Magic Formula Investing

Is for dedicated long-term investors

Magic formula investing, as developed by Joel Greenblatt and explained in his book The Little Book That Beats the Market, has been shown by him through back testing over the past 17 years to deliver an annualized return of over 30 per cent.

How to Implement the Strategy

The formula involves selecting stocks with a high return on capital that also exhibit a high earnings yield (low price earnings ratio). He recommends that 20 to 30 stocks be chosen to make up the portfolio.

To get started Greenblatt suggests investors work their way into the market by buying a tranche of say five to eight stocks every three months until a full selection of 20 to 30 stocks is made in the course of one year.

He indicates, for reasons explained in the book, that investors avoid banks and other financial institutions, as well as mutual finds and insurance companies because of the differences in their financial reporting compared to other companies.

At the end of one year, investors sell the first tranche of stocks that have been held for a year. The profitable shares are sold a few days after the year's end and non-profitable trades a few days before, in order to reduce tax costs. This may not be relevant in other tax jurisdictions.

Investors then buy another tranche of stocks and three months later sell off the next tranche that has been held for one year.

This cycle continues on for at least five years and preferably for longer.

Why Does the Magic Formula Investing Approach Work?

Greenblatt provides reasons why his magic formula investing approach works in his book The Little Book That Beats the Market. The book has been revised/updated in 2010 under the new title The Little Book That Still Beats the Market.

I have read the second of the two books which importantly discusses results that include the 2007-2009 period where the stock market was depressed - to say the least.

His main argument to explain why the approach works comes back to the fact that you are buying profitable companies that are also cheap. Not the most profitable and the cheapest stocks mind you, but a combination of the two characteristics.

This is accomplished by ranking the companies by their return on capital (profitability) and also on their earnings yield (low price earnings ratio). The ranks are then added and sorted to find the companies with the best combination of the two features, high profitability and cheapness.

While the market does not always give recognition to these companies, they have both a competitive and a pricing advantage - an edge in other words.

His other argument is that you are averaging over these good companies, both in terms of the number of companies held at any time and over the longer term.

Greenblatt argues that the formula should work just as well in foreign (non-U.S.) markets as the principles are the same. However, for these markets and for reasons that he does not fully explain, he suggests that non-U.S. investors filter for return on assets (instead of return on capital) and low price earnings ratio (instead of high earnings yield).

Why Doesn't Everybody Do It?

One would assume that if investors could earn an annualized return of over 30 per cent using this mechanical approach, then everyone would be into it.

Greenblatt discusses this question and argues that many investors would not have the resolve to follow the approach, as successful use requires investors to take a long-term position of at least five years but preferably longer.

He also indicates (and has demonstrated by back testing) that along the way, losses could potentially span several years. This would be another powerful reason to discourage investors from staying with the approach.

A further reason could be that a considerable amount of time to manage a portfolio of up to 30 stocks is required, with buying and selling taking place every three months once a full set of stocks is purchased.

To enable investors to choose an appropriate portfolio of stocks with greater ease, Greenblatt provides a website where a daily updated list of recommended (U.S.) stocks can be obtained at no cost.

To Conclude

From a value investing point of view, Greenblatt's magic formula investing strategy makes sense as it recommends investors buy good companies (with high return on capital) at cheap prices (low price earnings ratios).

In so doing, Grenblatt argues that his approach combines that of Benjamin Graham and Warren Buffett.

It is an interesting approach in that while most stocks are only held for a year, the overall strategy requires a long term commitment to work effectively. The short stock holding period of one year distinguishes it from a pure value investing approach.

For people like me who have trouble selling stocks, the approach overcomes this problem as the focus is much more on averaging profits on the overall portfolio rather than on the performance of a particular stock.

Each stock makes a limited contribution (positive or negative) to the overall result, much like a bit player in a theatrical performance.

I have allocated a limited proportion of my portfolio to this magic formula investing approach. But it will be a several years before I can indicate how successful it has been for me. However, I am currently earning just under 40% annualised, including dividends and franking credits. So it is a good start.

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Query about Magic Formula Investing 
It's an interesting strategy John. I just wonder what happens if one of the stocks purchased in the first tranche still has a high return on capital and …

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