Does the Magic Formula Really Work?

Written by

Jae Jun

follow me on



What You Will Learn

  • Understanding what the Magic Formula is and how to use it
  • Performance of the Magic Formula and whether it is achievable
  • Whether the Magic Formula is worth using going forward


That’s what you need to beat the market and that’s what the Magic Formula is supposed to do.

As a result of brilliant marketing, promotion and becoming a New York Times bestseller in 2005, Joel Greenblatt has turned the Magic Formula into a key strategy for many in the value investing and mechanical investing community.

Buy at least 20 stocks from the Magic Formula screening tooland then rebalance at the end of the year. Do this and you will beat the market, the book says.

The Little Book that Beats the Market

little book that beats the marketGreenblatt wrote The Little Book that Beats the Market for his children who were aged between 6-15 at the time.

It’s written in plain English and 6th grade math to make it easy to follow along. This is the strong point of the Magic Formula theme.

Everything is very easy to understand. The concept is simple, the explanation is simple, but most important of all, the execution for investors is simple enough to do on their own.

In it’s most naked form, the Magic Formula is described by Greenblatt as

a long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices.

The Ingredients to the Magic Formula

Here is the formula courtesy of wikipedia. From beginning to end, it consists of 9 steps.

1. Establish a minimum market capitalization (usually greater than $50 million).
2. Exclude utility and financial stocks
3. Exclude foreign companies (American Depositary Receipts)
4. Determine company’s earnings yield = EBIT / enterprise value.
5. Determine company’s return on capital = ebit / (net fixed assets + working capital)
6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
7. Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
9. Continue over a long-term (3–5+ year) period.

Pay close attention to step 4 and 5 because they are the key driving formulas for it all to work.

  • Earnings Yield = EBIT / Enterprise Value
  • Return on Capital = EBIT / (Net Fixed Assets + Working Capital)
Get Access to More Content
Get instant access to value investing spreadsheets, how to's and stock ideas.

Earnings Yield is used because it targets companies with below-average prices. The idea behind of Return on Capital is to select good companies that are outperforming. This fits in line with what Greenblatt said

a long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices.

The Magical Performance

So how magic is this Magic Formula in terms of performance? This table of values is from the revised 2010 version of the book.

and a better representation.

Starting with $10,000 the Magic Formula would have made you a millionaire by 2009.

The Magic Formula is famous for returning a 30% CAGR. From 1988 to 2004, it did achieve a 30.8% return, but the CAGR has declined significantly. No strategy can sustain a CAGR of 30%. Although the backtest in the book only provides data up to 2009, I wouldn’t count on 2010-2012 results showing vast out-performance.

The Magic Formula is a Fraud?

By popular demand, the Magic Formula will soon be added to the list of value stock screens, but the one thing that has held it back is the reliability of the backtest performed by Greenblatt.

I just don’t believe the results are as good as it seems.

What’s more, other blogs have tried to simulate the Magic Formula performance from the book, but none of them  have come close.

Backtesting the Magic Formula

Although the Magic Formula screen I’m using has the same fundamental formula and tries to follow the Little Book, it ends up being slightly different to Greenblatt’s version.

Here is how the screen is constructed.

  • No OTC stocks
  • No ADR’s
  • No financial companies
  • No utilities
  • No real estate companies
  • Market cap greater than $50m
  • 5 year average of ROI ranks in the top 35%
  • Slippage of 2%
  • Carry cost of 1%
  • 100% long
  • Stocks selected based on ranking of Earnings Yield = EBIT / Enterprise Value and  Return on Capital = EBIT / (Net Fixed Assets + Working Capital)

To try and compare apples to apples, data from 1999 to 2009 is used as the data only goes back as far as 1999, and 2009 is the latest year provided in Greenblatt’s Book.

(click to enlarge)

magic formula backtest

magic formula stats

Although the backtest version kills the market over the same period, it doesn’t match or beat the Greenblatt version.

However, if I adjust the slippage to 0%, it comes awfully close. CAGR over the same period then becomes 17.33%, which is oh so close to the original 18.57%.

