The Magic Formula Strategy (Greenblatt) Backtest
Last Updated on January 31, 2023
The Magic Formula Strategy, popularized by Joel Greenblatt’s book “The Little Book That Beats the Market,” has received mixed reactions from the stock market. Some investors have reported positive results using the strategy, while others criticize it for lacking a solid theoretical basis and not taking into account company-specific factors. Let’s find out what the Magic Formula strategy is about.
The Magic Formula strategy is a stock selection method popularized by Joel Greenblatt’s book “The Little Book That Beats the Market.” It involves ranking companies based on two factors: a high return on capital and a high earnings yield. The companies with the best combination of these two metrics are considered the best investments. The strategy aims to find undervalued companies with strong financials that have the potential for high returns over the long term.
In this post, we take a look at the Magic Formula strategy. We provide you with a backtest at the end of the article.
Unlocking the Power of the Magic Formula Strategy
The Magic Formula strategy is a stock selection method that focuses on two key financial metrics to identify fairly priced stocks with high growth potential. The two metrics used in the strategy are the return on capital (ROC) and earnings yield (EY). Companies with a high ROC and a high EY are considered to have strong financials and are more likely to perform well in the stock market.
To implement the strategy, investors start by identifying a universe of stocks, typically large-cap or mid-cap companies that trade on a major stock exchange. Next, they rank the stocks based on their ROC and EY. The companies with the best combination of these two metrics are considered the best investments.
The strategy can be implemented through passive investing, by investing in an index fund that tracks a basket of stocks selected based on the Magic Formula, or through active investing, by selecting individual stocks using the Magic Formula.
While the Magic Formula has received criticism for its simplicity and lack of consideration for company-specific factors, proponents argue that the strategy has proven to be effective in the long run. By focusing on companies with strong financials, the strategy aims to minimize risk and maximize returns for investors over the long term.
However, it’s important to note that the performance of the Magic Formula Strategy can vary depending on market conditions and individual investor preferences. Nonetheless, it can be a useful tool for investors looking to minimize risk and maximize returns over the long term.
How to Optimize Your Portfolio with the Magic Formula
The Magic Formula Strategy provides a simple and effective method for selecting stocks to optimize your portfolio. Here are the steps to help you implement the strategy:
- Identify the universe of stocks: We assume you already have a universe of stocks from where you select the components of your portfolio. If you don’t, start by selecting a group of stocks, typically large-cap or mid-cap companies that trade on a major stock exchange, which will serve as your universe of stocks to choose from.
- Rank stocks based on financial metrics: Use the Magic Formula to rank the stocks. The formula ranks stocks based on two key financial metrics, return on capital (ROC) and earnings yield (EY). So, you have to calculate the ROC and EY for each stock in your universe and rank them.
- Select the top stocks: Choose the top 20-30 stocks with the highest combination of ROC and EY. These stocks are considered to have strong financials and are more likely to perform well in the stock market.
- Have a diversified portfolio: To minimize risk, ensure your portfolio is diversified across different market sectors and geographical locations if possible.
- Rebalance your portfolio: Regularly review and rebalance your portfolio to ensure it aligns with your investment goals and risk tolerance.
- Monitor performance: Regularly monitor the performance of your portfolio and make adjustments as needed. The Magic Formula is a long-term investment strategy, so be patient and avoid making impulsive decisions based on short-term market movements.
Backtesting Your Magic Formula Strategy
Backtesting the Magic Formula Strategy involves simulating the strategy on historical data to how it would have performed in the past. Evaluating a strategy’s historical performance may determine its effectiveness in generating returns. Here are the steps to backtest the strategy:
- Identify the universe of stocks: Choose a group of stocks, typically large-cap or mid-cap companies that trade on a major stock exchange, to serve as your universe of stocks to choose from.
- Obtain historical data: Collect historical data on the stocks in your universe, including their prices, earnings, and other financial metrics. Trading platforms like TradingView may have enough historical data. But if your platform doesn’t have enough, you can use financial databases such as Yahoo Finance and Google Finance or databases offered by financial data providers, such as MultiCharts.
- Calculate the ROC and EY: The Magic Formula ranks stocks based on two financial metrics, return on capital (ROC) and earnings yield (EY). Calculate the ROC and EY for each stock in your universe.
- Select the top stocks: Using the historical data, rank the stocks based on their ROC and EY and select the top stocks. These are the stocks that would have been considered the best investments according to the Magic Formula.
