Magic Formula Investing
Magic Formula Investing is an investment strategy proposed by Joel Greenblatt in his book "The Little Book That Still Beats the Market." This strategy selects stocks based on two key financial metrics: Return on Capital (ROC) and Earnings Yield (EY). The Magic Formula aims to systematically identify undervalued companies with strong profitability, leading to long-term excess returns.
Key characteristics include:
Return on Capital (ROC): Measures the efficiency of a company's use of capital to generate profits. The formula is ROC = EBIT / (Net Working Capital + Net Fixed Assets).
Earnings Yield (EY): Measures a company's earnings relative to its market value. The formula is EY = EBIT / Enterprise Value.
Systematic Selection: Each year, select the top 30 or 50 companies from the public market that meet the Magic Formula criteria.
Long-Term Investment: The strategy emphasizes holding investments for the long term to realize the intrinsic value of undervalued companies.
Example of Magic Formula Investing application:
An investor uses the Magic Formula to screen for qualifying stocks. The selected stocks share high ROC and high EY characteristics. Following the Magic Formula's recommendations, the investor buys these stocks and holds them for the long term, reassessing and adjusting the portfolio annually. Through this approach, the investor aims to achieve returns above the market average.
Definition:
Magic Formula Investing is an investment strategy proposed by Joel Greenblatt in his book "The Little Book That Still Beats the Market." This strategy selects stocks with potential high returns using two key financial metrics: Return on Capital (ROC) and Earnings Yield (EY). The goal of Magic Formula Investing is to systematically identify undervalued companies with strong profitability to achieve long-term excess returns.
Origin:
The concept of Magic Formula Investing was first introduced by Joel Greenblatt in 2005. In his book, he detailed the theoretical foundation and practical application of this strategy, and validated its effectiveness through extensive historical data. Greenblatt's research showed that ordinary investors could achieve significant excess returns in the stock market using simple formulas and systematic screening methods.
Categories and Characteristics:
1. Return on Capital (ROC): Measures the efficiency of a company in generating profits from its capital. Formula: ROC = EBIT / (Net Working Capital + Net Fixed Assets).
2. Earnings Yield (EY): Measures the ratio of a company's earnings per share to its market value. Formula: EY = EBIT / Enterprise Value.
3. Systematic Screening: Annually selects the top 30 or 50 companies from the public market that meet the Magic Formula criteria.
4. Long-term Investment: Emphasizes long-term holding to fully realize the intrinsic value of undervalued companies.
Specific Cases:
Case 1: An investor uses the Magic Formula to screen a batch of qualifying stocks. These stocks share the common characteristics of high Return on Capital and high Earnings Yield. Following the Magic Formula's advice, the investor buys these stocks and holds them long-term, re-evaluating and adjusting the portfolio annually. Through this method, the investor expects to achieve returns above the market average.
Case 2: Another investor applies the Magic Formula Investing strategy and selects a tech company and a manufacturing company in a given year. Both companies have high Return on Capital and high Earnings Yield. The investor purchases shares of these companies and observes over the next few years that their stock prices significantly increase due to strong profitability and market undervaluation, ultimately achieving excess returns.
Common Questions:
1. Is Magic Formula Investing applicable to all markets?
Magic Formula Investing is primarily applicable to stock markets, especially those with transparent information and publicly available financial data. Its effectiveness may be compromised in markets with opaque information or unreliable financial data.
2. How long do investors need to see returns?
Magic Formula Investing emphasizes long-term holding, typically recommending investors hold for at least 3-5 years to fully realize the intrinsic value of undervalued companies.
