The Magic Formula

The Magic Formula strategy was first described by Joel Greenblatt in the 2005 best-selling book The Little Book That Beats the Market and in the 2010 follow-up, The Little Book That Still Beats the Market.

Greenblatt mentioned two criteria for stock investing in the book: valuation and the return on invested capital (ROIC).

Greenblatt’s online stock screener tool helps investors select the top 20-30 ranked companies to invest in, thereby, helping them avoid running fundamental analyses of stocks and companies. These company rankings are majorly based on:

• The company’s earnings which are calculated as earnings before interest and taxes.
• The company’s earnings yield, which is calculated as earnings per share divided by the current stock price.
• The company’s ability to generate earnings from its assets.

Investors who use The Magic Formula sell their losing stocks before they have owned them for more than a year to benefit from the income tax provision that allows them to use losses to offset their gains.

They further sell the winning stocks after a year to benefit from the reduced income tax rates on long-term capital gains. Later, they start the process once again.

Greenblatt tested this formula on the 2,500 largest companies and the result gave a formidable annual return of 23.7%, measured against the group’s average of 12.4% per year. The result was 22.9% for the 1,000 largest companies against the group’s average of 11.7%.

By dividing the shares into ten groups, where group 1 consisted of the ones that score best on the ranking, Greenblatt got the following return per group among the 2,500 largest shares:

Overall, except for a period of three years, Greenblatt’s strategy outperformed the market 95% of the time. It is also worth mentioning that the standard deviation was lower than the market.