# Does the Magic Formula Really Work?

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Written by

Jae Jun

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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

Magic.

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 tool and 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

Greenblatt 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)

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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 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)

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.

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### 41 responses to “Does the Magic Formula Really Work?”

1. Carl says:

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.

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

3. seanickson says:

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

4. SS says:

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

5. 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.

6. what do you mean by manage it technically?

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

8. Chuck says:

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.

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

10. 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.

11. piyush says:

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.

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

13. value81 says:

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

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.

15. ValueFactors says:

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?

16. 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.

17. 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.

18. paudhe says:

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.

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

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

21. Shtelman says:

I don’t get the re-balancing part. Magic Formula states that you sell both losers and winners. The only difference is WHEN you sell it. One week before or one week after the year mark. I believe that is due to the taxation benefits. In my country taxation is bit different. We pay 13% on capital gain and 9% on dividends in the given calendar year.
BUT
Why selling all stocks after a year? Why not holding good stocks?
MF also suggests thst you build your portfolio by adding 2-3 stocks a month. Suppose i start on January. By december I have around 30 stocks. Now it’s time for re-balancing. How do I pick winners and losers? I have 2-3 stocks that I purchased on January, 2-3 bought in Feb, etc. So how do I rebalance? Or should I rebalance on Dec next year after holding the whole portfolio for a year?

Thank you!!

22. Other than taxes, you sell stocks because the same stocks may not fall into the screen now. After 1 year, the quality could have gone down or up. You need a new set of stocks that fit the criteria.

I don’t recall Greenblatt saying you should buy 2-3 a month. If there are 20 that show on the screen, then buy it and forget about it.

23. Shtelman says:

Here is his pont on building the Portfolio:

7. Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period

I still don’t understand why sell both loosers and winners ..?
8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.

Does that mean that when rebalancing I keep only those stocks that appear in the screener. If none of the stocks from the portfolio show up in the screener, than I sell them all? And keep those that remain in the screener?
So how he defines winners then? Those stocks that have positive capital gain after holding them for a year but disappearing from the screener should be considered as winners and must be sold?

I just don’t get the details, sorry.

24. nemo says:

I saw a presentation given by Greenblatt on the magic formula which explained how he constructed the portfolios for his backtesting. Greenblatt mentioned something which I didn’t pick up from reading his book, that is, that the backtesting involved the selection of 12 portfolios per year.
Basically, Greenblatt ran the “magic formula” to select the 30 highest ranked companies for say January of 1990 – that portfolio would be held for around one year (as you noted in your post). However, Greenblatt then repeated the exercise for February 1990, March 1990 as so forth. So each of the annual return figures shown in Greenblatt’s book represents some kind of average for twelve simulated porfolios for the relevant year.
Further, I believe that Greenblatt was aware of the criticisms made by Turnkey (and others), but Greenblatt chose to repeat the figures in the updated version of his book. To me, that suggests that Greenblatt was comfortable with the work he did, notwithstanding the criticisms or that the differences could be explained. For instance, I understand that the Turnkey work was based on portfolios selected from a universe of the 1,000 largest stocks by capitalisation; whereas Greenblatt’s backtesting involved a bigger universe.

25. Sam Chisholm says:

I am also unsure how you would average in… If you only buy or sell once a year what do you do with all the funds you would accumulate to invest during the year? Are those supposed to sit in cash until you buy? Shouldn’t that return(or lack of) count towards overall performance?

26. this is assuming that you don’t contribute. If you add extra funds, IRR is calculated based on different cash inflow outflow. So it’s unfair to adjust for cash coming in during the year.

27. Gregory Joziak says:

you sell individual purchases after 12months. that means you sell and buy new stocks after 12 months every month…. ec if u bought P&G, Apple and McDonalds in Jan 2014, in Jan 15 u’ll sell only these 3 companies and buy 3 new to fill ur portfolio

28. Ahmed almarri says:

Hi jae,

Just started exploring the world of investing, and while I know I’m on the right track in terms of learning considering I follow your blog and some others. I find it overwhelming to see so many different criterias and screening styles and valuation equations available that seem to be doing a good job. I know I’m probably asking this question because I have missed some basic principles. Appreciate if you can help me out and direct me to how I would decide on which screens to pick and when. If there are books you may recommend that would help in the topic

Thanks

29. dont bother with screens and stuff like that right now.

Here’s a list of my book recs. Go through it and you’ll be an awesome investor in no time.

Keep being awesome.
http://try.oldschoolvalue.com/best-investment-books/

30. Ahmed almarri says:

Thanks, came across the link after I posted. I’ll start there and see where I go. Really glad I came across your blog and a few others. I find your blog extremely easy to read.

Hope I can learn enough before the bull market ends!

31. MFQuestion says:

Just an into this article, thanks for writing it. I was using the magic formula pre-2009 and would make enough on a few thousand dollars to pay my trading account:) I knew it would take time and more money. But my question is..I quit because the tax laws we about to change on capital gains. and you would be taxed more selling before or after a year. Those laws changed right? I didn’t think you would make any money with the higher tax rate. I thought that was the whole point. thoughts on the MFbefore and after tax law changes? thank you.

32. The think with taxes is that it’s different for other people. If you can offset it somehow, that works out.
If you do it via a non taxable account, you can continue growing it.