The “magic formula investing” system parameters and principles are used by Joel Greenblatt in his approach to value investing to outperform the market. In his book ‘The Little Book that Beats the Market’, Greenblatt writes that this system buys cheap stocks of 30 companies that have high earnings yield and also a high return on their capital.
Magic formula investing system parameters:
- Stocks need a minimum market capitalization greater than $50 million.
- No utility and financial stocks can be used.
- No foreign company American Depositary Receipts (ADRs). Only use primary U.S. exchange listed companies.
- Screen for company’s earnings yield = EBIT / enterprise value.
- Screen for company’s return on capital = EBIT / (net fixed assets + working capital).
- Filter to rank the stocks on your list by both highest earnings yield and highest return on capital in percentages.
- Buy 2 or 3 positions a month on average for the next year from the best stocks from your screen filter. Accumulate an investing portfolio of 20 to 30 of the highest ranked stocks of companies from your stock screener by building positions slowly and consistently.
- Annually rebalance the stock portfolio, exiting losing stocks one week before the one year mark and exit winners a week after the one year mark.
- Go back to step 1 and start over.
- Repeat this system over the long-term for 5, 10, or more years to get the most benefit of a larger time period.
The book shows that the magic formula investing system beats the S&P 500 96% of the time over the market data sampled and averaged a 17-year annual return of +30.8%.
The Joel Greenblatt magic formula investing system is basically creating an annual value index of 20-30 of the stocks of the companies that are at a great price in relation to the value of their return on capital. This is a value investing system shared by one of the most successful investors and money managers of the past 35 years.