Joel Greenblatt introduced the magic formula in 2005, in his bestseller 'The little book that beats the market'.
How does it work?
The strategy looks for companies with the following characteristics:
- You can purchase the shares at a bargain price.
- The business excels at making money.
Can you give an example of a magic formula company?
Let's take Altria, the holding with subsidiaries that include Philip Morris USA. Altria performs particulary well on 2 ratios:
To find companies that are trading at bargain prices, we look at the earnings yield.
In the chart above, you can see all US companies excluding utilities and financial companies. Altria's earnings yield is 9.98%, which puts it in the red bar. Out of 3228 companies, only about 100 of them have a higher earnings yield.
Why earnings yield instead of Price/Earnings?
Earnings yield is not widely available and you have to use a paid service like ValueSignals to get reliable numbers. We could have used the more popular and available price-to-earnings ratio, but there are very good reasons why Greenblatt doesn't use rely on it:
- Companies are taxed at different levels, so we have to look at pre-tax earnings to compare them. Operating earnings or EBIT is a much cleaner way of looking at the company's earnings.
- Companies have different levels of debt, which is not considered when looking only at market capitalization. Enterprise value is the closest measure of the value of a company's total value.
To find companies that excel at making money, we use the Return on Invested Capital (ROIC), more commonly known as ROC. Let's have a look if Altria excels in this area.
As you can see, Altria is very good at making money. It's at the top of the histogram, and only a few companies do better.
Why is ROC this high?
To calculate ROC, we divide the operating income by the sum of net fixed assets and net working capital.
- We already used Operating income in the earnings yield. For the last 12 months, the company generated 11bn.
- Altria only needed 2 billion dollars in cash to purchase fixed assets to conduct its business over the same period.
- The company is in excellent financial health and did not need any additional capital to cover its short-term obligations.
For every dollar Altria spent, it generated 6 dollars. Only very well-run companies can achieve results like these.
How can I find more magic formula companies?
It's pretty simple. You can use Joel's stock screener, which is available at magicformulainvesting.com. Just select whether you want the top 30 or 50 companies, and the list pops up in seconds. There are a few issues.
- Security. This site has been compromised, and all users have been asked to change their passwords. The site is just a companion to sell more books and has not been updated for quite a long time.
- The results are very restricted. As you can see in the screenshot above, you get the company name, the ticker, the market cap, the stock quote price, and the date of the most recent quarter. You don't get the magic formula score, the earnings yield, the ROC, or any other information.
- It only covers the US.
- You can't add any filters. For instance, looking at the US, I might want to exclude the pink sheets or look at Nyse. Or I might need to increase the minimum market Cap.
Another way is to use the ValueSignals stock screener.
As you can see in the screenshot above, you can run this screen on the US alone, but I also included Canada. I removed the pink sheets and OTC. In the screenshot, you can see the magic formula score, the ROC and the earnings yield. On top of that, you can also see other factors, such as the Piotroski F-score. Finally, I can drill down on the company to see the reports we already discussed in the section above for Altria.
What filters do we use?
For the template screen, we implemented the following filters
- Market Cap > $50m
- All stocks, excluding utility and financial stocks
Why is your list slightly different from MagicFormulaInvesting.com
In general, the same companies show up in the top 50 of both stock screeners. There are differences, however. Our list, for instance, features Aaron's holdings, a company that is not on Greenblatt's list. The explanation is quite simple. Even if Joel Greenblatt published quite some detail about his calculation, he did not disclose everything. To calculate net working capital, he uses excess cash. Unfortunately, he did not disclose the formula he used to calculate it. We tested many different formulae and used the one that created the biggest overlap between the lists.
Combining the Magic Formula with other value indicators
Studies have shown that while the magic formula works on its own, it's even better to combine it with other factors. In our research, we found that it works even better when combining it with a momentum factor. The one that worked best in our test was the 6-month price index. You can read more about this here.
In our glossary:
Return on Capital (ROC)Return On Capital (ROC) measures a company's efficiency at allocating capital under its control to profitable investments.. more...
Earnings YieldThe standard definition of earnings yield is the earnings per share divided by the price of a share.. more...
Greenblatt Magic FormulaMagic Formula (MF) score.. more...
In our blog:
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In our research:
Magic FormulaThe Magic Formula was developed by Joel Greenblatt in his book, ‘The Little Book That Still Beats the Market’.. more...
Magic FormulaWith this combination we wanted to determine if the results of the Magic Formula could be improved by adding an additional factor to select companies to invest in.. more...
In our scorecard manual:
Magic FormulaJoel Greenblatt, one of the most successful hedge fund managers with a spectacular track record, created a very simple and effective formula that can easily be understood by even the most novice investors.. more...