June 2011 by company size.
USA from 1988 to 2004
Another compelling example comes from Joel Greenblatt’s own testing in the US, which formed the basis of the Magic Formula. His book showed that from 1988 to 2004, applying the Magic Formula could yield an average return of 30.8% per year, far surpassing the market average.
These remarkable results highlight the potential of the Magic Formula in a well-established market like the US. This data is comprehensively detailed in the The Little Book That Still Beats the Market returns 1988 to 2004 returns.
More Backtests in Europe
Further confirming the strategy’s value, additional tests have been conducted across various markets in Europe, including Finland and the Benelux region.
For instance, the Magic Formula applied to the Finnish market from 1997 to 2010 showed that it significantly outperformed the general market, a finding detailed in Topias Kukkasniemi’s master's thesis, which is summarized here: Magic Formula in Finland 1997 to 2010.
Similarly, in Belgium, Luxembourg, and the Netherlands, applying the Magic Formula from 1995 to 2014 would have yielded an average yearly return of 7.7% above the market, detailed in the thesis by Pim Postma and which you can read about here: Magic Formula in Belgium Luxembourg and the Netherlands 1995 to 2014.
Key Point: The Magic Formula has proven its effectiveness in developed markets, consistently outperforming standard market indices through careful selection of undervalued, high-ROIC companies, as evidenced by extensive back-testing in Europe and historical data from the US.
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Integrating Other Strategies with the Magic Formula
Combining the Magic Formula with other investment ratios and indicators can significantly enhance its returns. By integrating additional metrics such as momentum, you can capture a broader range of factors that might affect a stock's performance, potentially giving you even better returns.
Magic Formula with Momentum
For example, a compelling strategy that has been tested is the integration of the Magic Formula with momentum indicators.
Back testing this combination in Europe from June 1999 to June 2011 showed substantial improvements in returns.
By first selecting the top 20% Magic Formula companies and then filtering these by the highest 6-month price index (a common momentum indicator), you could have dramatically increased your returns.
This strategy produced an impressive return of 783.3% over the 12-year period, which was a 600.5% improvement over using the Magic Formula alone. You can see the detailed results of this combination here: Magic Formula returns when combined with a third ratio in Europe from June 1999 to June 2011.
This shows you the power of layering strategies.
By using the Magic Formula to identify fundamentally strong, undervalued companies, and then applying a momentum filter to select those in an upward price trend, you successfully combine quality (ROIC) value (Earnings Yield) and momentum (Price Index 6 months).
This approach not only diversifies the investment strategy but also taps into different aspects of market dynamics, thereby potentially reducing risk and enhancing returns.
Key Point: Integrating the Magic Formula with momentum indicators has proven to yield significantly higher returns, as shown by extensive back-testing. This strategy lets you benefit from both the intrinsic value of stocks and their market momentum, leading to a more robust, dynamic investing approach.
Conclusion
The Magic Formula is a powerful investment strategy for anyone looking to make smart investments in developed markets.
It has been tested and proven to work, providing a strong foundation for your investment strategy.
Additional Magic Formula Back Tests
For more in-depth information on the Magic Formula including a summary of all the back tests we could find go here: Summary of all the backtests on the Magic Formula we could find
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