Investing > Complete Guide to Magic Formula Investing

Complete Guide to Magic Formula Investing

Anyone can invest in an index fund—but magic formula investing can single out the best stocks that the S&P 500 has to offer.

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Updated June 06, 2022

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What is the easiest way to invest (but so that you actually make money)?

Believe it or not, the answer to this question is simple: Just buy an S&P 500 index fund and let your portfolio grow with the market. This method, often preferred by retirement investors, is simple and fairly low-risk over the long term because the stock market grows about 10% per year on average even when the near-term situation is looking very different.

But the problem with this approach is that it will never provide returns that are above the stock market average—it is the average. However, there is a way to tweak it so it outperforms the market while retaining all the benefits of a boring risk parity portfolio that is becoming less and less appealing to investors as time goes on. ⏳

This improved method is called magic formula investing, and despite its obviously market-y name, it has shown great results since it was invented. Essentially, instead of buying, say, the top 500 companies in the U.S. through an ETF, what if we vigorously filter through all of these and only invest in the top 50 value stocks that have the best risk-reward ratio?

Naturally, this should give us an above-average return whatever that might be—and fortunately, magic formula investing isn’t hard to pull off, even for beginners. In this article, we will explain how this investment method works, what its results have been since it was developed, and how you can apply a bit of ‘magic’ to your investments.

Let’s get straight to it. 👇

What you’ll learn
  • What is Magic Formula Investing?
  • Understanding the Magic Formula Investing
  • How the Magic Formula Method Works
  • Success Rate of the MFI
  • Advantages
  • Disadvantages
  • Conclusion
  • Get Started with a Stock Broker

What Exactly is Magic Formula Investing? 📚

The main idea behind magic formula investing is the following: picking the best stocks out of all the top-tier value stocks on the markets, and investing in them in order to surpass the average stock market return. Instead of investing in a broad market index, just pick the very best few companies from that index and invest in them.

And this logic is sound—if we look at an index like the S&P 500, it only makes sense that some of the 500 stocks perform below average and that some perform way above average. For example, Apple vastly outperformed the market, as well as its FAANG peers in 2022, as well as many years prior.

Is this a coincidence? Probably not, says Joel Greenblatt, the hedge fund manager and Colombia UNI professor who developed and popularized magic formula investing.

Greenblatt’s method helps investors choose and rank medium and large-cap stocks according to certain fundamental data that can speak volumes of a company’s future prospects. Using this method, Greenblatt managed to pull off an average 24% yearly return from 1998 to 2009—which is outstanding, especially considering that the dot-com crash and the housing market crash happened during this period.

However, as an investment expert and a hedge fund manager, Greenblatt had a deeper understanding of fundamental analysis and how it can be applied to his method. So, let’s dive into all the fundamental factors that he used to achieve a decade of success.

Understanding the “Magic” Formula

The beautiful thing about magical formula investing—which we will call MFI from now on —is that we can just take any stock, run it through a series of very simple checks, and see if it is worth investing in. 

And what makes this even simpler is that MFI only works with value stocks like Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), and Target (NYSE:TGT) that are easy to find, trade, and research.

Moreover, there aren’t too many value stocks on the market because only a select few companies ever reach this title. The only thing an investor needs to do after that is to look under the hood of each company and see which ones show the most promise according to math and statistics—let’s see how all this works step-by-step.

Stock Requirements for Magic Formula Investing ☑

Greenblatt’s formula is generally only used on companies that have a market cap greater than $100 million, so startups, penny stocks, and most small-cap stocks are out of the question. Moreover, the formula excludes foreign companies, financial stocks, and utilities because they have a special position in the market.

For example, utility companies and banks are entities of national importance, so some rules that apply to other stocks on the free market don’t apply to them. After we’ve pushed these stocks away, it is time to start crunching numbers.

Earnings Before Interest and Taxes (EBIT) 💰

Instead of just focusing on a company’s earnings, studying its earnings before interest  and taxes provides a clearer view of its performance. For instance, when a new president comes along and raises corporate tax from 21% to 28%, any company may have lower earnings as a result, even if its sales are increasing.

The same goes for FED’s counter-inflationary increases in interest rates. Even if a company has very little debt, an increase in interest rates will make that debt more expensive, and that will be felt in the company’s net earnings.

But if we look at earnings before these two deductions, we can see how the company is really performing financially speaking, and not just how much money it has left over at the end of the month.

Earnings before interest and taxes—or EBIT, for short—is calculated by taking a company’s revenue and subtracting expenses, but without subtracting tax and interest expenses. But, it is often just easier to find this info online—stock exchanges show fundamental data on all their listings on their official websites. Alternatively, investors can make use of the leading software for analyzing stocks to find this information as well.

Formula used to calculate Earnings Before Interest and Taxes (EBIT)
Investors can use a company’s EBIT to gain a clearer perspective on its performance.

