Magic Formula Investing: Will It Work?

Today I’m reviewing the idea of Magic Formula Investing (MFI) as introduced in the book The Little Book That Beats the Market by Joel Greenblatt.

The author Joel Greenblatt (Wikipedia bio) is a hedge fund manager. In this book he offered a “magic formula” that beats the market, or so he claimed. The underlying principles for the magic formula are very simple:

  • Buy good companies
  • Pay a bargain price

At first glance, there is nothing wrong with the two principles. All else being equal, everybody wants good companies, not bad ones. All else being equal, everybody would like to pay a bargain price, not an inflated price. But in real life all else are not equal. Good companies are usually not cheap. Cheap companies usually have something wrong with them. The magic formula attempts to solve this problem. It ranks companies by their return on capital (good companies) and earnings yield (bargain price). It then gives you stocks that rank high when both criteria are taken into consideration.

The book has a support site magicformulainvesting.com. It’ll run the formula for you and produce a list of suggested stocks. For the time being, the site is free. You are supposed to buy 5-7 stocks every 2-3 months until you have 20-30 stocks. Then you will re-run the screen. If the first batch of stocks you bought a year ago are not on the list any more, sell them and replace with new stocks on the list. Repeat for each batch around their 1-year anniversary. It is a very concentrated and high turnover strategy. At any time you only have 20-30 stocks and you are replacing 100% of your portfolio every year if the stocks you own fall off the list. Instead, if you buy a total market index mutual fund, you will own thousands of stocks, not just 20 to 30, with very little turnover.

Does it work? Greenblatt said it did over 17 years from 1988 to 2004.

“Over the last 17 years, owning a portfolio of approximately 30 stocks that had the best combination of a high return on capital and a high earnings yield would have returned approximately 30.8 percent per year.” (p. 52, italics original)

There’s no way to independently verify that record but let’s accept it as accurate. What about the next 17 years? That’s what I’m interested in. I don’t have a time machine which turns the clock back 17 years. And you know what they say about past performance and future performance. As rich as he may be, Greenblatt doesn’t offer any warranty on how the magic formula will turn out in the future. If you have poor results, don’t come crying. He will not make you whole. You are supposed to believe in the formula and stick with it.

Remember, 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!” (p. 135, italics original)

What if it didn’t work out even after 5 years? I guess Greenblatt will say you should stick with the formula even longer. Or maybe you will get a “oops, sorry.”

Is this strategy something you can use for your entire portfolio? I don’t think so. Betting everything on 20-30 stocks is very risky. I went to magicformulainvesting.com and got my list of stocks with the minimum market capitalization set at $100 million, as the book recommended. I then run Morningstar’s Instant X-Ray tool on them and here’s what I got:

So basically it wants me to invest 64% of my money in small cap stocks, whereas small cap stocks make up only less than 10% of the U.S. stock market. No way. Can you spell RISKY? Will it beat the market? Maybe, maybe not. I’m not going to wager all my investment dollars on it to find out.

JLP at AllFinancialMatters.com started a simulation on Magic Formula Investing in January 2007. He got good results for the short 6-month period until the last update in early July. But note he is only doing it with hypothetical dollars, not real money. It will also be interesting to see how Magic Formula Investing did in the recent stock market sell-off. If blogger Marsh_Gerda’s experience is typical, it’s not pretty. He had accumulated healthy extra returns over the broad market since February 2006. In three weeks, those extra gains built up in the last 17 months were completely wiped out.

What about doing this only for “play money”? Well, I don’t have “play money.” All my investments are from my hard earned dollars. Why do I want to “play” or gamble with them? Besides, what’s the point of beating the market on only 2% of your investments? How much difference will it make?

Andrew Tobias, who wrote the foreword for Greenblatt’s book, had this succinct statement in his book The Only Investment Guide You’ll Ever Need (review in previous post):

“In the financial marketplace, you get what you pay for, if you are careful. If you try to get more, you get burned.”

