In the world of value investing, few strategies have gained as much attention as the Magic Formula, popularized by Joel Greenblatt in his 2005 book “The Little Book That Beats the Market.” The Magic Formula, also known as the “Magic Formula Investing,” is a simple, straightforward approach to identifying undervalued stocks with high potential for returns. But, in today’s fast-paced, tech-driven market, many investors wonder: Does magic formula investing still work?
The Origins of the Magic Formula
To understand the Magic Formula, it’s essential to delve into its roots. Joel Greenblatt, a renowned value investor and founder of Gotham Capital, set out to create a strategy that would outperform the market without requiring extensive financial analysis or complicated mathematical models. By combining two key metrics, Greenblatt aimed to identify companies with high returns on capital and low price-to-earnings ratios.
The Magic Formula consists of two primary components:
- Return on Capital (ROC): A measure of a company’s profitability, calculated by dividing Earnings Before Interest and Taxes (EBIT) by Total Capital (debt and equity).
- Earnings Yield: The inverse of the price-to-earnings (P/E) ratio, calculated by dividing EBIT by Enterprise Value (market capitalization + debt – cash).
Greenblatt’s philosophy revolves around the idea that buying companies with high ROC and low Earnings Yield will lead to superior returns over time. By focusing on these two metrics, investors can identify undervalued stocks with strong financial performance.
The Magic Formula’s Early Success
Between 1988 and 2004, Greenblatt’s Magic Formula strategy generated impressive returns, outperforming the S&P 500 by a significant margin. The strategy’s success can be attributed to its ability to identify undervalued companies with strong fundamentals, which ultimately drove their stock prices higher.
During this period, the Magic Formula portfolio returned around 30% per annum, compared to the S&P 500’s 12% annual return. These results sparked widespread interest in the strategy, and many investors and fund managers began to adopt it.
The Magic Formula in Modern Times
However, as with any investment strategy, the Magic Formula’s effectiveness has been tested in the intervening years. The post-2008 financial crisis landscape, characterized by low interest rates, quantitative easing, and the rise of passive investing, has presented new challenges for value investors.
The Challenges Facing Value Investing
The value investing philosophy, which underpins the Magic Formula, has struggled in recent years. The prolonged bull market, fueled by central banks’ accommodative policies, has led to a shift towards momentum investing and growth stocks. This environment has made it difficult for value investors to find undervalued companies with strong fundamentals.
Additionally, the rise of passive investing and index tracking has increased the influence of benchmarks on stock prices. This has led to a phenomenon known as the “index effect,” where stocks are bid up or down based on their inclusion in or exclusion from popular indexes, rather than their underlying fundamentals.
The Impact on the Magic Formula
In this environment, the Magic Formula’s performance has suffered. Since 2009, the strategy has underperformed the broader market, raising concerns about its relevance in modern times.
A 2019 study by researchers at the University of Nebraska-Lincoln and the University of Oregon found that the Magic Formula’s returns had declined significantly since the financial crisis. The study attributed this decline to the increasing popularity of passive investing and the shift towards momentum-driven markets.
Does the Magic Formula Still Work?
Despite the challenges facing value investing and the Magic Formula, many argue that the strategy remains relevant in today’s market.
Adapting to Changing Market Conditions
Proponents of the Magic Formula argue that the strategy can be adapted to accommodate changing market conditions. By refining the original formula to incorporate additional metrics or adjust the weighting of existing metrics, investors can improve its performance.
For example, some investors have modified the Magic Formula to include metrics such as:
- Price-to-Book Ratio: A measure of a company’s price relative to its book value, which can help identify undervalued stocks.
- Fundamental Momentum: A metric that combines a company’s earnings growth with its price momentum, helping to identify stocks with strong growth potential.
By incorporating these metrics, investors can create a more robust and adaptive version of the Magic Formula, better suited to today’s market conditions.
The Importance of Patience and Discipline
Another crucial aspect of the Magic Formula’s success is the need for patience and discipline. Value investing, by its very nature, involves waiting for the market to recognize a company’s intrinsic value. This requires investors to adopt a long-term perspective, ignoring short-term market fluctuations and staying committed to their strategy.
In today’s fast-paced, news-driven market, it’s easy to get caught up in the hype and abandon a strategy at the first sign of underperformance. However, it’s essential to remember that the Magic Formula is a long-term strategy, designed to identify undervalued companies with strong fundamentals.
By combining the Magic Formula with a patient and disciplined approach, investors can increase their chances of success, even in today’s challenging market environment.
Real-World Examples of the Magic Formula in Action
Despite the challenges facing the Magic Formula, many investors continue to use the strategy to identify undervalued stocks with strong potential. Here are a few real-world examples:
- Walmart Inc. (WMT): In 2019, Walmart’s stock was trading at a low Earnings Yield of around 5%, with a high Return on Capital of over 15%. The Magic Formula would have identified Walmart as an undervalued stock with strong fundamentals, which has since rallied over 50%.
