Magic formula investing is a rule-based investing. This investing strategy teaches investors a simple and easily understood method for value investing. Besides, this strategy relies on quantitative screens from companies and stocks.
The magic formula aims to beat the stock market the average annual returns. In simple terms, this strategy works by ranking the stocks according to their price and returns on capital.
With this strategy, investors can approach value investing from an unemotional and methodical perspective. It was developed by Joel Greenblatt. He is an investor, hedge fund manager, and business professor. However, the strategy works for large-cap stocks, yet it does not work for any small- or micro-cap companies.
How does Magic Formula Investing Work?
This strategy was first described within a best-selling book in 1980, “The Little Book That Beats the Market”, from Joel Greenblatt.
Inside the book, Greenblatt mentions two criteria for stock investing, they are the stock price and the company’s cost of capital. Besides, in the book, he also mentions ways to find those two things, investors do not use fundamental analysis. But, they use Greenblatt’s online stock screener that select 20 to 30 top-ranked companies, instead.
Here are the things considered by that screener:
- The stock earnings. The system calculates the earnings before interest and taxes (EBIT).
- The yield. The system calculates the yield by dividing the earnings per share (EPS) by the current stock price.
- The return on capital. This measures the efficiency of the companies to generate earnings out of their asset.
Using this strategy, investors sell the losing stocks before holding them for one year in order to get the benefit from the income tax provision. Consequently, investors can lose to offset their gains.
Besides, they sell the winning stocks after a year mark, in order to get the benefits to reduce income tax rates on the long term capital gain.