Is a stock’s EBIT improving over time? Is it better than the market average? Does it look like the company is planning something that will reliably increase its EBIT? How does this stock look compared to the other stocks I like? These are all the questions that need to be asked.

Earnings Per Share (EPS) 💵

Now that we have examined a company’s performance, we need to see if its stock is overpriced or not—and we can do this by looking at earnings per share or EPS. A company’s EPS is its net profits divided by the number of shares outstanding, which is the total number of shares held by all shareholders, including private investors and institutions.

So, this formula tells us how much money a company is making per share. If it has 100 shares and makes $5,000 per year, that is an EPS of $50 per share, which is very nice. But, if just one share of the company costs, say, $650, then the stock is likely overpriced as it costs far more than the company earns.

Earnings per share (EPS) formula
Earnings per share tells us the amount of money a company makes per share.

Naturally, the more earnings per share, the better. However, some growth stocks, especially in the tech industry, have shown great results despite a low EPS. The most popular example is TSLA—a stock that grew because of its future prospects (cutting-edge tech, dominant position in the EV industry, and Elon Musk as its CEO) and not its financials.

This is why MFI focuses only on value stocks—these are usually huge brands (like Target, Microsoft, etc.), and are already well-established in the market and won’t become the “next big thing.” They are already big and their goal is to remain so. 

In order to do that, value stock companies need to operate as efficiently as possible and keep their finances in order—which means that using a metric like EPS to measure their worth is a reliable method.

Return on Capital Employed (ROCE) 💳

Greenblatt’s return on capital formula used in MFI is different from the regularly used ROC. Namely, Greenblatt’s version calculates how well a company can utilize its capital by dividing EBIT by capital employed. 

Capital employed is simply the total amount of money that a company spends with the goal of making a profit. This means money used for R&D, marketing, building a new factory, etc.

By dividing EBIT with capital employed on a 12-month scale, we get an idea of how efficiently a company uses its capital. Basically, every company wants to use its capital to increase its earnings over the long- or medium-term—if a company can invest relatively little money and still get a big boost in earnings as a result, that’s the ideal scenario.

Return on Capital Employed (ROCE) formula
ROCE is a ratio used in finance to show whether a company is generating profits from its capital, or not.

Therefore, the higher the ROCE, the better. As a rule of thumb, companies with a 2-digit ROCE are favored more in magic formula investing because this indicates that a company has a defensive edge and might even indicate that a company has an economic moat.

A Breakdown of How the Magic Formula Method Works 👨‍🏫

The best way to approach a new soup recipe is to write down all the ingredients in order—that way, you can just follow the recipe step by step. We will do the same: Here is a checklist of all the requirements a stock needs to meet, as well as the analyses an investor needs to conduct in order for the MFI to work as intended:

1. Set the Market Cap 📊

The first thing we need to do is determine which companies to look at and compare—to do that according to MFI, we should exclude all companies with a market capitalization lower than $100 million. However, this number can be higher or lower depending on the investor’s preferences and risk tolerance. 

Greenblatt himself recommended excluding all companies with a market cap under $1 billion because large-cap companies are usually lower-risk as they are less volatile. So, a higher market cap requirement is recommended for beginners.

2. Exclude Certain Industries ❌

The MFI method should not be used on financial stocks, utilities, as well as on ADRs, or foreign stocks. The reason behind this is that these types of stocks don’t play by the same rules as the rest, and as such, their financials don’t have the same meaning. Here is what we mean:

Financial stocks like banks essentially live off of debt. Banks borrow money from clients and other banks and then loan that money to at a higher rate. If we use a metric like earnings before interest (EBIT) to rate a banking stock, we will get a skewed image of how well that bank is doing. Banks need to borrow in order to lend to other borrowers and make a profit, and so, debt isn’t necessarily a bad thing. 🤔

Then there are utility stocks. These are companies that have key roles in the country’s infrastructure and are practically too big and too important to fail. In times of crisis, governments may bail out utility companies to make sure they keep working at all costs—therefore, they exist in a different situation to, say, unessential luxury goods stocks and can’t be analyzed using MFI.

And the last asset that needs to be excluded are foreign stocks—or ADRs, which give individuals effective ownership of non-U.S. stocks. Foreign companies may exist in a completely different economic climate. 

For example, Russian stocks became close to worthless in 2022 because of the Ukrainian conflict—a fate not shared by the markets in the U.S. and Europe. Therefore, comparing stocks from different countries using MFI will not give us reliable results. All foreign stocks should be excluded from our analysis.

