Definitions

magic formula

Magic Formula Investing

Magic Formula Investing is a term that refers to an investment technique outlined by Joel Greenblatt that uses the principles of value investing.

Methodology

Greenblatt suggests purchasing 30 "good companies": cheap stocks with a high earnings yield and a high return on capital. He touts the success of his magic formula in his book The Little Book that Beats the Market, citing that it does in fact beat the S&P 500 96% of the time, and has averaged a 17-year annual return of 30.8%

Formula

  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 long-term (3-5 year) period.

References

External links

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