Joel Greenblatt's Magic Formula: Explanation, Testing, and Application

Introduction

Magic Formula Investing is a method developed by Joel Greenblatt in his book "The Little Book That Still Beats the Market." This method aims to identify undervalued stocks with a high return on invested capital. The foundation of this strategy is a formula that combines two key metrics: earnings yield and ROIC (return on invested capital).

The Magic Formula

The Magic Formula consists of two parts:

1. Earnings Yield (EY): The formula for EY is calculated as net income divided by the market price of the stock. This metric provides insight into how much profit a stock generates relative to its price.

- - - Net Income: $1,000,000 Market Price of the Stock: $50 - - - Thus, EY = $1,000,000 / $50 = 20%

1. ROIC (Return on Invested Capital): This metric measures the ability of a company to generate profits from the capital it has invested in its business. It is calculated as EBIT (earnings before interest and taxes) divided by total capital.

- - - - - EBIT: $1,500,000 Total Capital: $10,000,000 - ROIC = $1,500,000 / $10,000,000 = 15%

Final Formula

The Magic Formula combines these two metrics:

• Magic Formula Score = Earnings Yield + ROIC

Investors look for stocks with the highest combined values of these two metrics.

Historical Backtesting and Results

Historical backtesting of the Magic Formula from 1988 to 2009 resulted in an average annual return of around 30%. This result is remarkable, especially when compared to average market returns. Even during skeptical views at the time, Greenblatt's findings prompted investor interest.

Reasons for the Success of This Strategy

• Focus on Value: By targeting undervalued stocks, the strategy reduced the risks associated with investing.
• Capital Efficiency Focus: A high ROIC indicates that a firm efficiently utilizes its capital to generate profits.

Practical Application in QMA

Using the QMA Screener

To practice the Magic Formula within the QMA platform, you can use the screener that combines the factors from the formula mentioned above.

1. FVS Filter: This filter identifies stocks trading at low price-to-value ratios.
2. EQS Filter: It helps identify companies with high ROIC, a key component of the Magic Formula.

In QMA, you can find a selection of stocks that meet these criteria, thereby streamlining your investment process. The 5-pillar score helps evaluate quality not only based on key metrics but also according to other standards, like competitiveness and market potential.

Limitations and Survival Bias

Despite its strengths, the Magic Formula should be used cautiously:

• Survival Bias: Historical analyses often overlook companies that have failed or experienced significant declines, thus skewing the resulting scores.
• Volatility: While the strategy can work long-term, it may display significant short-term losses during market cycles.
• Parameter Inefficacy: Changes in the market can affect how well the strategy performs in the future, particularly in different economic cycles.

Conclusion

The Magic Formula represents a useful model for identifying undervalued stocks. By leveraging helpful features in QMA such as the screener and 5-pillar score, you can effectively implement this strategy into your portfolio. However, be mindful of the limitations and challenges associated with this investment method.

Where to find this in QMA

All mentioned features like FVS and EQS filters can be found in the Screener section on the QMA platform. To analyze portfolio health and monitor its status, use the portfolio-health function.

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Disclaimer: This article is for informational purposes only and does not constitute investment advice. None of the information provided should be regarded as a solicitation to buy or sell stocks. Always conduct your own thorough research before investing.