The Magic Formula to Beating the Market

by | Sep 23, 2020

Joel Greenblatt is an American Investor, writer, professor, and hedge fund manager. His fund, Gotham Capital achieved a 48.5% compounded annual return from 1985 to 2005. Greenblatt says he wanted to write a short accessible guide to investing that even his kids could understand. That guide is The Little Book that Still Beats the Market.

While the book and the investment strategy detailed within it are simple, the implied returns you could achieve from following it are superb. Greenblatt calls his investment strategy “The Magic Formula”. During 17 years (1987 – 2004) of testing The Magic Formula achieved an average annual return of 30.8%. The overall market average for that same period was just 12.3% per year. $11 thousand invested in the Magic Formula would have grown to more than $1 million. $11 thousand invested in the overall market would have grown to just $79 thousand.

Growth of $11,000 at a rate of 30.8% for 17 years. Source: www.investor.gov

The Little Book that Still Beats the Market makes some big claims. Here are 5 things I learned from it. 

Most people should not invest in individual stocks

There are many ways you can save or invest your money, you can:

  1. Hide it under your mattress 
  2. Put it in a savings account.
  3. Lend it to the Government (government bonds). 
  4. Lend it to a company (corporate bonds).
  5. Invest in real estate.
  6. Or, invest in a company (stocks). 

Many people agree that investing in stocks offers the greatest return on investment of the most popular asset classes. If you want to invest in stocks you can:

  1. Invest in a mutual fund. Even though 90% fail to beat the market and you probably won’t be able to pick which ones will beat the market in the future.
  2. Invest in a hedge fund. You will need at least $500,000 and you still aren’t guaranteed to beat the market after fees are taken into account. 
  3. Pick your own stock. You probably shouldn’t unless you are capable of finding normalized earnings and then predicting those earnings into the future with a high degree of certainty. If you don’t understand what that means then you definitely shouldn’t be picking your own stocks. 
  4. Invest in an Index fund or ETF. The simplest and best way to achieve average market returns. 

None of the 4 strategies mentioned will help you beat the market. But there is a strategy that you can use which strongly suggests that you can beat the market and do so taking on less risk than investing in an Index Fund. That strategy is The Magic Formula but more on that later. 

First, you need to understand why The Magic Formula works. 

Markets are mad

It turns out that the stock market is mad. Pick any stock and go and look at the price history for the past year. Chances are that you are going to see a huge difference between the highest and lowest price. Just look at the price chart for Apple for the past year. 

Apple price chart from October 2019 to October 2020. Source: www.tradingview.com

Over the past year, you could have bought Apple for as little as $54 or as much as $134. That is a difference in the price of almost 60%. The value of Apple did not change by 60% over that year and yet the price did. That is just crazy. But the market being crazy is not a bad thing. It’s a very good thing. The fact that the market is crazy gives us opportunities to buy companies when they are cheap and sell them when they are expensive. 

What makes a company ‘cheap’

Imagine there are two companies up for sale. The first company called Terrific Tony’s generated a profit of $100,000 last year. The second company called Sad Sally’s generated $50,000 last year. Both companies will cost you $1 million.

All things being equal which company would you prefer to buy?

Terrific Tony’s.

If Terrific Tony’s can continue to generate $100,000 a year you will get your money back within 10 years.

If Sad Sally continues to generate $50,000 a year it will take 20 years for you to make back your money. 

Terrific Tony’s has an earnings yield of 10% whereas Sad Sally’s has an earnings yield of 5%. 

Earnings yield = earnings (profit) / Cost of the company. 

Terrific Tony’s earnings yield = $100,000 / $1 million = 10%

Sad Sally’s earnings yield = $50,000 / $1 million = 5%. 

All things being equal a company with a higher earnings yield is cheaper than a company with a lower earnings yield. 

You may have heard of the PE ratio. The PE ratio is just the inverse of the earnings yield. 

PE Ratio = Cost of the company / Earnings.

All things being equal a company with a low PE ratio is cheaper than a company with a high PE ratio. 

If Terrific Tony’s can maintain their yearly earnings of $100,000 a year we will get our money back within 10 years or a 10% return per year. 

What if they can increase their yearly earnings. Then we would get our money back in less than 10 years or, a return greater than 10%.  

But what if their earnings decrease? Then it will take longer than 10 years for us to get our money back or, a return of less than 10%.

It all comes down to the earnings the company will be able to generate in the future. Wouldn’t it be nice if we could choose companies that are likely to be able to maintain or grow their earnings in the future? That would be a ‘good’ company.

