Beating The Market With The Magic Formula Investing Strategy
When it comes to investing, we’d all like to outperform the Worlds markets. Is there a simple or magic formula I hear you ask? Well lucky for you my friends… there is! Well according to Joel Greenblatt that is.
In 2005, Joel published The Little Book That Beats the Market – a New York Times bestseller and within this book lies the Magic Formula.
The intention of the Magic Formula is to come up with a selection of stocks that will outperform the general stock market such as the S&P 500. Stock picking in general sounds easy, but it’s notoriously hard.
Even Mr Greenblatt said, “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”
What is this magical formula I hear you cry?
Well bear with me a second….
According to Investopedia there are just 9 steps …
- Set a minimum market capitalization for your portfolio companies. This should be typically higher than $100 million.
- Ensure you exclude any financial or utility stocks when you choose your companies.
- Exclude American Depositary Receipts (ADRs). These are stocks in foreign companies.
- Calculate each company’s earnings yield (EBIT ÷ Enterprise Value).
- Calculate each company’s return on capital [EBIT ÷ (Net Fixed Assets + Working Capital)].
- Rank selected companies by highest earnings yields and highest return on capital.
- Buy two to three positions each month in the top 20 to 30 companies, over the course of a year.
- Each year, rebalance the portfolio by selling off losers one week before the year term ends. Sell off winners one week after the year mark.
- Repeat the process each year for a minimum of five to 10 years or more.
However, if you’re not in the mood for the above, then luckily for you, they’ve even made a website. At magicformulainvesting.com the calculations are all done for you!
All you need to do is register and follow steps 7, 8 & 9 above.
The big question now is does it actually work?
Does the Magic Formula still work?
Luckily there’s a lot of research into this. You can see more detail in our YouTube video…
The original book claims a 33% annual return from 1988 to 2004, when the market average was 15%.
Investopedia wrote this about a study by reasonabledeviations.com
“The magic formula can no longer boast returns of a 30% compound annual growth rate, but some studies nonetheless show favorable results. A backtest of market performance between 2003 and 2015 found that the magic formula strategy had annualized returns of 11.4%, compared with 8.7% from the S&P500. “This is clearly an outperformance of the benchmark,” wrote the author of the backtest, “but by nowhere near as much as the Little Book claims.””
The website quant-investing.com not only backtested the formula in other countries, they applied other factors such as the price to book ratio and return on invested capital. ‘The Best combination +783% was Momentum (600.5% improvement)’.
Portfolio123.com created a screener which came up with the following results. “After a spectacular 2009 (in which the Greenblatt portfolios beat the market by an average of 50%), stocks bought in 2010 lagged the market by 3%, and stocks bought in 2011 lagged the market by 28%. They beat the market by 7% in 2012 and 11% in 2013, but lagged the market by 9% in 2014, 10% in 2015, 13% in both 2016 and 2017, and 21% in 2018. Lastly, stocks bought in 2019, in the first nine months of that year and held for one year, lagged the market by 23%. Ouch! If you’d bought the thirty highest-ranked stocks every week over the last ten years and held them for one year, you would have made an average of 2.20% per year, while if you’d bought the S&P 500 ETF SPY instead, you would have made an average of 13.02%”.
A few YouTubers have been testing it recently too and have found the following:
- Everything Money showed a 2 year return of 26.3% in the video ‘Does Magic Formula Investing Work? | Seth’s Little Book Update’.
- Individual investor found that his magic formula portfolio was -0.36%, but the S&P 500 was -8.36% in the same period in the video ‘Investing using the Magic Formula – April 2022’
- Jack Duffley says it’s not working at moment. The Portfolio is down by over 17% after about a year in the video ‘Does it Get Better? – Magic Formula Portfolio’.
Even Joel Greenblatt in his interview with Forbes admits that the magic formula doesn’t work every year.
A quick google of ‘does the magic formula work?’ will give you a sea of further opinions. Many professionals are against it, because it is just too simple. However, that doesn’t mean that they are right, of course they have to say that.
So there we have it a firm conclusion that the magic investing formula works….. kind of…. in some years.
Often the big problem with any strategy is not the strategy, unfortunately it’s being human!
Will you remember and do you have time to make changes every month. Or even continue the strategy after 2 bad years. Would you have the strength to buy a stock whose price is falling sharply, when the media is panicking like it’s the end of the world. Or to sell a stock that appears to be shooting to the moon.
Well, I’m not sure it’s for me, but good luck to all those who try it.
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