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What Is Magic Formula Investing?

Magic Formula Investing is a simple, rule-based approach to value investing. It ranks stocks using fixed criteria, so you don’t have to make emotional or complex decisions. This method helps you pick companies based on price and how efficiently they use their capital.

The idea behind Magic Formula Investing is to create a disciplined way to invest in good companies at reasonable prices. It was developed by Joel Greenblatt, an investor and professor. His goal was to make value investing easier for everyone.

The formula avoids small-cap, foreign, utility, and financial companies. It focuses only on U.S.-based, large-cap businesses. The strategy helps you stay consistent by following the same steps each year. If you're wondering what is Magic Formula Investing, think of it as a repeatable way to make informed choices based on facts, not feelings.

By ranking companies and investing in the highest scorers, Magic Formula Investing gives you a framework to stay focused and organised.

Working of Magic Formula Investing

Magic Formula Investing was explained in Joel Greenblatt’s books—The Little Book That Beats the Market and The Little Book That Still Beats the Market. He designed it for investors who want a straightforward system to select stocks.

You don’t need to analyse each company yourself. Instead, you use a tool that screens and ranks companies based on two main factors:

  • Earnings yield which is calculated by dividing a company's EBIT (Earnings Before Interest and Taxes) by its enterprise value. This helps you understand how much earnings the company generates compared to its total valuation.

  • Return on capital which is worked out by dividing EBIT by the sum of net fixed assets and working capital. This tells you how efficiently a company uses its capital to produce earnings.

You invest in 20 to 30 of the highest-ranked companies. Buy 2 to 3 new positions each month. Keep each stock for a year. Sell the losers one week before the year ends. Sell the winners one week after the year ends. Then, repeat the process.

This routine helps you benefit from tax rules. Losses can reduce your taxable gains. Holding winners for over a year lets you pay lower long-term capital gains tax.

If you’ve been asking what is Magic Formula Investing, it’s a way to remove emotion from investing. You follow a schedule and stick with the numbers. Many investors use this method to aim for better-than-average outcomes without guessing or reacting to the market.

Requirements for Magic Formula Investing

To follow Magic Formula Investing, you’ll need to meet some basic conditions:

  • Only include companies with market caps over $50 million.

  • Exclude utility, financial, and non-U.S. companies.

  • Don’t include American Depository Receipts (ADRs).

  • Calculate earnings yield: EBIT ÷ Enterprise Value.

  • Calculate return on capital: EBIT ÷ (Net Fixed Assets + Working Capital).

  • Rank stocks by both metrics.

  • Pick the highest-ranking 20 to 30.

  • Buy a few each month across the year.

  • Rebalance every 12 months: sell losers just before, and winners just after the one-year mark.

  • Repeat this process yearly for at least 5–10 years.

Magic Formula Investing doesn’t ask you to forecast the market. You follow fixed steps. Some studies suggest it has shown strong back-tested results against indexes like the S&P 500. It also teaches you to be patient and consistent, which are key traits for long-term investors.

Pros & Cons of Magic Formula Investing

Magic Formula Investing has its strengths and drawbacks. Let’s break them down:

Pros

  • The rules are clear and simple. You don’t need expert knowledge or heavy analysis. This makes it easy for anyone to follow the process without getting overwhelmed or confused by complex investing methods.

  • It removes the need to make emotional choices. You follow numbers and logic instead of reacting to market swings. This can help you stay steady and avoid rash decisions that might hurt your long-term goals.

  • If applied over several years, it can help you build a more disciplined approach. You don’t chase trends or try to time the market. You just stick with the plan and let the system work.

Cons

  • The results may not always match past success. Market behaviour changes over time, so you might see weaker outcomes compared to earlier tests of the method.

  • Some say the formula is too basic. It leaves out factors like debt levels or dividends. Adding extra variables might improve accuracy, but it also makes the system more complex.

  • When many people use the same strategy, it can become less effective. More competition for the same stocks may affect prices and reduce the edge that the formula once offered.

While Magic Formula Investing is designed to guide you toward rational decisions, it's not foolproof. It simplifies investing but doesn’t guarantee success every year. Like any method, it has good and bad periods. Still, it can be useful if you prefer a structured and disciplined approach.

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