Magic Formula Investing

Definition

Magic Formula Investing is a stock-picking technique developed by Joel Greenblatt, a successful hedge fund manager and author. The formula involves selecting companies with a high earnings yield and strong return on capital to generate a list of potentially undervalued stocks. The goal of this method is to simplify investing decisions while maximizing returns by focusing on fundamental financial metrics.

Phonetic

The phonetics of the keyword “Magic Formula Investing” are:- M: Mike- A: Alpha- G: Golf- I: India- C: Charlie (for the word “Magic”)- F: Foxtrot- O: Oscar- R: Romeo- M: Mike- U: Uniform- L: Lima- A: Alpha (for the word “Formula”)- I: India- N: November- V: Victor- E: Echo- S: Sierra- T: Tango- I: India- N: November- G: Golf (for the word “Investing”)

Key Takeaways

1. Magic Formula Investing is a long-term stock investing strategy developed by Joel Greenblatt to help investors identify high-quality companies at discounted prices.
2. The strategy uses a simple, quantitative screening method that combines Return on Invested Capital (ROIC) and Earnings Yield to rank stocks and identify those with the best combination of quality and value.
3. Although this approach may involve higher portfolio turnover and be subject to short-term market fluctuations, it has historically outperformed the market over the long run as a passive strategy, providing investors with attractive risk-adjusted returns.

Importance

Magic Formula Investing is an important business/finance term because it refers to a simplified, systematic, and value-focused approach to stock market investing, developed by renowned investor Joel Greenblatt. This method ranks stocks based on their profitability and valuation, helping investors identify undervalued, high-quality companies with strong financial performance. Utilizing the magic formula can potentially provide investors with higher returns compared to the broader market, while minimizing the impact of biases, emotions, and market inefficiencies. Consequently, Magic Formula Investing has emerged as a popular strategy for individual investors who aim to build a well-balanced, long-term portfolio while minimizing risks and maximizing returns.

Explanation

Magic Formula Investing (MFI) serves as an investment strategy that aims to simplify the process of identifying and selecting efficient investments in undervalued stocks with attractive financial performances. Developed by Joel Greenblatt, a renowned hedge fund manager, the primary purpose of this formula is to enable investors to leverage a quantitative, systematic approach when sifting through the vast universe of stocks. By utilizing a combination of fundamental metrics, such as a firm’s Return on Invested Capital (ROIC) and Earnings Yield, MFI caters to value-oriented investors who seek to maximize their returns by investing in high-quality businesses trading at discounted prices. The allure of Magic Formula Investing stems from its straightforward methodology and the promise of consistently outperforming the broader market. The process involves ranking the stock universe based on the two aforementioned factors and then constructing a portfolio comprising the top-ranked stocks. This approach advocates that, over the long run, the portfolio will experience superior returns as quality businesses with discounted valuations appreciate to their fair intrinsic value. Furthermore, MFI’s systematic nature offers a disciplined and objective framework for decision-making, reducing biases and emotions that often impact investment choices. As a result, Magic Formula Investing has gained credibility and popularity among investors seeking an effective and accessible strategy for value investing in the ever-changing financial market landscape.

Examples

Magic Formula Investing is a stock-picking strategy developed by Joel Greenblatt, a hedge fund manager, and author of the book “The Little Book That Beats the Market.” The strategy ranks stocks by their attractiveness based on their cheap valuation (high earnings yield) and high return on invested capital (ROIC). 1. Apple Inc. (NASDAQ: AAPL):In 2013, Apple Inc. met the criteria for Magic Formula Investing as the company had a high earnings yield and return on invested capital. The earnings yield was around 10.7%, and the return on invested capital was 29%. The stock was considered undervalued compared to its potential profits. Over the next few years, Apple’s share price grew significantly, providing strong returns for those who followed Greenblatt’s strategy. 2. Gilead Sciences (NASDAQ: GILD):In 2015, Gilead Sciences, a biopharmaceutical company, qualified as an attractive stock according to Magic Formula Investing. At the time, the company had an earnings yield of around 14% and a return on invested capital of 102%. Gilead Sciences’ strong fundamentals and financial performance allowed it to maintain high returns on investment, making it a suitable candidate for the Magic Formula. Investors who purchased GILD at the time would have experienced periods of considerable gains over the following years. 3. General Motors (NYSE: GM):In 2018, General Motors met the Magic Formula Investing criteria due to its high earnings yield and return on invested capital. The company had an earnings yield of around 11% and a return on invested capital of 12%. These metrics suggested that General Motors was undervalued and poised for growth. Since then, GM’s stock price has seen substantial growth, with investors experiencing impressive returns over time. Please note that these examples are historical and may not reflect the current state of these stocks. It’s essential to conduct thorough research and due diligence before making any investment decisions.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Value Investing
• Return on Invested Capital (ROIC)
• Earnings Yield
• Joel Greenblatt
• Ranking System

Sources for More Information

• Magic Formula Investing Official Website
• Investopedia – Magic Formula Investing
• Quant Investing
• Wikipedia