Understanding the Magic Formula: A Value Investing Strategy

Imagine a value investing strategy that claims to have returned investors a 30% Compound Annual Growth Rate (CAGR) over 26 years. If you had invested ₹1 lakh into this strategy, it says you would have turned into over ₹9 crore! Sounds incredible, right? That’s the Magic Formula investment technique. In this article, we will dive deep into this investment strategy, exploring its origin, the nine key rules it follows, backtesting data, and its relevance in both the U.S. and Indian markets.

The Origins of the Magic Formula

Joel Greenblatt, a renowned asset manager since the 1980s, wrote a book titled The Little Book That Beats the Market, where he presented the magic formula for value investing. Greenblatt is a professional investment manager with an impressive $6.3 billion in Assets Under Management (AUM). His magic formula is said to be a simplified version of the value investing strategies used by legends like Warren Buffett and Charlie Munger.

In his book, Greenblatt outlines how investors can generate market-beating returns by following a set of simple rules. His confidence in the strategy led to a follow-up book, The Little Book That Still Beats the Market, further emphasising its relevance. The formula has been consistently applied for over two decades and claims to outperform traditional market benchmarks.

What is the Magic Formula?

The magic formula is a stock-picking strategy based on two financial metrics: earnings yield and return on capital (ROC). The strategy focuses on buying good companies at bargain prices, similar to Warren Buffett's approach, but Greenblatt simplifies the process into an easy-to-follow method.

The key idea behind the formula is to select companies with a high earnings yield (indicating that the company is undervalued) and a high return on capital (showing that the company is efficiently using its capital to generate profits). These two metrics help identify companies that have strong earning potential and are available at a relatively cheap price.

Why Use the Magic Formula?

Greenblatt wanted to simplify stock picking to make it understandable even to a teenager. The book is written in simple language and provides a clear framework to follow, making value investing more accessible to beginners. As Greenblatt famously 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.”

In short, the magic formula provides a structured way to invest in the stock market, ensuring that investors are not making random picks but are following a tested and data-driven strategy.

The Nine Rules of the Magic Formula

Now that we have a basic understanding of the magic formula, let's break down the nine rules that form the foundation of this strategy:

1. Market Cap Greater Than $50 Million

The formula requires that you only assess companies with a market cap greater than $50 million. In the Indian context, this translates to about ₹400 crore. However, we’ll focus on companies with a market cap of over ₹1,000 crore to account for inflation and currency depreciation.

2. Exclude Utility and Financial Stocks

Greenblatt’s strategy excludes utility and financial companies. Although he doesn’t provide a specific reason, it is likely because these industries tend to carry high debt levels, which may misrepresent/skew the financial metrics the formula relies on.

3. Avoid International Companies

The formula excludes international companies. Since there are very few foreign companies listed in our country, this rule is easily applicable in the Indian market.

4. Calculate Earnings Yield

Earnings yield can be calculated as earnings per share divided by the current share price, or using the formula EBITDA divided by enterprise value. The goal is to understand the company’s earnings capacity, essentially evaluating how well it is managing its profits relative to its price.

5. Calculate Return on Capital (ROC)

Return on capital measures the company's profitability relative to the capital invested in the business. This metric reveals how efficiently the company is using its resources. Think of Coca-Cola, which can generate high profits with relatively low capital due to the brand's long-standing moat. This rule is designed to simplify Buffett's approach to analysing a company's earnings potential.

6. Rank Companies Based on Earnings Yield and ROC

Once you’ve calculated the earnings yield and return on capital for each company, rank them accordingly. Companies with the highest combined earnings yield and ROC should be prioritised.

7. Invest in Top 20-30 Companies

After ranking the companies, invest in the top 20-30 based on their earnings yield and ROC. In the second edition of the book, Greenblatt introduced a small tweak: invest only in companies with a price-to-earnings (P/E) ratio greater than five. This helps to avoid low-quality or overly volatile stocks.

8. Rebalance Your Portfolio Annually

Greenblatt suggests rebalancing your portfolio once a year. He also introduces a useful tax-saving tip: sell loss-making stocks in the 51st week to account for short-term capital losses, which can be offset against other gains. Hold profitable investments for over 52 weeks to benefit from lower long-term capital gains taxes.

9. Stick to the Strategy for 5-10 Years

Finally, the magic formula requires patience. You need to stick to this strategy for at least five to ten years to see the compounding effect and generate significant returns. Short-term fluctuations in the market can cause temporary losses, but the long-term benefits are where the real value lies.

Backtesting the Magic Formula

Backtesting of the magic formula has shown positive results in different markets. Studies have consistently proven that the strategy outperforms the market over time, especially in non-bearish market conditions. Greenblatt’s own backtest of the U.S. market suggests that the formula has outperformed benchmarks like the S&P500 by a significant margin.

A study conducted in India in 2022 by professors from the University of Delhi revealed that the magic formula worked well in the Indian market. Over a period from July 2012 to 2020, the BSE Sensex gave returns of around 99.8%, while Greenblatt’s magic formula returned more than 1% CAGR during the same period.

This shows that the magic formula is not only relevant in the U.S. market but can also be applied successfully in India. With backtested data supporting its credibility, the magic formula stands as a proven, easy-to-implement value investing strategy.

How to Use the Magic Formula Screener in India?

To implement magic formula investing effectively, you can use online tools such as screener.in. This stock screener platform allows you to filter companies based on specific criteria aligned with the Magic Formula's rules. Here's how you can set up the screener:

1. Set a market capitalisation filter of greater than ₹1,000 crore.
2. Set a return on invested capital (ROIC) filter of greater than 25%.

After applying these filters, you'll generate a list of potential quality companies to evaluate. The next step involves exporting this data into an Excel sheet for further analysis.

Once you have your list of companies, the next step is ranking them based on their ROIC and earnings yield. Use Excel's rank function to assign ranks to each metric. After ranking, add up the ranks to derive a combined score that reflects both the earnings yield and ROIC. The companies with the lowest total rank are your best candidates for investment.

With your ranked list in hand, it's essential to conduct a thorough analysis of each company. Look for any "shady" companies that might not align with the quality standards outlined in the Magic Formula. For instance, while a company may appear at the top of the list, further investigation might reveal potential red flags.

As emphasised in the rules, it's crucial to rebalance your portfolio annually. This involves selling off underperforming stocks and maintaining a long-term investing outlook. Adhering to magic formula investing over a 5 to 10-year horizon can help mitigate short-term volatility and potentially yield higher risk-adjusted returns.

Disadvantages of the Magic Formula

While the Magic Formula presents a structured approach to systematic value investing, it's not without its drawbacks:

• Return Expectations: The promised 30% CAGR may not be replicable in the current market environment, particularly in India.
• Complexity of Smaller Companies: Some smaller market cap companies may have less transparent financials, making them harder to analyse.
• Market Conditions: The formula tends to outperform during bullish markets but may lag in bearish conditions.

Conclusion

Joel Greenblatt’s magic formula is a time-tested value investing strategy that simplifies stock picking for long-term investors. By focusing on high earnings yield and return on capital, the formula helps investors find good companies at reasonable prices. The nine rules of the formula make it easy to implement, even for beginners, and the strategy has been backtested successfully in both the U.S. and Indian markets.

If you're looking for a simple yet effective stock-picking method, the magic formula could be a great starting point for your investment journey!

Watch: How To Spot Hidden Stock Gems: Easy Value Investing Screener

Disclaimer: We are not SEBI-Registered Investment Advisors. The investment strategy mentioned in this article is purely for educational purposes. Please do your own research before investing!