I’ve been reviewing a research paper on Joel Greenblatt's "Magic Formula" investing, a strategy detailed in his "Little Book That Beats the Market." The findings are compelling.
Joel Greenblatt (born 1957)
a prominent American value investor, hedge fund manager, author, and academic, widely respected for his ability to simplify complex financial concepts and his exceptional historical investment performance.
The core idea is simple and powerful: systematically buy good companies at cheap prices. It’s an attempt to quantify the core philosophies of investing legends like Benjamin Graham (buy cheap) and Warren Buffett (buy good).
The "magic" relies on just two key metrics to rank stocks:
Earnings Yield (The "Cheap" Factor): This identifies companies that are cheap relative to their earnings. The paper notes it uses the formula EBIT / Enterprise Value to get a clean, comparable number.
Return on Capital (The "Good" Factor): This identifies high-quality, efficient companies. The formula used is EBIT / (Net Fixed Assets + Net Working Capital), measuring how much profit a company generates from its core operating assets.
The process is straightforward: All stocks are ranked on both metrics, the ranks are combined, and the portfolio is built from the "top decile" (top 10%) of stocks with the best combined ranking.
So, does it work?
The back-tested data in the paper is remarkable. It highlights a 22-year period (1988-2009) where a $10,000 investment in the S&P 500 would have grown to $74,000. That same $10,000 invested using the Magic Formula was shown to grow to $1,100,000.
Further back tests (from 1988-2004) confirmed the ranking's effectiveness, showing that the top 10% of formula stocks generated the highest annualized returns (over 18%), while the bottom 10% performed the worst.
The Important Caveat:
This is not a "win every year" strategy. The paper's data clearly shows individual years where the formula underperformed the S&P 500. It’s a disciplined, long-term approach that requires patience, as its true outperformance was demonstrated over multi-year periods, not in short-term sprints.
The paper's data is also now more than a decade old. For those interested, it would be a valuable and interesting exercise to run your own back tests using recent data (e.g., 2011-today) to see if the formula still holds its "magic" in today's market. You may find that, like many value strategies, its performance comes in cycles.
In summary, the Magic Formula provides a quantitative, rules-based method for value investing, aiming to remove emotion and focus solely on combining Price (High Earnings Yield) and Quality (High Return on Capital) to achieve long-term, market-beating returns.