Simplifying magic formula investing: How can you create a magic portfolio?

A common perception regarding the stock market is that it is a realm for risk-takers, however, if you look at it closely, its truth rather sounds convenient to the ears. If we tell you that you can devise sure shot methods to boost your portfolio and reduce the risk of losing almost completely… it would rather sound incorrect.

The very existence of Magic Formula is an answer to all your questions. To put it in simple words magic formula is a method of investing that guarantees your chances of outperforming in the market. It is strategized in such a way that its primary focus is on screening companies that fall under the specific criteria of the investor and it is approached in a methodical/ technical and unemotional way to manage a portfolio.

Listening to investment gurus and dreaming of compiling their ideas together to form a perfect and fool proof blend of investment strategy is what Magic Formula aims at. This technique was developed by Joel Greenblatt and has been a massive success in the world of stock markets.

The Wharton graduate wrote a book wherein he divides stock investing into two criteria. Firstly, stock price and secondly, company cost of capital. Alternative to the fundamental analysis which is usually done for different companies and stocks, investors have now started using Greenblatt’s online stock screener to choose and invest in the top 20-30 high-ranked companies.

If you wonder how the magic formula ranks a company here’s how:

1) Their earnings in terms of stocks which get calculated by EBIT or also known as Earning Before Interest and Taxes.

2) The return on capital is used to measure how effectively they have generated earnings from their assets.

3) Their yield is calculated in the form of earnings per share (EPS) divided by the current stock price.

Investors who are seen to be using the Magic Formula usually sell the stocks which are losing value much prior to when they held them; i.e for approximately one year. Simply, to benefit from avoiding the income tax provision which allows investors to utilise losses to offset the gains they make. The winning stock is sold after the period of one year, in order to benefit from the reduced rates of income tax over the long-term capital gains. Then they start the process all over again.

As Greenblatt stated in a 2006 interview with Barron's, the magic formula is designed to help investors with “buying good companies, on average, at cheap prices, on average.” Using this straightforward, non-emotional approach, investors screen for companies that are good prospects from a value investing perspective.

What would you require to begin the magic?

One must understand that the valuation of $100 Million is a must for any company to be put under the Magic Formula. This clearly means that the magic formula excludes “small-cap” stocks.

Here’s a list of a few pointers that show us how the magic formula functions:

1. A minimum market capitalization is set for your portfolio company or companies. [Usually higher than $100 Million]

2. Financial or utility stocks are excluded while choosing the companies

3. Company’s earning yield is calculated: [EBIT/Enterprise Value]

4. Company’s return on capital is calculated: [EBIT/(Net Fixed Asset+Working Capital)]

5. Ranking is done for the selected companies from the companies providing the highest earning yields as well as the highest return on capital.

6. You can buy a position in the top 20-30 ranked companies across a course of one year

7. Every year the portfolio must be rebalanced by the selling of loser stocks [lower ranked] almost a week before the year ends and after approximately one week after the year mark you must sell off the winning stock.

8. This process must be repeated almost every 5-10 years.

According to Greenblatt this method of investing has provided almost 30% returns annually.

Although there might be a difference in the calculation of the returns gained from the strategy, quite a few financial researchers have noticed and determined that the approach of using the magical formula investing has resulted in good returns when backtested as compared to the S&P 500.

Let us discuss a few pros and cons of magic formula investing:

1. As you might have observed, it is really simple and has lucid instructions hence it is easy to follow and imply in the real world by almost any investor.

2. It is a pure numbers game and does not involve any emotional tangents in the process of decision-making.

3. It is a tried and tested method and has always given boosted gains in backtests.

However,

1. The returns achieved aren’t always as high as promised.

2. It does not cover different foreign stocks and financial or utility stocks

3. The addition of newer variables and different factors in the formula can increase its efficiency.

If you need a better understanding you can refer to these numbers of each company’s Return on Capital(ROC) and Earnings Yield (EY). A combination of these is used to rank every company.

You must play the game and hold your position for a longer period of time and maintain your position for almost a year to get any promising results.

To conclude here, the magic formula is a pretty basic; number as well as a rules-based system which is crafted to provide high returns which are within the limits of an average investor. By following this simple, algorithm-based approach, the magic formula allows investors to easily detect any outperforming as well as undervalued companies, without allowing emotions or hasty decisions to cloud their judgement. Even if the returns observed today are much lower as compared to when the Magic Formula was first devised it is still a promising and a sure shot method to gain returns on your investments.