Magic Formula is a stock screen popularized by Joel Greenblatt in his book “The Little Book that Beats the Market”. According to his backtest, 19 years so far (as of nov 2019), the methodology presented consistently beats the S&P 500 index.
Greenblatt recommends buying 30 companies every year with highest earnings yield and return on capital. These are defined as
How to Use Magic Formula Investing Process?
The detailed process is as follows:
- Decide on the minimum market capitalization you want to use. He suggests $50 million and above. At Value Stock Guide, we look for stocks above $30 million in market cap
- Exclude Utilities and Financial Stocks
- Exclude non-US stocks. You want to screen for stocks on US exchanges, and exclude ADRs
- Rank all companies above the minimum market capitalization to find highest Greenblatt Earnings Yield and highest Greenblatt Return on Capital. You can assign 50% and 50% weights to each metric to help in the ranking process
- Purchases 20-30 of the highest ranked stocks in the shortlist, buying 2-3 stocks each month.
- At the end of the year, sell the losers a week before year end. Sell the winners a week after the year end
- In the new year, repeat this process by running the screen again and finding the 20-30 top rated Magic Formula stocks for this year
- Keep on doing this every year for long term
Many investors report this process to be worthwhile in helping their portfolio earn above market returns. It also has the advantage of being quasi-passive investing, as you are picking stocks only a few times each year.
Why this Works?
There are a few things to note here. Using the modified definitions of earnings yield and return on capital (by using EBIT and EV to calculate them instead of Net Income and Book Value), helps in removing the accounting artifacts that tend to color Net Income and Book Value metrics and possibly making them less useful. Return on Capital is a good indicator for a company’s operating efficiency and is a proxy for its competitive advantage, or MOAT.
Here are Value Stock Guide, you will find Magic Formula screens run every month for small cap, mid cap and large cap stocks. Recent screens can be easily accessed on our Stock Screens page. All VSG screens are run in the Stock Rover research platform, and you are able to download each screen criteria for use in your own Stock Rover account.