That’s something you always have to remember whenever you are attracted to any scheme, no matter what it is. In the end, I guess I’m not that interested in beating the market. If I beat the market, something is wrong. That means I took a bet and the bet came in my favor. But wait a minute, why did I take a bet with my hard earned money in the first place? Gambling is not investing.

Rating: * (avoid).

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Comments

  1. Anonymous says

    Couple of problems with your post.
    1) If you are setting the minimum market cap at 100 million, you will naturally get small cap stocks to show up. If you set it higher, you won’t. Regardless, historically speaking, small cap value stocks outperform most other segments of the market

    2) The experience of other individuals who you comment on, is over a very brief period of time. Greenblatt realizes there may be a couple of bad years in a row, but encourages the investor to hang on to the formula. In his book, he claims that when looking at 3 year rolling returns, there was never a loss and the market average and S&P were both beaten.

    3) You say if you are beating the averages, something is wrong.
    But isn’t that the point of value investing – essentially you are saying the concept of value investing as a whole is null and void, and that the efficient market theorists are correct. If you feel that way, just stick to an S&P index fund.

  2. Sam says

    Hi,

    If you want to know how the Magic Formula holds up on European markets, visit my blog.
    I can say that even is this bad period it isn’t bad, with hardly no effort.

    And it doesn’t matter that much that they are small caps, just that they are good companies. Anyway if you feel like visiting the blog here is the adres. investingeuro.blogspot.com

  3. S. says

    The problem with this magic formula is that it does not prevent you from selecting losers. It’s a pure statistic method which, as far as we are concerned, is open to further improvement.

    Determining which stocks are undervalued or which are justly beaten up, is a very difficult task, which we believe is best executed by people who know the company very well, the insiders. Therefore, we track the insider tradings of the companies in the Top 25 list of the Magic Formula, and publish them on a regular base on this site:

    http://magicformulainsidetraders.blogspot.com/

    What’s even more important about inside tradings is that when executives bought shares in their own companies, the stock tended to outperform the total market by 8.9% over the next 12 months. Conversely when they sold shares, the stock underperformed the market by 5.4% (Nejat Seyhun, a renowned professor and researcher in the field of insider trading at the University of Michigan).

  4. Anonymous says

    Having started with the MF, with real and a fairly substantial amount of capital at the end of Dec. 2007, I have to say I am quite pleased with the results. I’m up about 13%, in a market that has been somewhat erratic, but largely off it’s highs.

    I start with a min cap of 50, looking at the top 50, but if I don’t find stocks I like there, I go to the top 100.

    Admittedly, I don’t blindly picks the stocks. I see that there is no very recent bad news (like they’re going under), I take a quick look at earnings for the last 4 quarters to make sure there are no one time gains included, I avoid stocks which have a high short position, and I do look for a current ratio above 2. Oh, and the stock should be near it’s 52 week low, although I’m not as stubborn about that criterion. My goal is to hold 20 stocks, as I’ve realized it’s a lot of work, so 30 would be too much.

    Also, I use zecco, which gives me 10 free trades a month.

    There are some issues with the list, I’ll admit. Its supposed to exclude stocks with one time gains, but doesn’t always. It’s also not supposed to include foreign companies, but I notice Chinese stocks show up once in a while.

    Remember, you are collecting 20-30 stocks, spread across different industries. That’s a lot, and it’s reasonably diversified.

    Hope that helps.

  5. dan says

    i read this stupid book…it was the WORST financial advice book i have ever read….all FLUFF, no substance! and who in there right mind would TRUST something called a “magic formula”!?!!?!?!?!? if this moron really got a 40% return on his hedge fund….he would be in the Forbes billionaire list…..he’s NOT!

  6. dr. michael corey says

    recently found the greenblatt on the jewish new years flying to denver.read it on the way(slow reader),thot it was provence on that date.will try it with real money and let you know results in a year.seems like the magic cant be worse then i do on my own

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