Magic formula investing

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Magic formula investing is an investment technique outlined by Joel Greenblatt that uses the principles of value investing.

Contents

Development

Greenblatt introduced magic formula investing in his book, The Little Book That Beats the Market, a method for determining which stocks to buy: "cheap and good companies" with a high earnings yield and a high return on invested capital. His strategy is featured in The Guru Investor by John P. Reese. [1] [2] [3] [4] He suggests purchasing 30 "good companies": cheap stocks with a high earnings yield and a high return on capital. He describes this as a simplified version of the strategy employed by Warren Buffett and Charlie Munger of Berkshire Hathaway

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 a long-term (5–10+ year) period.

Critical analysis

A number of studies have found merit in Greenblatt's "magic investing formula" in various markets around the world. However, the studies have also often noted increased volatility, short-term underperformance and other potential risks.

Comparison to other Investing formulas

A 2024 study evaluates the formula for the U.S. market from 1963 to 2022 and compares it with the performance of the Piotroski F-Score, Acquirer's Multiple, and Conservative Formula. The study finds that all four formulas generate significant raw and risk-adjusted returns, primarily by providing efficient exposure to well-established style factors. However, no single formula consistently outperforms across all performance metrics. While the Acquirer's Multiple achieves the highest returns for top decile portfolios and the Conservative Formula leads in CAPM alpha and return spread, the Magic Formula exhibits the highest remaining alpha after adjusting for common factors. [15]

See also

References

  1. Persson, V. & Selander, N., 2009. Back testing “The Magic Formula” in the Nordic region. Stockholm: Stockholm School of Economics.
  2. Davyclov, D., Tikkanen, J. & Äijö, J., 2016. Magic Formula vs. Traditional Value Investment Strategies in the Finnish Stock Market. Nordic Journal of Business, 65(3–4), pp. 38–54.
  3. Oscar Gustavsson and Oskar Strömberg. Magic Formula Investing and The Swedish Stock Market: Can the Magic Formula beat the market? Bachelor’s thesis, Fall Semester 2017, Lund University
  4. Luo, Min (2019). "Case Study of Magic Formula Based on Value Investment in Chinese A-shares Market". Advances in Computational Science and Computing. Advances in Intelligent Systems and Computing. Vol. 877. pp. 177–194. doi:10.1007/978-3-030-02116-0_22. ISBN   978-3-030-02115-3. S2CID   158778392.
  5. Persson, V. & Selander, N., 2009. Back testing "The Magic Formula" in the Nordic region. Stockholm: Stockholm School of Economics.
  6. Davyclov, D., Tikkanen, J. & Äijö, J., 2016. Magic Formula vs. Traditional Value Investment Strategies in the Finnish Stock Market. Nordic Journal of Business, 65(3–4), pp. 38–54.
  7. Gunnar Juliao de Paula, Alexander (2016) Backtesting the Magic Formula in the Brazilian Stock Market. Masters Thesis, University of Gothenburg
  8. Oscar Gustavsson and Oskar Strömberg. http://lup.lub.lu.se/luur/download?func=downloadFile&recordOId=8932178&fileOId=8932179 Magic Formula Investing and The Swedish Stock Market: Can the Magic Formula beat the market?] Bachelor's thesis, Fall Semester 2017, Lund University
  9. Luo, Min (2019). "Case Study of Magic Formula Based on Value Investment in Chinese A-shares Market". Advances in Computational Science and Computing. Advances in Intelligent Systems and Computing. Vol. 877. pp. 177–194. doi:10.1007/978-3-030-02116-0_22. ISBN   978-3-030-02115-3. S2CID   158778392.
  10. "A critical look at Greenblatt's Magic Formula · Reasonable Deviations".
  11. Vestre, Tobias & Wikheim, Viktor, 2022. The Magic Formula. The Norwegian School of Economics.
  12. Preet, Simmar (2022). "Back Testing Magic Formula on Indian Stock Markets: An Analysis of Magic Formula Strategy". SSRN   3945468.
  13. "Home - ValueWalk" (PDF).
  14. Thibault Le Flanchec, Le Flanchec. "L'histoire vous le dira : étude de la stratégie Value-Quality".
  15. Schwartz, M. & Hanauer, M.X., 2024. Formula Investing. SSRN Working Paper No. 5043197.

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