What makes a company ‘good’

Let’s say it cost $500,000 to build the stores that Terrific Tony’s and Sad Sally’s operates out of. 

It cost $500,000 to build Terrific Tony’s store and they generated $100,000 last year. Terrific Tony’s generated a return on their investment of 20%. This is called the return on capital.

$100,000 / $500,000 = 20%

It cost $500,000 to build Sad Sally’s store and they generated $50,000 last year. Sad Sally’s is generating a return on capital of 10%. 

$50,000 / $500,000 = 10%

Given that Terrific Tony’s is generating a return on capital of 20% and Sad Sally’s is generating a return on capital of 10% it is safe to say that Terrific Tony’s is the better company. 

Companies that earn a higher return on capital are ‘better’ than companies that earn a lower return on capital. A high return on capital means that the company can generate high amounts of profit from the money they invest within the company. 

A high return on capital also indicates that there is something ‘special’ about that company. That special something could indicate the presence of what Warren Buffett calls a ‘moat’. A moat is a competitive advantage one company has over its rivals which allows them to protect market share and increase prices. If a company can protect its market share and increase prices then it should be able to maintain or increase its earnings over time. 

How you can use The Magic Formula to get above-average market returns

What the magic formula aims to do is buy good companies at cheap prices. That is buy companies with a high return on capital and a high earnings yield (low PE).

What the magic formula does is rank the largest 3500 companies on a US Index by earnings yield. The company with the highest earnings yield will get a rank of 1. The company with the lowest earnings yield will get a rank of 3500. It then ranks those companies by return on capital. The company with the highest return on capital will get a rank of 1. The company with the lowest return on capital will get a rank of 3500. It then adds the two ranks together to get a combined rank. On average the companies with a lower combined rank are cheaper and better than the companies with a higher combined rank.

Here are the step by step instructions to using The Magic Formula.

Step 1

Go to magicformulainvesting.com.

Step 2

Register so that you may use the screener.

Step 3

Choose your company size. For most people a market cap of $50 million or greater is ideal.

Step 4

Choose the number of stocks you want the screener to generate. The screener will generate 30 to 50 stocks with the lowest combined ranking of earnings yield and return on equity. 

Step 5

Buy 20 to 30 of the stocks generated over the next 9 to 10 months. This means using 20 to 30% of the money you wish to invest to buy 5 to 7 stocks. A month or two later you would use another 20 to 30% of your money to buy the next 5 to 7 stocks. Keep doing so until you have 20 to 30 stocks in your portfolio.

Step 6

Sell each stock after you have held them for one year. For tax purposes you are going to sell your losers a few days before one year has passed. For winners, you are going to sell them a few days after one year has passed. Use the money from each sale to buy 5 to 7 new Magic Formula companies.

Step 7

Repeat this process until you are very wealthy. 

NOTE:

Greenblatt says “you must be committed to continuing this process for a minimum of three to five years, regardless of results. Otherwise, you will most likely quit before the magic formula has a chance to work.” That is because over any given year the Magic Formula fails to beat the market 25% of the time. Stick to the formula for 2 years and there is a 17% chance that you will underperform. Stick to the formula for 3 years and there is a 5% chance that you will underperform. But stick to the formula for more than 3 years and you will beat the market every time.

Summary

The Little Book that Still Beats the Market is a simple explanation of how the stock market works that even a child could understand. It is the simplicity of the book and the strategy detailed within that makes the Magic Formula so powerful.

There are many ways you can invest your money. Many people agree that investing in stocks is the best way. There are also many ways to invest in stocks. Index fund investing is becoming an increasingly popular way to invest in stocks and they will get you as close to market average returns as possible. There’s nothing wrong with average market returns either. Historically the stock market has generated around 10% returns each year. 

Investing in individual stocks can be exciting. But without proper education, you probably shouldn’t. Greenblatt says “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

So if you want to beat the stock market with a high degree of certainty and a low amount of risk then you have one other alternative, The Magic Formula. That is buying the 20 to 30 stocks with the lowest combined rankings of earnings yield and return on equity from the largest 3500 stocks on a US stock exchange. Holding those stocks for approximately one year, selling them and then buying another batch of stock to hold for one year, rinse and repeat.

Using this strategy could reward you with returns of 30%+ per year if applied over the long term. 

To read more about the Magic Formula get your own copy of The Little Book that Still Beats the Market. (THIS IS NOT AN AFFILIATE LINK.)

Please remember this is not financial advice. Information provided is for educational and entertainment purposes only and in no way is to be considered financial advice. Before acting, you should consider seeking independent personal financial advice that is tailored to your needs.

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