- Evaluate performance: Evaluate the performance of the top stocks over the historical period. You can use various performance metrics such as return on investment (ROI), total return, and Sharpe ratio to determine how well the Magic Formula performed.
- Compare performance to a benchmark: Compare the performance of the Magic Formula to a benchmark, such as the S&P 500, to see how well it performed relative to the market.
- Repeat the process: Repeat the backtesting process over different historical periods to get a more complete understanding of the Magic Formula’s performance.
The Benefits of Using the Magic Formula Strategy
The Magic Formula strategy is an attractive investment strategy for investors looking to optimize their portfolios. The strategy has several benefits for investors looking to invest over the long term:
- Simplicity: The Magic Formula is a simple investment strategy that relies on just two financial metrics, return on capital (ROC) and earnings yield (EY), making it easy to understand and implement.
- Long-term perspective: The Magic Formula is a long-term investment strategy that focuses on generating returns over the long term, rather than short-term market movements.
- Minimizing risk: By selecting stocks based on their financial strength, the Magic Formula helps minimize risk and reduce the chances of losing money in the stock market.
- Diversification: The Magic Formula strategy helps create a diversified portfolio by selecting a mix of 20-30 stocks, rather than just one or two. This helps to spread out the risks in the investment.
- Good returns: Historical data has shown that the Magic Formula has outperformed the market over the long term, generating higher returns for investors.
- Low-cost investment strategy: Unlike other investment strategies, the Magic Formula does not require the use of expensive financial products or the services of a financial advisor, making it a low-cost investment strategy.
Rules for Investing with the Magic Formula
The Magic Formula investing strategy is a simple, quantitative approach to stock selection that has been proven to generate higher returns over the long term. The strategy has nine key rules to follow to maximize returns and minimize risk.
- Market capitalization: Only include stocks with a market capitalization above $50 million, $100 million, or $200 million. This ensures that you are only investing in well-established companies.
- Exclude certain sectors: Exclude financial and utility stocks. This helps to reduce sector-specific risk.
- No foreign stocks: Exclude foreign companies or American Depositary Receipts (ADRs).
- Earnings Yield: Determine the company’s earnings yield, which is calculated by dividing its earnings before interest and taxes (EBIT) by its enterprise value (EV). This metric helps to assess the company’s profitability.
- Return on Capital: Determine the company’s return on capital, which is calculated by dividing its EBIT by the sum of its net fixed assets and working capital. This metric helps to assess the efficiency of the company’s capital deployment.
- Ranking: Based on Steps 1 through 5, rank the results according to earnings yield and return on capital. These rankings should be expressed as percentages.
- Portfolio construction: Invest in 20 to 30 of the highest-ranked companies, accumulating two to three positions per month over a 12-month period. This helps to achieve a well-diversified portfolio.
- Rebalancing: Rebalance the portfolio once per year, selling losers 51 weeks after purchase and selling winners 53 weeks after purchase. This is for tax purposes, as losers are held for less than a year, and winners are held for longer than a year.
- Long-term focus: Use the strategy over the long term. For example, choose to implement it for at least five years. This helps to capture the full benefits of the Magic Formula and avoid short-term market fluctuations.
The Magic Formula: A Guide for Beginners
The Magic Formula is a simple investment strategy that can help beginners generate higher returns and minimize risk. Here are the key things a beginner should know about the Magic Formula strategy:
- The two metrics for ranking stocks: The Magic Formula is used in selecting stocks based on two financial metrics, return on capital (ROC) and earnings yield (EY). It’s important to understand these metrics and how they are used to select stocks for investment.
- Diversification across market sectors and industries: Diversification is key to reducing risk and maximizing returns. Invest in a mix of 20-30 stocks from different sectors and industries, rather than just picking stocks from one or two sectors, to reduce the risk of losing money on a single stock.
- Long-term perspective: The Magic Formula is a long-term investment strategy, so it’s important to have a long-term perspective and avoid making short-term, emotional decisions based on market fluctuations. Joel Greenblatt, the creator of the formula, recommends staying invested for at least five years.
- Sticking to the formula: Follow the Magic Formula strictly and avoid making emotional or subjective decisions. The formula has been proven to generate higher returns over the long term, so sticking to it for at least five years is essential for success.
