The Magic Formula Investing system was developed by Joel Greenblatt to be a compliment to his best selling book â€œThe Little Book That Beats the Marketâ€. The Magic Formula Investing system is a terrific system for those who have neither the time nor the inclination to do research themselves. The Magic Formula Investing system does it for them as long as they believe in the system.
The Magic Formula Investing Premise
The basic premise behind The Little Book that Beats the Market and the system is that you should buy quality stocks for a cheap price. The Magic Formula Investing system looks at two things. The earnings of the company and the earnings yield of the company.
The earnings yield is basically the price to earnings ratio backwards. It is the earnings divided by the stock price whereas the price to earnings ratio is the stock price divided by the earnings. By looking at earnings, the Magic Formula Investing system is looking at the return on capital. By focusing on this metric, the system is looking at how well the company is reinvesting the earnings that it is making into growing the business.
Why the Magic Formula Investing System Works
Because you are looking at companies with the best rates of return on capital, you are getting companies that are making effective uses of their cash and assets. This usually happens with companies that are growing and have strong management.
By looking at the earnings yield you are looking for companies with the highest earnings yields. This by definition means that they are trading at a low price to earnings ratio.
The kicker comes because the Magic Formula Investing system combines the two metrics and weights them evenly. In the end it is telling you which stocks have the best combination of return on capital and are trading at a cheap price.
How to Use the Magic Formula Investing System
This is the best part of the system. It is easy. You use the screening system at the free website which you can find in the book. You run the screen and it will give you anywhere from 25 to 100 companies based on what you choose. You can also specify the minimum market capitalization if you want to only focus on larger stocks.
Next you buy at least 20 of the stocks on the list in equal weight. You hold for one year. If the stock has a loss at the end of that year you sell after 364 days. If it has a gain you sell after 367 days to make sure you have a long term capital gain.
You then go back to the first step and repeat the process.
While it sounds too good to be true, that is not the case. The system has been back tested and has out performed the market for long periods of time. It even out performed the market during the 2008 meltdown.
If you donâ€™t have a lot of time for research but still want to invest on your own, the Magic Formula Investing system is a great place to start.