Are you new to investing and looking for a straightforward yet effective strategy to navigate the stock market? Then, look no further than the Magic Formula Investment Strategy, developed by Joel Greenblatt and explained in his great book “The Little Book that Still Beats the Market”.
This beginner's guide will help you break down the core concepts of Magic Formula investing into easy-to-understand parts, helping you unlock its potential for significant investment returns.
The Essence of Magic Formula Investing:
At its heart, the Magic Formula is a systematic approach designed to help investors find high-quality stocks at bargain prices.
As mentioned, Joel Greenblatt introduced this strategy in his book "The Little Book That Still Beats the Market," aiming to simplify the investment process for individuals managing their own portfolios.
The magic lies in its simplicity: it focuses on two main criteria – earnings yield and return on invested capital (ROIC) – to rank companies.
By doing so, it identifies quality businesses that are profitable but also available at a cheap price.
Understanding Earnings Yield and ROIC:
Earnings Yield is essentially a measure of how much bang for your buck (profit to invested capital) a stock gives you. It's calculated by taking the company's operating profit and dividing it by its enterprise value.
On the other hand, Return on Invested Capital (ROIC) tells us how effectively a company is using its capital to generate profits. High ROIC values are indicative of companies that have a competitive edge, efficiently turning their investments into earnings.
How to Implement the Magic Formula:
Implementing the Magic Formula is a straightforward process.
First, you screen for stocks that have a high earnings yield – Cheap Companies.
Secondly, you must screen for stocks that have a high ROIC – Quality Companies.
Thirdly you combine these rankings to produce a list of companies that have both a high ROIC and are Cheap.
Fourthly, you must rank them so that the best (Cheap and Quality) combined companies are at the top.
This may sound like a lot of work but we have done it all for you, take a look at this article: How to implement the Magic Formula investment strategy
Click here to start finding your own Magic Formula ideas NOW!
Buy, Hold, Sell, Repeat:
Greenblatt suggests that you buy 20-30 of these top-ranked stocks, hold them for a year, and then repeating the process.
This method encourages discipline and long-term investment, reducing the temptation to react to market volatility.
Why It Works for Beginners:
The beauty of the Magic Formula lies in its simplicity.
It demystifies the investment process, making it an excellent strategy for beginners. You don't need to be a finance expert to understand or apply it.
By focusing on two fundamental financial metrics, it helps new investors make informed decisions, steering clear of the speculative, high-risk investments that often lead to loss.
Best of all, it promotes a disciplined approach to investing, emphasizing the importance of patience and consistency over chasing short-term gains.
Case Studies and Success Stories:
Many investors have found success with the Magic Formula, as evidenced by numerous back tests we have been able to find.
They highlight the strategy's effectiveness in identifying quality, undervalued stocks that eventually lead to great returns.
While past performance is not always indicative of future results, these examples serve as a testament to the formula's potential when applied with diligence and patience.
The following summaries are taken from the article: 2023 Backtest Update: Mastering the Magic Formula.
If you would like to see more information on the back just click the above link.
Magic Formula in the US (1988-2004):
- Market Tested: United States
- Back Test Period: 1988 to 2004
- Return: Achieved an astonishing average return of 33% over 16 years, far surpassing the market average return. This performance is based on an equally weighted index of the 3,500-stock universe Joel used when testing the Magic Formula.
Magic Formula in Europe (1999-2011):
- Market Tested: Europe
- Back Test Period: June 1999 to June 2011
- Return: Companies with the best Magic Formula rank (Q1) significantly outperformed the market, which returned only 30.54% over the same 12-year period. The best-ranked companies did up to 152.3% better than the market, showcasing the formula's effectiveness across European markets.
Enhancing Returns with Momentum (1999-2011):
- Market Tested: Europe
- Improvement: By integrating the Magic Formula with momentum (6-month price index), returns improved from 183% to 783%, indicating a substantial enhancement over using the Magic Formula alone.
Magic Formula in Finland (1997-2010):
- Market Tested: Finland
- Back Test Period: May 1997 to May 2010
- Finding: The Magic Formula proved to outperform the market, with an interesting discovery that companies ranked just below the top 25% of Magic Formula companies offered better returns than those in the top 25%. This peculiar finding adds an intriguing layer to the formula's application.
Magic Formula in Belgium, Luxembourg, and the Netherlands (1995-2014):
- Market Tested: Benelux (Belgium, Luxembourg, and the Netherlands)
- Back Test Period: 1995 to 2014
- Return: Achieved an average annual market beating return of 7.7% without taking additional risk, convincingly outperforming the market during the 20-year test period. This performance reaffirms the strategy's robustness in the Benelux markets.
Magic Formula and Momentum Strategy in Europe (2016-2023):
- Market Tested: 17 Eurozone countries
- Back Test Period: January 2016 to January 2023
- Performance: Despite underperforming the market in 2018, 2019, 2022, and 2023, it excelled in all other periods. It remained ahead of the benchmark EURO STOXX Index overall, with a CAGR of +9.6% compared to the market's +7.3%, demonstrating the strategy's resilience and potential for growth over time.
Click here to start finding your own Magic Formula ideas NOW!
Conclusion:
As you can see Magic Formula Investing offers a clear, accessible path to stock market investing for beginners.
By selecting high-quality, undervalued stocks, it provides a structured approach to building a profitable investment portfolio.
Remember, the key to success with the Magic Formula, as with any investment strategy, lies in consistent application and a long-term perspective.
As you embark on your investment journey, consider the Magic Formula as a valuable tool in your arsenal, one that simplifies decision-making and promotes sound investment practices.
Click here to start finding your own Magic Formula ideas NOW!
Please note: This website is not associated with Joel Greenblatt and MagicFormulaInvesting.com in any way. Neither Mr Greenblatt nor MagicFormulaInvesting.com has endorsed this website's investment advice, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website.