- Microsoft Corporation (MSFT): In 2016, Microsoft’s stock was trading at a low Earnings Yield of around 4%, with a high Return on Capital of over 25%. The Magic Formula would have identified Microsoft as an undervalued stock with strong fundamentals, which has since rallied over 300%.
These examples illustrate the Magic Formula’s potential to identify undervalued stocks with strong fundamentals, even in today’s challenging market environment.
Conclusion
The Magic Formula, popularized by Joel Greenblatt, remains a powerful tool for value investors looking to identify undervalued stocks with strong potential. While the strategy has faced challenges in recent years, its core principles remain sound.
By adapting the Magic Formula to accommodate changing market conditions, exercising patience and discipline, and focusing on long-term fundamentals, investors can still use the strategy to achieve success in today’s market.
In conclusion, the Magic Formula still holds its charm, offering a straightforward and effective approach to value investing. By embracing the strategy’s core principles and embracing the importance of patience and discipline, investors can increase their chances of success in the world of value investing.
What is the Magic Formula?
The Magic Formula is a stock-screening strategy that was popularized by Joel Greenblatt in his 2006 book “The Little Book That Beats the Market.” It’s a simple, quantitative approach to identifying undervalued stocks that have a high potential for long-term growth. The formula is based on two key metrics: return on capital (ROC) and earnings yield. ROC measures a company’s profitability, while earnings yield measures its valuation.
By combining these two metrics, the Magic Formula provides a ranking system that allows investors to identify top-notch companies at bargain prices. The formula is designed to be simple, easy to use, and accessible to individual investors, making it an attractive option for those who want to build wealth in the stock market without getting bogged down in complex financial analysis.
How does the Magic Formula work?
The Magic Formula works by ranking stocks based on their ROC and earnings yield. The formula looks for companies with high ROC and high earnings yield, as these are often indicative of undervalued companies with strong fundamentals. The stocks are then ranked in a spreadsheet, with the top-ranked stocks being those that have the highest combined score.
The beauty of the Magic Formula lies in its simplicity and ease of use. Investors can easily screen for stocks using the formula, without needing to delve into complex financial analysis or spend hours poring over financial statements. By focusing on just two key metrics, the Magic Formula provides a straightforward and efficient way to identify top-performing stocks.
Is the Magic Formula still effective?
While the Magic Formula was extremely effective in the early 2000s, its performance has been more mixed in recent years. This is likely due to a number of factors, including the increasing popularity of quantitative investing strategies and the rise of indexing. Nevertheless, many investors continue to use the Magic Formula as a valuable tool in their investment toolkit.
Despite its somewhat diminished performance, the Magic Formula remains a useful strategy for identifying undervalued stocks with strong fundamentals. By combining it with other investment approaches, such as value investing or dividend investing, investors can create a more diversified and robust portfolio.
Can anyone use the Magic Formula?
Yes, anyone can use the Magic Formula, regardless of their investment experience or expertise. The formula is designed to be simple and easy to use, making it accessible to individual investors of all levels. All you need is a spreadsheet program, such as Microsoft Excel, and access to financial data on the stocks you’re interested in.
That being said, it’s still important to have a basic understanding of investing and financial analysis before using the Magic Formula. Investors should also be prepared to do their own research and due diligence on any stocks they’re considering, rather than simply relying on the formula.
What are some limitations of the Magic Formula?
One of the main limitations of the Magic Formula is that it’s a purely quantitative approach, which means it doesn’t take into account qualitative factors, such as management quality or industry trends. It’s also a relatively simple formula, which may not capture the full complexity of a company’s financial situation.
Another limitation of the Magic Formula is that it’s based on historical data, which may not be indicative of a company’s future performance. Additionally, the formula can be sensitive to the specific metrics used and the weightings assigned to them, which can affect its performance.
How can I combine the Magic Formula with other investment strategies?
The Magic Formula can be combined with other investment strategies, such as value investing, dividend investing, or growth investing, to create a more diversified and robust portfolio. For example, an investor might use the Magic Formula to identify undervalued stocks, and then apply a value investing approach to further evaluate their potential.
By combining the Magic Formula with other strategies, investors can create a more comprehensive and nuanced investment approach that takes into account a range of factors, including financial metrics, industry trends, and qualitative factors.
Is the Magic Formula a get-rich-quick scheme?
No, the Magic Formula is not a get-rich-quick scheme. While it may be possible to use the formula to earn quick profits, its true value lies in its ability to help investors build long-term wealth through a disciplined and patient approach to investing. The Magic Formula is designed to be a tool for identifying undervalued stocks, not a way to make overnight fortunes.
In fact, Joel Greenblatt, the creator of the Magic Formula, emphasizes the importance of long-term investing and avoiding get-rich-quick schemes. He advocates for a patient and disciplined approach to investing, using the Magic Formula as a tool to identify high-quality companies at bargain prices.