Magic formula investing is a strategy that was created by the American hedge fund manager and Columbia University professor: Joel Greenblatt. The core of the strategy is its formula-driven approach that focuses on buying good companies at favorable prices in order to maximize returns. As one can understand, Greenblatt prefixed the word “magic” to his formula to improve its marketability but in numbers and when back-tested, his magic portfolio does deliver an annualized return of 23.8% between 1998 and 2009 which was far higher than S&P 500’s 9.6% CAGR.

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📝 CHAPTERS
00:00 Introduction
01:26 The Magic Formula Strategy
06:16 How does the Magic Formula work?
08:07 Indian stocks & the Magic Formula

📝 THE MAGIC FORMULA STRATEGY

Greenblatt uses the ratio of the company’s operating earnings to the enterprise value which he labels as the earnings yield. These two financial metrics can be easily found in the profit & loss statement and the balance sheet of the company. Although, enterprise value will require a quick calculation on your part which is nothing but the summation of the company’s market cap and debt after subtracting the cash in the business. Greenblatt’s earnings yield is a representation of a company’s cheapness and as you might have expected the higher the earnings yield, the cheaper is that company. Now, when it comes to identifying good companies Greenblatt prefers using the “return on capital” metric.

The return on capital or the ROC of a company is calculated as its operating earnings or EBIT divided by the sum of net working capital and the company’s depreciation adjusted value of fixed assets. In essence, the ROC is a proxy for business quality as companies that are more efficient users of capital also tend to have a better brand, a superior product, a unique business model and a wider economic moat. So on one hand, the magic formula uses the earnings yield which quantifies how cheap the company is and on the other hand, it utilizes the company’s return on capital which quantifies the efficiency and quality of the business.

Now the Joel Greenblatt magic formula investing strategy is a set of 9 rules. The first three rules are conditions i.e. the minimum market cap, excluded sectors and geographies. More significantly, the strategy excludes financial companies and while the book didn’t give us a reason for this exclusion.This is more to do with a financial company’s unique business model and its heavy use of leverage. Steps 4 and 5 are where we plug in the earnings yield and the return on capital per the calculations we had done earlier. Step 6 which is about allocating a rank for each company on the basis of their earnings yield and their return on capital. Step 7 in a method similar to what we just did Greenblatt’s strategy requires investing into 20 to 30 of the highest ranked companies. He goes on to suggest that these stocks should be accumulated on a progressive basis i.e. invest into 6 to 7 companies every three months over a 12 month period. Step 8 of the strategy requires investor to rebalance their portfolio once a year. And since there is some taxation involved the ideal approach here is to sell the portfolio’s loser stocks in the 51st week after purchase so that one can book a short term capital loss and subsequently sell the portfolio’s winners in the 53rd week after purchase. The final step, step 9 is to persist with this approach over a period of at least 5 years to derive maximum benefits under this strategy.

📝 INDIAN STOCKS & THE MAGIC FORMULA

We applied the magic formula approach to Indian stocks did some tweaking like setting a minimum market cap condition of 1,000 crores etc. and came up with some stocks which are listed not necessarily in the order of ranking but includes the earnings yield and return on capital for your reference.A large part of the selection landed on: chemical companies that includes commodity, agro and speciality chemicals, construction and engineering companies, iron & steel and metal companies, oil & gas and some pharmaceutical companies

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