The Magic Formula Investing Strategy===

Investing in the stock market can be an overwhelming undertaking for many individuals. However, Joel Greenblatt’s Magic Formula Investing technique simplifies the process by providing a step-by-step guide to value investing. Greenblatt, an American academician, investor, and hedge fund manager, developed the Magic Formula Investing strategy based on two key principles: investing in high-quality companies and buying them at a discount. This article provides a comprehensive guide on the Magic Formula Investing strategy, including key principles and performance analysis.

Understanding the Key Principles of Joel Greenblatt’s Strategy

The Magic Formula Investing strategy is based on two key principles: investing in high-quality companies and buying them at a discount. Greenblatt believes that investing in high-quality companies with a consistent track record of profitability and strong fundamentals is a sound investment strategy. However, he also believes in buying such companies at a discount to their intrinsic value, which can be determined using a company’s earnings yield and return on invested capital.

The earnings yield is calculated by dividing the company’s earnings before interest and taxes (EBIT) by its enterprise value (EV). The return on invested capital (ROIC) is calculated by dividing the company’s earnings before interest and taxes (EBIT) by its invested capital. Greenblatt believes that companies with a high earnings yield and a high ROIC are undervalued and have a high probability of outperforming the market.

Analyzing the Performance of Magic Formula Investing

The Magic Formula Investing strategy has a proven track record of outperforming the market. According to Greenblatt’s research, an investment in the top 30 Magic Formula stocks each year from 1988 to 2004 would have returned an average annualized return of 30.8%, compared to the market’s average annualized return of 12.4%. However, it is important to note that past performance is not indicative of future results, and the strategy does come with some risks.

One of the risks associated with the Magic Formula Investing strategy is that it requires a long-term investment horizon. Greenblatt recommends holding each position for at least one year to maximize returns. Additionally, the strategy may underperform during market downturns, as investors may shy away from undervalued stocks during uncertain economic times.

Implementing the Magic Formula Investing: A Step-by-Step Guide

Implementing the Magic Formula Investing strategy is relatively straightforward. The first step is to create a list of high-quality companies. Greenblatt recommends using a screening tool, such as his free stock screener, to identify companies with a high earnings yield and a high ROIC. The next step is to rank the companies based on their Magic Formula score, which is calculated by adding the earnings yield and ROIC ranks.

Once the companies have been ranked, the next step is to build a portfolio of the top-ranked companies. Greenblatt recommends holding each position for at least one year and rebalancing the portfolio annually to maintain the desired Magic Formula exposure. It is also important to conduct thorough research on each company and consider any potential risks before investing.

Example Code

Here’s a simple Python code to calculate the Magic Formula score for a list of companies:

def magic_formula_score(company):
    earnings_yield = company["EBIT"] / company["EV"]
    roic = company["EBIT"] / company["Invested Capital"]
    magic_formula_score = earnings_yield.rank() + roic.rank()
    return magic_formula_score

OUTRO:

The Magic Formula Investing strategy is a proven method for outperforming the market. By investing in high-quality companies at a discount, investors can achieve exceptional returns over the long term. However, it is important to conduct thorough research and consider any potential risks before investing. By following the step-by-step guide and using tools such as Greenblatt’s stock screener, investors can successfully implement the Magic Formula Investing strategy and achieve their financial goals.