Magic Formula Investing: Why Does it Work?

A Magic Formula Investing post has become an annual ritual on Sentiments & Bubbles. Using the Magic Formula as an investing strategy was popularised by Joel Greenblatt in The Little Book that ‘Still’ Beats the Market

Magic Formula Investing is a strategy whereby we end up buying shares in companies that have both, a high earnings yield and a high return on capital. In other words, we buy shares in good businesses (ones with high returns on capital) but only when they were available at bargain prices (priced to give us a high earnings yield). How does the Magic Formula achieve this objective? I have published a post on Magic Formula investing in the past. You can click The Magic Formula for Stock Selection to read the earlier post. In this post, I have tried to find out why Magic Formula Investing works.

Why does the Magic Formula Work?

In any strategy, the longer you use it, the better are the chances of success. Reason being, in the short-term Mr Market, is a depressive maniac. In the long-term, however, Mr Market tends to get it right and is pretty rational. In my opinion, a Magic Formula strategy when applied over the long run tends to work pretty well. The reasons are:

• The Magic Formula teaches an investor how to pick companies (businesses) that are trading at a discount to their intrinsic value. In this way, there is an inbuilt margin of safety. At the same time, by investing in thirty stocks, it ensures that the portfolio is a diversified one and the investing risk is mitigated.
• Warren Buffett has famously said: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. I think that the Magic Formula is a good filter that can be used to find such companies (businesses).
• From the universe of stocks that are listed on the National Stock Exchange of India (NSE), the Magic Formula acts as a filter, sorting stocks based on their fundamental attributes. The Magic Formula does not pinpoint or provide us with a list of stocks that will outperform. It just gives us a list of ‘probable stock ideas’.
• Investing is a game of probabilities, not possibilities. When we invest, what we are trying to figure out is which stocks are currently trading at prices that are mispriced relative to expectations. In other words, our goal is not to determine which stocks will outperform, but to arrive at a list of stocks wherein the odds are mispriced. Effectively the ‘probable stock ideas’ generated with the help of the Magic Formula are those wherein the odds are mispriced. For all such shares, the probability of outperformance is higher. In probabilistic terms, the Magic Formula improves our chances of generating Alpha. That is why it works.
• The Magic Formula helps us find above-average companies at below-average prices. The assumption inherent in the method is that the company continues to reinvest its profits in its existing business at the historical rate. In other words, we assume that the past (financial) performance will continue in the future as well. In principle, I agree with the argument that this is a risky assumption to make. However, I feel that those who subscribe to this argument have either not understood the philosophy or are using it incorrectly. As I have highlighted above, the Magic Formula is only increasing the probability of outperformance, nothing else.
• Magic Formula Investing is a ‘rules-based strategy’. Rules-based investing isn’t a silver bullet. At the same time, any rules-based approach ensures that we have a reason, laid out in advance, for the decisions that we tend to make as part of the investing process. Do rules based investing strategies (like the Magic Formula) give us a behavioural edge? I think they do.

Magic Stocks of 2017

Those of you who do wish to use the Magic Formula as an investing strategy, my suggestion is read the Book first. The reason is that there are many caveats on how the formula should or should not be used.

I ran the numbers using the Magic Formula. I have used Nifty 500 Index as the basis (instead of the smaller broad-market indices like Mid-Cap, Small-Cap, etc.). The Nifty 500 index covers roughly 94 percent of the free float market capitalisation of the Indian Stock Market. As a result, the selection criteria is expanded to practically the entire universe of listed stocks. In most cases, published accounts for the year ended 31 March 2016 are considered in the calculation. The list of stocks can be downloaded by clicking Magic Stocks of 2017. Investors need to remember the following:

• The Magic Formula only works in the long-term. In the current scenario, time spans longer than twelve months are considered eternal. At the same time, most investors are reluctant to stick to a strategy that hasn’t been working in the recent past. The temptation to switch to what has been working is almost irresistible. Hence, it is tough to stick to a strategy over the long-term. Simply stated, for those of you whose investment time horizon is less than three years, Magic Stocks as a strategy would be practically useless.
• Investors must treat the list of Magic Stocks as a starting point for further research. For those of you who are too busy or otherwise unable to crunch the numbers, I suggest consulting an investment advisor.
• While using the methodology, the formula’s used for calculating the Return on Equity and the Earnings Yield, are critical. Without getting into the weeds, let me state that in the case of the Earnings Yield, there are many ways to calculate the ratio. I have simply used the inverse of the Price to Earnings Ratio. The book mentions a variant of the accepted method.
• There is no nirvana in investing; there never was nor will there ever be. Investing strategies keep going in and out of fashion. In such a scenario, the Magic Formula has proved to be a timeless strategy.