What is a Magic Formula Screen Developed by Joel Greenblatt?
The Magic Formula is a stock screening method created by investor Joel Greenblatt to find good companies at cheap prices. It answers the question of what is value investing by systematically ranking stocks based on just two factors: earnings yield and return on capital.
What is Value Investing and How Does the Magic Formula Fit In?
Did you know that a simple, two-part formula has historically outperformed many professional stock pickers? The Magic Formula is a stock screening method developed by famed investor Joel Greenblatt. It gives you a systematic way to find good, undervalued companies, which is the core of what is value investing. At its heart, value investing is the art of buying stocks for less than their true, underlying worth. Think of it as finding a high-quality television on sale for half its price.
Joel Greenblatt, an adjunct professor at Columbia Business School and a successful hedge fund manager, wanted to create a tool for the average person. He wanted to give everyone a way to apply sound investment principles without needing a finance degree. His book, “The Little Book That Beats the Market,” introduced this very formula.
The Magic Formula automates the search for two things every value investor wants:
- A good business: A company that is highly profitable and uses its money efficiently.
- A cheap price: A company whose stock is trading for less than it is actually worth.
By ranking companies based on these two ideas, the formula creates a list of potential investment opportunities. It removes emotion from the decision-making process, which is often an investor’s biggest enemy.
The Two Pillars of the Magic Formula
The entire strategy rests on two simple, yet powerful, metrics. Greenblatt believed these two factors were the best indicators of a good company available at a bargain price. Let's break them down.
1. Earnings Yield (Finding Cheap Companies)
Earnings yield tells you how cheap a company is relative to its profits. It’s a bit like the inverse of the Price-to-Earnings (P/E) ratio but is considered more comprehensive. The formula looks at a company's earnings before interest and taxes (EBIT) and compares it to its enterprise value.
Enterprise Value = Market Capitalization + Debt - Cash
A high earnings yield is good. It means you are getting more profit for the price you pay for the business. Imagine you could buy a small business. A high earnings yield is like getting a high rate of return on your purchase from day one.
2. Return on Capital (Finding Good Companies)
Return on Capital, or ROC, tells you how good a company is at its job. Specifically, it measures how much profit a company generates from the money invested in its operations (like factories, equipment, and inventory). The formula for this is also based on EBIT.
Return on Capital = EBIT / (Net Working Capital + Net Fixed Assets)
A high return on capital is a sign of a great business. It shows that the management is skilled at turning money into more money. These are often companies with a strong competitive advantage that allows them to earn high profits without spending a ton of capital.
How to Use the Magic Formula Screen Step-by-Step
Applying the formula is a straightforward process. You are essentially creating a ranked list of stocks and picking from the top. While some websites do this automatically, understanding the steps is crucial.
- Establish a Minimum Size: Start by setting a minimum market capitalization, for example, 50 million or 100 million dollars. This helps you avoid tiny, illiquid, and highly risky companies.
- Exclude Certain Industries: The formula is not designed for financial firms (like banks) or utility companies. Their financial structures are very different, and these metrics don't provide a fair comparison.
- Rank by Earnings Yield: Take all the remaining companies and rank them from best (highest earnings yield) to worst (lowest). The company with the highest yield gets rank #1, the second-highest gets #2, and so on.
- Rank by Return on Capital: Now, re-rank that same list of companies based on their return on capital. The company with the highest ROC gets rank #1.
- Combine the Ranks: Add the two rank numbers together for each company. A company that is #10 in earnings yield and #20 in return on capital would have a combined score of 30.
- Buy the Top Stocks: The companies with the lowest combined scores are your top candidates. The Magic Formula strategy suggests buying a basket of 20 to 30 of these top-ranked stocks to ensure diversification.
- Hold and Rebalance: You hold these stocks for one year. After a year, you sell them and repeat the process, buying the new list of top-ranked companies. This disciplined approach is key to the strategy's long-term success. You can find the data needed for these calculations, like EBIT, in a company's public filings on databases like the SEC's EDGAR. You can search for company filings here.
Pros and Cons of the Magic Formula Approach
No investment strategy is perfect. The Magic Formula has its strengths, but you must also be aware of its weaknesses.
| Pros | Cons |
|---|---|
| Removes Emotion: It's a purely mechanical system, preventing fear and greed from influencing your decisions. | Can Be Volatile: The portfolio can experience significant ups and downs, especially in the short term. |
| Simple to Understand: The logic is based on two common-sense principles: buy good and cheap. | Requires Patience: The strategy may underperform the market for months or even a few years. It requires discipline to stick with it. |
| Strong Historical Performance: In backtests, the formula has shown impressive long-term returns. | Ignores Qualitative Factors: It doesn't consider management quality, brand strength, or industry trends. |
| Focuses on Business Quality: It forces you to look at the underlying profitability of a business, not just its stock price. | Past Performance is No Guarantee: The market changes, and there's no certainty that historical results will repeat. |
Is Greenblatt's Magic Formula Still Effective?
This is a common question, and the answer is nuanced. The principles behind the Magic Formula—buying profitable businesses at reasonable prices—are timeless. That is the definition of what is value investing. However, the investment world has changed since the book was first published.
The formula can work, but it demands immense patience. It often picks stocks that are out of favor, and it can take a long time for the market to recognize their value. During these periods, your portfolio might look very different from the popular indexes, and you might feel like you're missing out.
The strategy's effectiveness depends heavily on an investor's ability to stick to the plan through good times and bad. It is not a get-rich-quick scheme. Instead, see it as a powerful starting point for your research. The list of stocks the formula generates is a great place to begin your own deeper analysis before committing any money.
Frequently Asked Questions
- What are the two main parts of the Magic Formula?
- The Magic Formula is based on two key metrics: Earnings Yield, which measures how cheap a company is, and Return on Capital, which measures how good a company is at generating profits from its investments.
- Does the Magic Formula work for all types of companies?
- No, Joel Greenblatt recommends excluding financial and utility companies. Their financial structures are different, and the formula's metrics are not as effective for evaluating them.
- Is the Magic Formula a guaranteed way to make money?
- No investment strategy is guaranteed. While the Magic Formula has a strong historical track record, it can be volatile and may underperform the market for extended periods. It requires discipline and patience.
- How many stocks should you buy using the Magic Formula?
- The strategy recommends building a diversified portfolio of 20 to 30 of the top-ranked stocks. This helps to reduce the risk associated with any single company performing poorly.