Does the Magic Formula for investment still works?
A few years ago, Joel Greenblatt, came up with a formula that’s expected to beat the market year over year. Joel Greenblatt called the investing formula; 'the Magic formula' and it became very popular very fast. It’s designed to find good companies at bargain prices.
The formula was explained in detail in a book titled “ The little book that beats the market”.
The Magic formula boasts about high returns, low risk, simplicity and logic. The question is, is this formula still working? And if so, how much money can we make from it year over year by applying the formula.
What is the Magic Formula?
The Magic Formula investing involves owning a mixture of 30 stocks that has the best combination of a high return on capital and high earnings yield. These stocks are expected to return a robust return annually.
The formula claims that, if the formula returns 30 % annually on an $11,000 investment for 17 years, $ 11,000 would have returned $ 1 million. During that same year, the market averaged 12.3 percent and returned just $79,000. If the magic formula remains impressive as reported by Joel, this will mean that the magic formula is far better than just investing in the S&P 500 or in other mutual funds that mimic the market average return.
How does the magic formula works?
According to Joel Greenblatt, the formula combs through the list of the largest 3500 companies that are listed on the stock market. Then the program ranks each company’s stock and assigns a ranking number from 1 – 3500 based on their return capital.
The company with the highest return on capital is ranked 1st and the company with the least returns is at the bottom of the pile, 3,500. The companies that are at the bottom are usually losing money.
Review of the steps above.
The formula combs through all the stocks that are publicly traded and it assigns ranks to each based on return on capital.
The company with the highest return is ranked 1st, and the second-highest is 2nd, fiftieth is 50th as so on.
After the magic formula has sorted the stocks from 1 to 3,500 based on return on capital. Then the formula takes the listed stocks again and follows the same procedure to rank it based on earnings. This means the company with the best earning returns out of the stocks from a fresh new search using all the stocks that are listed on the stock exchange is ranked 1st. The stocks are then ranked according to earnings returns. Also, this means that out of the 3,500 stocks, the stock with the best earnings return will be ranked 1st. And so on for the rest of the stocks, the stock with the lowest earnings will be ranked the last, in this case, we are looking at 3,500 stocks, therefore the lowest has 3,500th rank.
Take away, the formula has ranked the stocks based on return on capital first, then it ranks for earning yield. After this step, the formula says that any company that has the combination of both factors ( return on capital and return on earnings) are the preferred companies to take a look at. However, getting a good ranking combination of both does not mean that’s the best ranked company to invest in.
Example.
If a company is ranked 287th best in the return on capital and 124th on the return highest in earnings yield, the stock will receive a 411 ranking (287 + 124). And we can apply he same calculation to a stock ranked 2nd in return on capital and the stock that ranks 937th in earnings yield; we now have 2 + 937 to give us a ranking of 939 combined ranking.
Based on the calculation above, a company with a combined rank of 411 is better ranked than the stock with 939th rank.
The formula requires the investor to own a combination of 30 of these stocks, and several backtests shows that they tend to perform well and beat the market year over year. The formula did a variation of test for different times and with different market value and concluded that if followed correctly, it would beat the market over time.
The Magic formula Investing rule
Comb through all stocks that are traded on the stock exchange and rank them based on return on Capital on capital.
Rank all stocks based on earnings yield.
The combination of both scores gives which investments to consider buying.
Hold at least 30 stocks and hold if for a year.
Sell the loser before the end of its first year.
Note: You don’t have to do the test yourself, Joel Greenblatt has a program that runs the numbers and gives out the top-ranking stocks.
Investors can access the handful of researched stocks that fits the magic formula criteria on the Magicformulainvesting.com.
Steps to using the Magicformulainvesting.com
Go to the website
Follow the instruction for choosing the company size( some companies are at the $50million level while some are $ 200 million and over $1 billion respectively.
Follow the instruction to obtain the list of top-ranked magic formula companies.
Buy 5 to 7 top-ranked companies and continue to add more gradually every 3 months until you have 30 stocks in your portfolio. According to the book, after like 9 or 11 months, the portfolio should have between 20 to 30 stocks in it.
Sell each stock after holding it for one year. For tax purposes and to generate the maximum revenue, sell the winner after a few days after one year and the loser after holding them for a few days less than a year. Use the proceeds to buy other new companies that fit the magic formula criteria.
The above instructions show how to use the magic formula, how to come up with companies that fit the criteria and how to use the formula.
Investingport has studied the formula long ago and we have tested it. We used Investopedia stock simulator to buy into a group of companies that fit under the magic formula and these are our findings. Investopedia is a good platform to use for those that want to invest with play money. We used the simulator part of Investopedia page to buy a group stock using an account balance of $1,000,000.00. We started the test on Aril 17, 2019.
As of now the account is down - $45,349.00 (-9.40 %). Note, we did not invest all of the 1 million that we have to invest with. We only used close to half a million.
List of stocks that we bought in our Magic Formula Case Study investment account.
We bought, ACOR, AEIS, AEZS, ALSN, AMCX, ABC, AGX, BIIB, HRB, DLX, DHX, EVOP, GME. As stated above, the stock account should have about 20 to 30 stocks by the 9th month. We now have 13 and we plan to buy more. Out of $ 1 million, we spend about $500 K, minus fees. The value of the stock that we purchased is now down to $ 437,325.50, our account balance stood at, Cash $521,348.14.
We are down 9.9 percent so far and we are just 8 months into the investment and at this rate, the stocks that we selected may not beat the market before December. But note that we started the fund investment test in April 2019.
For transparency purposes, we would like to let you all know that we did not trade the account actively, but we will now begin trading actively as instructed by the formula. With that said, our result may not speak for the overall formula’s performances.
We did further research and found other investors that are also tracking their system. Here is how they perform.
Magic Formula 1X Total $65,058.31 - $21,485.19 (-24.83 %)
We have learned about the Magic Formula, now is time to learn about the mind behind the famous formula. His name is Joel Greenblatt and he was a former hedge fund manager. He is an author and he still manages money for a living. Joel and Robert Goldstein manage Gotham Funds. He also serves as an adjunct professor at Columbia University. Joel is specialized in Value Investing, he is a former chairman of the board of Alliant Techsystems and the founder of the New York Securities Auction Corporation. Pzena Investment management is also one of his establishments.
About Gotham Capital
Mr Greenblatt started Gotham Capital in 1985 with just $ 7 million. Michael Milken who is famous for Junk- bond investing funded Joel Greenblatt during the early start of Gotham Capital. The fund returned 40 % average return annually between 1985 and 2006.
Joel Greenblatt’s Net Worth is around $500 million.
Conclusion: Although the formula is underperforming for us right now, we plan to continue to actively trade the account as recommended in the book “ The little book that beat the market”. We understand that this 6 to 8-month term that we held the stocks that are listed above, is not sufficient to conclude that the formula works or does not work. Our position is to continue to test the best investment strategy out there and provide our case study to our readers.
This is not the end of this article, feel free to bookmark it because we are going to continue to test this formula while we also continue to update the result. And you may not want to miss it.
Be the first to comment!
You must login to comment