The Magic Formula: A look at how to simplify ‘cheap,’ ‘good’

The Magic Formula is an abstract thought experiment, the parameters of “cheap” and “good” are both simplified. “Cheap” is taken to mean that a company, compared to other companies, trades at a price that is cheap compared to its earnings. But instead of using the simple price-to-earnings ratio, Joel Greenblatt’s Magic Formula uses the adjusted metric of EBIT/enterprise value.

“Good” is taken to mean that a company, compared to other companies, can reinvest its money at higher rates of return. The adjusted metric that the Magic Formula uses to calculate this is EBIT/(Net Working Capital + Net Fixed Assets).

What it’s all about

The Magic Formula ranks the stocks in the market by how cheap they are and how good they are and then combines these rankings to get an ordering of how cheap and good each stock is.

In “The Little Book That Still Beats the Market,” Greenblatt reported that the Magic Formula applied to stocks more than $50 million from 1988 to 2009 returned a total of 23.8 percent annualized. By comparison, the Standard & Poor’s 500 index returned a total of 9.5 percent annualized over that same period.

What tends to happen is this. The Magic Formula will give you a list of stocks to choose from. Most people will exercise their judgment and pick from the lists the stocks that look the safest or the most promising. They’ll purposely avoid the ugliest looking companies that they just know will lose money.

And what will happen is that the stocks that tended to look the best will actually perform the worst, and the stocks that looked the worst will perform the best.

Implementation

A few tips for implementing the Magic Formula without style drift due to behavioral error:

  1. Decide on a fixed asset allocation to the Magic Formula, and then stick with it by putting the same dollar amount into the Magic Formula every month.
  2. Don’t time the market. Concretely, this means making your contributions regularly rather than according to your whim or any other market-timing factors.
  3. Pick stocks randomly from the Magic Formula list and resist the urge to “just this once” selectively buy or not buy a stock, no matter how great your knowledge on that specific company.

The last point is the most important, and the hardest to stick with. You will end up buying a lot of stocks that look like value traps, and a lot of those stocks will in fact be value traps. The easiest way to fail, and ironically what happens to almost everyone who tries the Magic Formula, is that they just cannot stick with it in a systematic way. You will end up beating the market over the long run. That’s what will happen if you buy stocks that are both cheaper than the market and better than the market.

 

Umberto Fedeli is president and CEO of The Fedeli Group. He is an investor in numerous ventures. He is on the boards of directors of the Cleveland Clinic Foundation, John Carroll University, the Cleveland Chapter of the Young Presidents’ Organization and The 50 Club.