Magic Formula Investing
What is Magic Formula Investing?
The Magic Formula is a formula used for screening as described in Joel Greenblatt’s book The Little Book That Beats the Market. It selects stocks with High Earnings Yields and Return on Capital. Traditional value investment has focused on high earnings yields, and strong assets but return on capital adds an element of quality.
The Ingredients to the Magic Formula
As taken from Wikipedia:
1. Establish a minimum market capitalization (usually greater than $50 million).
2. Exclude utility and financial stocks
3. Exclude foreign companies (American Depositary Receipts)
4. Determine company’s earnings yield = EBIT / enterprise value.
5. Determine company’s return on capital = ebit / (net fixed assets + working capital)
6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
7. Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
9. Continue over a long-term (3–5+ year) period.
The core element to Magic Formula Stocks are:
- Earnings Yield = EBIT / Enterprise Value
- Return on Capital = EBIT / (Net Fixed Assets + Working Capital)