This article is your step-by-step guide on how to use the Magic Formula investment strategy to pick stocks.
It explains what the strategy is, how to calculate the ratios, where to find the data needed, how to rank and filter stocks, and how to construct a portfolio. Useful for beginners new to the strategy.
As you know the Magic Formula is a well-known stock picking strategy made famous by Joel Greenblatt in his book The Little Book That Still Beats the Market.
This simple but effective method ranks stocks based on a combination of high returns on capital and cheap valuations.
In this post, we'll walk through the step-by-step process of using the Magic Formula to select stocks for your portfolio.
Calculating the Magic Formula
The Magic Formula ranks stocks using two financial ratios
- EBIT / Enterprise Value (EBIT stands for Earnings Before Interest and Taxes)vand
- Return on Invested Capital.
Enterprise Value is calculated as Market Cap + Debt - Cash. Return on Capital measures how effectively a company uses its money (capital and debt) to generate returns.
To calculate the Magic Formula score, you separately rank all stocks by EBIT/EV. For example the company with the highest EBIT/Enterprise Value would get a value of 1, the next best 2 and so forth.
You then do the same for Return on Invested Capital.
You then add the two ratings for each company and rank all the stocks on this combined ranking. The stocks with the lowest combined ranking thus are the best Magic Formula stocks.
Finding the Data Needed
To calculate the Magic Formula scores, you'll need to find the EBIT, Enterprise Value, and Return on Invested Capital figures for all the stocks you want to screen.
Financial websites like Yahoo Finance and Morningstar provide much of this data. You can also download financial statements from company investor relations sites or use stock screening tools like the Quant Investing stock screener.
Ranking and Filtering Stocks
Once you have the data, rank the stocks by lowest Magic Formula scores. Remember - the lower the better. You'll then want to filter out penny stocks, low traded value stocks.
Constructing a Portfolio
With your filtered list of top Magic Formula stocks, build a portfolio of about 20-30 companies.
Hold for one year, then replace stocks and rebalance.
Use equal weight positions (invest the same amount in each stock) to avoid overexposure to individual stocks.
Stick to your buy and sell rules, as patience and commitment is key!
Conclusion
Using the Magic Formula to pick cheap, high-return stocks can give you a long-term performance edge over the market.
Follow the steps of calculating the formula, getting data, ranking and filtering stocks, and constructing a portfolio.
Stay disciplined, and you may just beat the market (remember – no strategy works all the time) with this evidence-backed strategy.
Give the Magic Formula a try today!
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