Magic Formula Investing

Magic Formula Investing (MFI) is a value investing strategy developed by Joel Greenblatt, a successful hedge fund manager and professor at Columbia Business School. Designed to help individual investors systematically identify high-quality, undervalued stocks, the strategy combines financial logic with a rules-based approach.

Greenblatt introduced this concept in his widely read book, The Little Book That Beats the Market, aiming to distill decades of investing experience into a method that balances simplicity with effectiveness.

Key Takeaways

What Is Magic Formula Investing?

At its core, Magic Formula Investing is built around two principles:

1. Invest in companies with a high return on capital (ROC) — indicating efficient use of capital to generate profits.
2. Buy those companies when they are trading at a high earnings yield (EY) — meaning they’re priced attractively relative to earnings.

By ranking companies based on these two criteria and combining the ranks, investors can target stocks that are both good businesses and cheap to buy.

How the Magic Formula Works

Magic Formula Investing follows a clear, data-driven sequence:

1. Calculate Return on Capital (ROC):
   ROC = EBIT / (Net Working Capital + Net Fixed Assets)
   This measures how well a company uses capital to generate earnings.
2. Calculate Earnings Yield (EY):
   EY = EBIT / Enterprise Value
   This estimates how much return an investor is getting for each dollar invested in the company.
3. Rank all companies in the market separately based on ROC and EY.
4. Add the two ranks together, and select companies with the best combined rankings.
5. Filter out:
   • Financial and utility companies (due to inconsistent accounting structures)
   • Companies with a market cap below a chosen threshold (e.g., $50 million)
   • Foreign firms (optional based on data reliability)
6. Build a portfolio:
   • Select 20–30 of the top-ranked companies.
   • Invest equal amounts in each.
   • Hold positions for one year, then rebalance.

Real-World Example (Illustrative)

Does the Magic Formula Work?

Historical data suggests that the Magic Formula strategy has the potential to outperform the market over the long run. According to analysis featured in the AAII Journal, the strategy systematically ranks stocks based on quality and value, offering individual investors a disciplined approach to stock selection. While the article doesn’t cite specific return figures, other sources have reported that the strategy achieved impressive results over extended periods, particularly in small- and mid-cap stocks.

However, as with any investment strategy, past performance does not guarantee future results. The Magic Formula can underperform during certain market environments—especially in momentum-driven bull markets where fundamentals are overshadowed by investor sentiment and speculative growth.

Strengths and Limitations

Strengths:

• Emotionally neutral and rules-based.
• Avoids overpriced hype stocks by focusing on fundamentals.
• Encourages long-term discipline.

Limitations:

• May lag during momentum-driven market phases.
• Excludes sectors like financials and utilities.
• Requires patience and tolerance for short-term volatility.
• Annual rebalancing may lead to taxable events.

Common Misconceptions

• “It’s a quick way to get rich.”
  In reality, the Magic Formula is a long-term strategy. It may take years to show strong returns.
• “It’s risk-free.”
  Like all investing, there’s risk involved. Some stocks may perform poorly or decline in value.
• “All companies qualify.”
  The formula intentionally excludes certain sectors and very small-cap stocks to improve consistency.

Tools to Implement the Strategy

Investors can access Magic Formula stock screens through:

• MagicFormulaInvesting.com – Greenblatt’s official free screener.
• Stock screeners from platforms like Finviz, Screener.co, or Portfolio123 (customizable).
• Spreadsheet-based models using financial statement data and ranking algorithms.

FAQs

Can I use the Magic Formula for short-term trading?
No. It is designed for long-term investing with annual rebalancing. Frequent trading goes against the strategy’s fundamentals.

Is this strategy suitable for all markets?
While primarily designed for U.S. stocks, it can be adapted to international markets, but local data consistency may vary.

What’s the minimum capital needed?
There’s no strict minimum, but a diversified portfolio of 20–30 stocks may require several thousand dollars to execute effectively.

Key Takeaways

• Magic Formula Investing aims to buy high-quality companies at low prices.
• It ranks stocks based on return on capital and earnings yield to determine overall value.
• The strategy is rules-based, repeatable, and long-term focused.
• It has historically outperformed the market, but is not immune to volatility or market downturns.
• Tools like MagicFormulaInvesting.com make implementation accessible for individual investors.
• The approach requires discipline and patience, not short-term trading.

Full Tutorial