What is Magic Formula Investing (the magic investment formula)?
The magic investment formula is a rule-based, disciplined investment strategy. It is a method for value-oriented investing and is designed to increase the chances of outperforming the market. The aim is to outperform the average annual returns of the stock market. The Swiss Performance Index (SPI), for example, can serve as a market return and thus as a reference value for the Swiss market, or the S&P 500 Index for the US market. It is recommended to buy 20-30 “good” companies that are inexpensive and have a high earnings yield and return on investment (ROI).
The formula was developed by Joel Greenblatt. He is an investor, hedge fund manager and economics professor at the renowned Columbia University. However, the formula excludes certain types of companies, for example companies with low market capitalization, financial companies and companies in the utilities sector (electricity, natural gas, water, etc.).
The calculation method
To select shares, investors can use Greenblatt’sonline tool to select 20-30 shares. There, shares are sorted according to the following criteria: earnings yield (EBIT = earnings before interest and taxes), earnings per share (EPS), which represents the return on the share, and return on capital, which is intended to measure how efficiently income is generated from assets.
The strategy basically follows the following procedure:
- Setting a minimum market capitalization (at least USD 50 million).
- When selecting companies, public utilities and financial service providers should be excluded. ADRs (American Depository Receipts) are also to be excluded.
- Calculation of the return on earnings of individual companies (EBIT / enterprise value).
- Calculation of each company’s return on capital [EBIT / (Nettoanlagevermögen + betriebsnotwendiges Vermögen)].
- Create a ranking list of selected companies by market capitalization, highest earnings and return on capital.
- To invest in the 20-30 best companies, you should invest in about 2-3 companies each month in stages.
- The share portfolio should be rebalanced every year. Price losers should be sold one week before the end of the term (shortly before the end of the first year) and price winners should be bought one week after the end of the term (shortly after the end of the first year).
- This process should be repeated every 5-10 years.
Advantages and disadvantages of Magic Formula Investing
A clear advantage of the method is the simplicity of the formula. The portfolio is put together according to simple rules. Another advantage of the method is that irrational decisions are avoided. However, investing with this method does not always bring the expected success. This may be due to a change in market dynamics, for example. Success may also be lower if many people invest using this method.