3. Make a List 📜

This is the simplest part of the process. Now that we know what the minimum market cap is and what to exclude, we can make a long list of stocks that we will then analyze and compare. A good way of doing this without any special software is to simply open an MS Excel sheet, list all the companies, and make it so that there are at least 5 columns so that all the relevant data can fit neatly—something like this:

Stock NameTickerShare PriceMarket CapEBITEPSROCE
Example Ltd. EXPL$36$420 m$31.7 m$1115

For a bit more useful info, we can also add a few columns that show us how much each of these metrics has grown over the past year or a few years on average. That way, if we spot that a company’s EBIT is steadily growing over time, we might like that stock more than the one that has a better EBIT but is stagnating.

4. Make the Calculations 🧮

After we’ve made our table and listed all the stocks, it’s time to add all the relevant metrics: These are EBIT, EPS, and ROCE. We’ve mentioned how each of these is calculated but to make a long list without an unreasonable amount of hassle, we need a few shortcuts.

The quickest way to get all this data is to simply look it up online. The official websites of all major stock exchanges should have this info about all the stocks listed there. The rest is grunt work and manually filling each box with numbers—or writing some magical code that will automatically update your table.

5. Create the Rankings 🥇

Now that we have our data, it is finally time to rank these stocks from best to worst. Make a top list for each of the categories—EBIT, EPS, and ROCE—and see if there are companies that rank in the top 10 for all 3 metrics.

If they do, we can put those stocks on the top. Then, we can see if there are companies that are in the top 20 and add them to the list next, and so on. This will give us a ranked list of companies that we can then invest in or continue to study further.

6. Build the Portfolio 📝

Once we’ve figured out what we like and don’t like, it is time to start buying. Greenblatt’s advice for investors is to buy shares of 2-3 stocks per month for a year. In other words, the idea is to buy the top 3 stocks from our list in the first month after our paycheck comes in, then the next 2-3 stocks next month, and so on. 

According to Greenblatt, owning 20 stocks like this makes for a reasonably diversified portfolio, which is why he suggested this approach for new investors. This portfolio should then perform well compared to the S&P 500 but can be made more well-rounded by adding recession-proof assets like gold to the mix.

7. Sell After 1 Year and Rebalance 🗓

It is also important to hold each of these assets for over a year because long-term capital gains tax becomes effective after 365 days of holding a stock, and it is a lot lower than short-term cap gains tax. However, if some of your positions are in the red after one year, Greenblatt suggests selling them at a loss before 365 days are up.

This is because selling a stock that has lost value after less than one year will make you eligible for a tax deduction—and that deduction will be greater if the stock is sold at a loss when it is still subject to short-term capital gains tax. Selling stocks at a loss to offset taxes is a very common practice in investing called tax-loss harvesting and it will lower all losses.

Essentially, it can often be more profitable to sell at a loss, lower your tax burden, and then reinvest your money than to idly sit and wait for the stock to bounce back eventually. So in summary, sell losers before one year is up, and sell winners after one year is up, rebalance your portfolio each month, rinse and repeat forever.

🧠 Pro tip: Every time you make a profit in the stock market, the government will demand its piece of the pie, hurting your gains. No one should pay more than necessary, so knowing how taxes work in stock trading is crucial for every investor.

Success Rate of Magic Formula Investing

Joel Greenblatt shared his results after using the MFI for almost 17 years in his capital work “The Little Book that Beats the Market,” and according to this book, he had an average annual return of almost 30% during that period. Needless to say, this level of returns is amazing and 3 times higher than the stock market average, but we cannot trust this statement blindly.

Investment gurus often exaggerate their claims, and even the words of reputable college professors like Greenblatt shouldn’t be taken at face value. Moreover, most of his career happened in the 90s, so we should forget about his 30% returns for a minute and look at a more recent example closer to today’s market conditions first.

Back in 2020, researchers backtested the MFI approach by creating a hypothetical portfolio that followed Greenblatt’s methodology to the letter from the period from 2003 to 2015. The results were encouraging but not mind-blowing—the hypothetical portfolio had an average yearly return of 11.4%.

Considering that the average stock market gain in this period was about 8.4% per year, the results of this backtested portfolio were in support of MFI. This method really did outperform the market, but not to the extent that Greenblatt’s supposed portfolio did. All in all, all this backtest tells us is that it might be better to use MFI than it is to simply invest in the S&P 500, but not that this strategy will generate 20%+ returns every year.

Advantages of MFI 🌟

First of all, MFI is a rules-based, algorithmic investing approach that can outperform the markets. The formula tells investors what and when to buy and sell—this is immensely valuable for the average investor because it completely takes investing psychology out of the picture, giving them a reliable investment method that won’t let them make an emotional decision.

Moreover, the method has been tested on more than a few occasions and even though Greenblatt’s supposed returns seem fairly unrealistic, it is reasonable to assume that MFI can beat the market most of the time, at least by a little bit. All of this plus the fact that this strategy carries no more risk than investing in a value stock ETF makes MFI a great method for long-term stock investors—even complete beginners.