- Monitoring your portfolio and rebalancing: Regularly monitor your portfolio to ensure that it remains in line with the Magic Formula and that you are getting the returns you expect. If necessary, make changes to ensure that your portfolio continues to meet your investment goals.
Analyzing Risk with the Magic Formula
Analyzing risk is an important aspect of investing, and the Magic Formula strategy is no exception. The Magic Formula strategy involves investing in high-quality, undervalued companies, which typically have lower levels of debt and strong earnings. This can reduce the overall risk in the portfolio compared to investing in companies with high levels of debt or weak earnings. However, as with all investing methods, the Magic Formula strategy comes with some level of risk.
One potential risk with the Magic Formula strategy is that the stocks chosen may not perform as well as expected, potentially leading to underperformance compared to the broader market. Additionally, value stocks, which this strategy tends to favor, can underperform growth stocks in certain market environments, such as during strong growth phases.
Another risk is that the strategy is based on historical data and may not hold up in the future. While the Magic Formula has a proven track record, past performance does not guarantee future results. Furthermore, the approach relies on a mechanical, quantitative approach to stock selection, which may not take into account important qualitative factors, like company management and brand name, which can impact a company’s performance.
Overall, the Magic Formula strategy can be a useful tool for investors seeking to invest in high-quality, undervalued companies, but one should understand the risks involved. It is important to perform due diligence, regularly monitor the portfolio, and be willing to adjust investments as conditions change.
Taking a Closer Look at the Magic Formula
The Magic Formula, as explained by Joel Greenblatt in his book “The Little Book that Beats the Market”, involves ranking stocks based on two metrics: earnings yield (EBIT/enterprise value) and return on capital (EBIT/invested capital). The idea is that by selecting the top 30-50 stocks based on these rankings, an investor can create a portfolio of high-quality, undervalued companies with strong earnings and low levels of debt.
One of the strengths of the Magic Formula is its simplicity and ease of implementation. The ranking system is straightforward and can be applied to a large universe of stocks to find investment opportunities. The strategy also has a proven track record, with historical data showing that it has outperformed the broader market over the long term.
However, despite its funky name, the Magic Formula is not the Holy Grail of investing. It does not guarantee success, and as with any other strategy, it does involve some level of risk. The strategy relies on historical data and may not perform as well in the future, especially if market conditions change.
Also, the approach can result in a portfolio that is heavily concentrated in a few sectors or industries, which increases the risk of underperformance if those sectors or industries underperform. You can prevent this by deliberately choosing top stocks across all industry sectors and industries.
Evaluating Performance with the Magic Formula
Evaluating performance is an important aspect of using the Magic Formula as an investment strategy. There are a few key metrics that can be used to measure the success of a portfolio built using the Magic Formula.
One common metric is total returns. This measures the change in portfolio value over a given period, including both price appreciation and dividends received. Comparing the total returns of the portfolio to a benchmark, such as the S&P 500, can provide insight into how the portfolio is performing relative to the broader market.
Another useful metric is alpha, which measures the excess return of a portfolio compared to a benchmark. A positive alpha indicates that the portfolio is outperforming the benchmark, while a negative alpha indicates underperformance. This metric can provide insight into whether the Magic Formula is adding value over a passive investment in the benchmark.
It’s also important to consider volatility when evaluating performance. Volatility measures the fluctuation in the value of the portfolio, and lower volatility typically indicates lower risk. Comparing the volatility of the Magic Formula portfolio to the benchmark can provide insight into whether the strategy is delivering a similar level of risk as the benchmark.
Maximizing Your Returns with the Magic Formula
Maximizing returns with the Magic Formula requires a combination of strategy selection and disciplined execution. Here are a few steps that can help:
- Choose the right stocks based on the Magic Formula criteria of earnings yield and return on capital to ensure that the portfolio is composed of high-quality and fairly priced stocks.
- Diversify your portfolio across different sectors and industries to help reduce risk and increase returns.
- Consider the impact of taxes, as they can significantly impact returns — tax-loss harvesting and holding investments for at least a year to take advantage of long-term capital gains rates can help reduce the tax impact.
- Consider using low-cost index funds or ETFs to implement the strategy, and minimize transaction costs by limiting the frequency of trades.
- Monitor performance regularly and adjust holdings as necessary to ensure that the portfolio continues to align with the Magic Formula criteria and personal financial goals.
The Magic Formula Strategy Backtest – Does It Work?
A backtest with trading rules and settings is coming shortly.