Magic formula investing

Magic formula investing is an investment technique outlined by Joel Greenblatt that uses the principles of value investing.

Methodology

Greenblatt suggests purchasing 30 "good companies": cheap stocks with a high earnings yield and a high return on capital. He touts the success of his magic formula in his book 'The Little Book that Beats the Market' (ISBN 0-471-73306-7), claiming that it does in fact beat the S&P 500 96% of the time, and has averaged a 17-year annual return of 30.8%.[1]

Formula
  1. Establish a minimum market capitalization (usually greater than $50 million).
  2. Exclude utility and financial stocks.
  3. Exclude foreign companies (American Depositary Receipts).
  4. Determine company's earnings yield = EBIT / enterprise value.
  5. Determine company's return on capital = EBIT / (net fixed assets + working capital).
  6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
  7. Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
  8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
  9. Continue over a long-term (5–10+ year) period.

See also

References
  1. Zen, Brian and Hamai, Garrett. "Joel Greenblatt Speaking at NYSSA". December 28, 2005.
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