Everything is predetermined and math-based, and yet simple, which is great because uncertainty can bring about feelings of fear and greed in investors—and these feelings are exactly what causes hasty, irrational, and costly decisions. All in all, MFI is a solid method that only more advanced traders might find fault with because it is shallow when it comes to analyzing individual stocks.

Disadvantages of MFI ⚠

From what we’ve discussed thus far, magic formula investing seems like a very reasonable, simple strategy with very alluring potential but fairly little downside. But, whenever something sounds too good to be true, it probably is, and MFI is not an exception to this rule—let’s see if this strategy has any major flaws:

First of all, Greenblatt suggests investing in 2-3 companies per month and only selling each position after a year. This means that an investor following MFI will have a stock portfolio of at least 24 to 36 stocks at any given moment—and this means they will practically have their personal index fund which is difficult to manage. 🎚

Why not just buy a cheap value stock ETF then? Well, very few ETFs have had the returns that Greenblatt had using MFI, so it makes more sense to use his strategy—or it would if the strategy didn’t have any glaring flaws.

For one, this strategy is all about value stocks, which means that it is not one bit recession-proof. Stocks go down during recessions, and so will an MFI portfolio unless it is supported by defensive assets—the portfolio is designed to work in bull markets but will suffer just like the S&P 500 during crashes and recessions.

And even its performance during bullish periods is uncertain—there is a lot more to investing than looking at 3 pieces of a company’s fundamental data. For example, even if a stock can meet Greenblatt’s criteria, its price can still be affected by other factors like commodity prices, news of a company scandal, or a public statement by an influential investor. 

All in all, magic formula investing isn’t really magic—it follows a certain logic that should produce an above-average portfolio in a bull market and doesn’t consider that many factors. Following formulas can sometimes get us into trouble if we don’t understand why we are following them, so it’s best to see this one as just one more investing strategy with clear limits and risks.

💡 Helpful tip: In addition to a proven strategy, investors also need to utilize a reliable stock trading app with the tools and research capabilities required to execute the strategy.

Conclusion: Should You Give This Strategy a Try? 🏁

When all the pros and cons are considered, we can safely arrive at the following conclusion: It seems like using the MFI method can produce better results than just buying an S&P 500 ETF or mutual fund, but there are no guarantees. 

Since the strategy revolves around singling out the most financially healthy and efficient companies, it makes sense that we can end up with a portfolio of above-average stocks in bullish market conditions. Plus, funds have management fees and a MFI portfolio doesn’t.

However, the first problem with MFI is that it only deals in stocks—and this means it will generate a portfolio that is not protected from a recession or a crash. Moreover, considering the myriad of factors that determine stock prices, magic formula investing is very limited and won’t account for every contingency. All in all, MFI is a simple way of picking value stocks based on their financials, but is very limited as it only focuses on a single asset class.  

Magic Formula Investing: FAQs

  • What Does Magic Formula Mean?

    The magic formula is a system of rating stocks according to certain fundamental data. The formula seeks to calculate which stock will have the best and most reliable growth based on their financial performance—but this mostly only applies to value stocks.

  • How Do You Use Magic Formula Investing?

    The first step of using MFI is picking out a group of stocks that meet all the requirements for MFI. Then, stocks are rated according to their earnings before interest (EBIT), earnings per share (EPS), and return on capital employed (ROCE). Finally, the stocks with the best results are picked over the rest and bought, only to be sold more than one year later in order to avoid short-term capital gains tax.

  • Does the Magic Formula Investing Work?

    During his career as an investor and hedge fund manager, the creator of the MFI Joel Greenblatt had a 24% average yearly return in the period from 1998 to 2009. This is an outstanding performance compared to the stock market average of 10%/year, especially considering the two recessions that happened during this time

  • What is the Magic Formula Portfolio?

    This is a portfolio consisting of stocks that showed the best results after being rated through an investing system called magic formula investing. Essentially, this should be a portfolio of value stocks that have the best financial prospects out of all similar stocks in the market, and should, therefore, outperform the market.

  • What is a Good Return on Capital Employed?

    As a rule of thumb, only stocks with a ROCE higher than 10 can be considered in MFI. This means that a company can use its capital to increase its earnings reliably, meaning it will likely continue to expand and appreciate in value.

  • Is Magic Formula Investing Good for Beginners?

    Yes. The method is straightforward, easy to use, and involves selling stocks after holding them for no less than one year to avoid short-term capital gains tax. In theory, the potential risks of MFI should be no greater than the overall stock market risks while the gains should be higher.

  • How Safe is Magic Formula Investing?

    If done properly, magic formula investing should be safer than investing in a broad-market index. Namely, MFI seeks to identify value stocks with the best risk-return ratio and best potential returns, essentially creating a portfolio that is an improved, optimized version of an S&P 500 index fund.

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