Magic formula investing: Explained
BY TIO Staff
|July 30, 2024In the world of trading, there are numerous strategies and methodologies that investors use to maximize their profits and minimize their risks. One such strategy is the 'Magic Formula Investing'. This strategy, popularized by Joel Greenblatt in his book "The Little Book That Beats The Market", is a quantitative method that seeks to identify high-quality companies that are trading at an attractive price. The 'magic' in the formula refers to its simplicity and effectiveness, and not to any mystical or supernatural elements.
The magic formula investing strategy is based on a simple principle: buy good companies at good prices. It uses two key financial metrics to identify these companies: return on capital (ROC) and earnings yield (EY). The formula ranks all companies in the market based on these two metrics, and suggests investing in the top ranked companies. This strategy is designed to be used over the long term, with the expectation that it will outperform the market over time.
Understanding the Magic Formula
The magic formula is a simple, yet powerful, investing strategy. It is based on the principle that investing in good companies at good prices will yield superior returns over the long term. The formula uses two key financial metrics to identify these companies: return on capital (ROC) and earnings yield (EY). ROC measures how effectively a company uses its capital to generate profits, while EY measures how much a company earns relative to its stock price.
The magic formula ranks all companies in the market based on these two metrics. It assigns a rank to each company based on its ROC and EY, and then combines these ranks to create a final rank. The top ranked companies are considered the best investment opportunities. The formula suggests investing in a portfolio of these top ranked companies, and holding each investment for at least one year.
Return on Capital (ROC)
Return on capital (ROC) is a key financial metric used in the magic formula. It measures how effectively a company uses its capital to generate profits. A high ROC indicates that a company is able to generate a high amount of profit for each dollar of capital it invests. This is a sign of a good company, as it indicates that the company is able to use its resources efficiently to generate profits.
The magic formula calculates ROC as operating profit divided by net working capital plus net fixed assets. This calculation gives a percentage that represents the return on capital. The higher the percentage, the better the company is at generating profits from its capital.
Earnings Yield (EY)
Earnings yield (EY) is the other key financial metric used in the magic formula. It measures how much a company earns relative to its stock price. A high EY indicates that a company's stock is priced attractively relative to its earnings. This is a sign of a good price, as it indicates that the stock is undervalued relative to the company's earnings.
The magic formula calculates EY as operating profit divided by enterprise value. This calculation gives a percentage that represents the earnings yield. The higher the percentage, the more attractive the stock price is relative to the company's earnings.
Implementing the Magic Formula
Implementing the magic formula investing strategy involves a few key steps. First, you need to rank all companies in the market based on their ROC and EY. This can be done using financial data from a variety of sources, including financial websites and databases. Once you have ranked all companies, you then need to invest in a portfolio of the top ranked companies. The formula suggests investing in at least 20 to 30 companies to ensure adequate diversification.
Once you have invested in a portfolio of companies, the formula suggests holding each investment for at least one year. This is because the formula is designed to work over the long term, and it may take time for the market to recognize the value in the companies you have invested in. After one year, you should re-evaluate your portfolio and make any necessary adjustments based on the current rankings.
Ranking Companies
Ranking companies based on their ROC and EY is a key step in implementing the magic formula. This involves gathering financial data for all companies in the market, and then calculating their ROC and EY. Once you have calculated these metrics, you can then rank all companies based on their ROC and EY. The companies with the highest combined rank are considered the best investment opportunities.
There are many sources of financial data that you can use to rank companies. These include financial websites, databases, and financial statements. It is important to use reliable and up-to-date data to ensure accurate rankings. It is also important to understand how to calculate ROC and EY, as these calculations are critical to the ranking process.
Investing in a Portfolio
Once you have ranked all companies, the next step is to invest in a portfolio of the top ranked companies. The magic formula suggests investing in at least 20 to 30 companies to ensure adequate diversification. This means that you should spread your investments across a variety of companies, rather than putting all your money into a few companies. This helps to spread risk and increase the potential for returns.
When investing in a portfolio, it is important to consider your own financial situation and risk tolerance. While the magic formula suggests a certain number of companies to invest in, you should adjust this number based on your own circumstances. For example, if you have a high risk tolerance, you may choose to invest in more companies. On the other hand, if you have a low risk tolerance, you may choose to invest in fewer companies.
Benefits and Risks of the Magic Formula
The magic formula investing strategy offers several benefits. First, it is a simple and straightforward strategy that anyone can implement. It does not require any advanced knowledge of finance or investing, and it can be implemented with a basic understanding of financial metrics. Second, it is a long-term strategy that is designed to outperform the market over time. This makes it a good strategy for long-term investors who are looking to build wealth over the long term.
However, the magic formula also comes with certain risks. First, it is a quantitative strategy that relies on financial metrics. While these metrics can provide valuable insights, they do not capture all aspects of a company's performance. For example, they do not capture qualitative factors like management quality or competitive positioning. Second, the magic formula requires patience and discipline. It may take time for the market to recognize the value in the companies you have invested in, and there may be periods of underperformance.
Benefits of the Magic Formula
One of the main benefits of the magic formula is its simplicity. The strategy is based on two key financial metrics, ROC and EY, and it involves a straightforward process of ranking companies and investing in a portfolio of the top ranked companies. This makes it a strategy that anyone can implement, regardless of their level of financial knowledge or investing experience.
Another benefit of the magic formula is its potential for long-term outperformance. The strategy is designed to identify high-quality companies that are trading at attractive prices. Over the long term, these companies are expected to outperform the market. This makes the magic formula a good strategy for long-term investors who are looking to build wealth over time.
Risks of the Magic Formula
While the magic formula offers several benefits, it also comes with certain risks. One of the main risks is that it is a quantitative strategy that relies on financial metrics. While these metrics can provide valuable insights, they do not capture all aspects of a company's performance. For example, they do not capture qualitative factors like management quality or competitive positioning. This means that the formula may overlook certain companies that could be good investment opportunities.
Another risk of the magic formula is that it requires patience and discipline. The strategy is designed to work over the long term, and it may take time for the market to recognize the value in the companies you have invested in. There may also be periods of underperformance, where the formula does not beat the market. This requires investors to have patience and stick with the strategy, even during these periods of underperformance.
Conclusion
The magic formula investing strategy is a simple, yet powerful, investing strategy. It is based on the principle of buying good companies at good prices, and it uses two key financial metrics, ROC and EY, to identify these companies. While the strategy offers several benefits, including simplicity and potential for long-term outperformance, it also comes with certain risks. These include reliance on financial metrics and the need for patience and discipline.
Despite these risks, the magic formula remains a popular investing strategy. It offers a systematic and disciplined approach to investing, and it has been shown to outperform the market over the long term. Whether you are a novice investor looking for a simple strategy to get started, or a seasoned investor looking for a new strategy to add to your toolbox, the magic formula is worth considering.
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