But I’m willing to bet that the original formula does not include factors such as fees and slippage in the results. If it did, it would fall to a level similar to my backtested results.

Either way, there goes my earlier comment about not believing in the results.

Sure it’s not the 30%+ CAGR that Greenblatt wrote about in the book, but there is magic in the air.

Download My Stock Analysis Scorecard
Get my customizable scorecard to see if your stocks pass the numbers test

Additional Links

  • Carl

    One thing I don’t like magic formula is that the portfolio needs to be rebalanced every year, which increases the costs and eats up the return.

  • Pingback: Monday links: the profit bubble | Abnormal Returns()

  • varadha

    Jae, can you explain how you adjust for slippage – viz., how do you really manage it technically ?

  • seanickson

    The magic formula fund (fnsax) also appears to have done well against the market since inception(11/10)

  • SS

    S&P 500 is not the best-fit benchmark here I am willing to bet.

  • Old School Value

    true. That’s what a low cost brokerage should be used. Still it’s only 20 transactions a year. Using something like optionshouse where its $4 a trade. That’s $80 for a year of trading.

    Far less than what majority pay.

  • Old School Value

    what do you mean by manage it technically?

  • Old School Value

    had no idea that this was officially launched as a mutual fund. Awesome. Makes it even easier.

  • Chuck

    The method in the hands of Greenblatt’s Formula Investing Funds has had mixed results.
    His US funds (fvvax, fnsax) have both beaten the S&P 500 6 mo’s and 1 year ending May 20 but the rolling 2 year is only matching the S&P 500. If you had bought either fund on the day it opened, though (a month just outside the 2 year chart) you would have beat the S&P by 5 points cumulatively. His International funds have not done so well.

  • Old School Value

    I saw that myself. But 2 years is a little early to judge though. At least 3 years is required.

  • Old School Value

    depends on what market cap the stocks in the screen show up. Following the book’s benchmark to keep things simple. I dont have data for the other markets at this time I’m afraid.

  • Pingback: Magic Formula Stocks Year To Date And The Top 5 « Market Blok()

  • piyush

    How do you determine the top stocks using two ranking criteria? I mean both would have different lists. So how does one determine the top 20 or 30 from that.

  • Old School Value

    rank was determined by portfolio123 which I used to get the list of stocks.

  • value81

    It would be at least 40 transactions per year: 20 buys and 20 sells.

  • Aditya

    Why not tell us how magic formula performed over 2010, 2011 and 2012? I’m curious to know how magic formula has done in that period, because I’d wager it’s only getting more popular.

  • Pingback: Top clicks this week on Abnormal Returns | Abnormal Returns()

  • ValueFactors

    I would be i very intetrested in seeing the performance of SP500 after utilities and financials have been taken out. Surely that would be a more relevant benchmark for comparison?

  • Old School Value

    40 trades only in the first year. After that you sell in Dec and buy in Jan the next year. So only 20 per year.

  • Old School Value
  • Old School Value

    and here’s the image with stats from 2010-2013 ytd.
    If I change the settings with no cost or fees, it’s matching the market.

  • Pingback: Week in Review 21 – Forex - Auroraspeedster()

  • Pingback: PDL BioPharma Inc. (PDLI), Bridgepoint Education Inc (BPI): Magic Formula Stocks YTD and the Top 5 - Insider Monkey()

  • paudhe

    so in year 1 you buy in jan and sell in Dec. in year 2, you buy in jan. Dont you also sell in Dec in year 2 to buy in Jan in year 3 again? Why isnt it 40 trades a year? Cant seem to understand why you say it is only 20 trades from year 2 onwards.

  • Old School Value

    You’re right. Not sure what I was thinking.

  • Aditya

    So sorry, I forgot to check your blog for a reply. Thanks so much Jae.

  • Pingback: Some Thoughts on Joel Greenblatt's Magic Formula and its YTD Results | Base Hit Investing()

  • Pingback: Stock Screens - Joel Greenblatt's Magic Formula - 7 Circles()