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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)

What is Magic Formula Investing?
Magic Formula Investing is an investment strategy developed by Joel Greenblatt, a renowned investor and professor. It focuses on identifying and investing in high-quality stocks that are undervalued based on specific financial metrics. The formula primarily considers two critical factors: a company’s return on invested capital (ROIC) and earnings yield.
How does Magic Formula Investing work?
Magic Formula Investing works by ranking stocks based on their ROIC and earnings yield, aiming to identify undervalued companies that generate high returns on invested capital. The strategy involves selecting the top 20-30 stocks from the ranking and then holding them for a one-year period. This process is repeated annually, reallocating the investments to a new set of top-ranking companies.
What are the benefits of using Magic Formula Investing?
The primary benefits of using the Magic Formula Investing strategy are improved investment returns compared to the overall market (based on historical performance) and a systematic and data-driven approach to selecting stocks. Additionally, the strategy is easy to follow and can be used by beginner investors as well as experienced professionals.
Are there any drawbacks to Magic Formula Investing?
Although Magic Formula Investing has demonstrated historical success, it’s not without its limitations. Drawbacks include potential short-term underperformance during certain market conditions and the fact that it focuses solely on quantitative metrics, ignoring qualitative aspects such as management effectiveness or product innovation.
Is Magic Formula Investing suitable for all investors?
While Magic Formula Investing can potentially provide substantial returns, it might not be suitable for all investors. It is best suited for those with a long-term investment horizon and a tolerance for short-term underperformance. Investors should consider their risk tolerance, investment goals, and overall financial situation before adopting any strategy.
How can I implement Magic Formula Investing?
Investors can implement the Magic Formula Investing strategy by following a few simple steps:1. Obtain a list of companies according to the chosen market capitalization limit.2. Calculate their ROIC and earnings yield.3. Rank the companies based on both metrics.4. Select the top 20-30 companies from the ranking.5. Allocate funds evenly across the selected companies.6. Hold the investments for a year.7. Repeat the process annually, rebalancing the investments into new top-ranking stocks.Alternatively, there are investment tools and resources available online to help simplify the process.
Can Magic Formula Investing be used in combination with other investment strategies?
Yes, Magic Formula Investing can be combined with other investment approaches to optimize returns or manage risk. Adding qualitative aspects, such as research on the company’s market position or management team, can also complement the quantitative nature of the Magic Formula.

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