Understanding the Magic Formula Investing Approach
I picked up Joel Greenblatt's book back when I was still early in my investing career, scrolling through some of the more popular small-cap value strategies people kept mentioning. The core idea is straightforward enough that you could explain it in a paragraph: buy companies that are both good and cheap. Good means high returns on capital. Cheap means low earnings yields. The book frames this as a simple scoring system that anyone can apply without needing a finance degree.
The method itself is what most people remember. You screen for companies with high earnings before interest and taxes relative to their enterprise value, then rank them by return on invested capital. Combine those two metrics into a single score, buy the top twenty or thirty companies, hold them for a year, and repeat. The theory says this tilts you toward profitable businesses trading below their intrinsic value, which should outperform over time. Greenblatt demonstrated this with a backtest that ran from 1988 to 2003 and showed double-digit annual returns above the market average.
The Little Book That Makes You Rich A Proven Market Beating Formula For Growth Investing Little Bo
The title has drifted through various editions and printings, so you will see slightly different wording depending on where you look. The first edition carried a more direct subtitle about beating the market with a simple strategy. Later printings softened the language. The actual formula inside has not changed much.
I learned the hard way that this does not work the way the backtest suggests. My first run-through with the Magic Formula screened a universe of stocks using Yahoo Finance data. I ranked them correctly, bought the top twenty, and held them for twelve months. The results underperformed the S&P by nearly eight percent that year. The problem was not the formula. It was the execution. I had missed the rebalancing cost, the tax drag from short-term capital gains, and the fact that the universe I used included penny stocks and distressed companies that the original study excluded. The backtest used a filtered universe of liquid, profitable companies. My screen pulled in garbage.
There are several things the book does not emphasize enough. First, the strategy requires discipline. When the market rotates away from value into growth, the formula will lag for years. I watched it underperform for three consecutive years during the 2017 bull run. That is when most people abandon it. The backtest covers a period that includes both value and growth outperformance cycles. You need to stick with it through the dry spells.
Second, the formula assumes you can actually buy the top-ranked stocks at the right price. In practice, institutional investors have access to better data and faster execution. By the time you screen, rank, and place orders, the prices have moved. I found this out when trying to buy a small-cap stock that ranked number one. The price jumped six percent after the weekend while I was debating whether to buy half a position or skip it entirely. The strategy works best when you can buy at closing prices without slippage.
The main downsides are real. The strategy concentrates heavily in small-cap and mid-cap stocks. These are less liquid, more volatile, and harder to exit quickly. If you need to raise cash during a market panic, you may not be able to sell without taking a steep hit. The backtest assumes you hold through drawdowns. Your actual experience may differ if you have a life event that forces you to sell.
I also found that the formula performs differently across international markets. The data is thinner outside the United States. Screening foreign stocks requires currency hedging, tax considerations, and access to reliable financial statements. The Magic Formula was designed for U.S. equities using GAAP financials. Trying to apply it to emerging markets introduces variables that the original study did not account for.
A practical alternative is to use a low-cost index fund that tilts toward value and quality factors. The research shows that combining value and profitability factors produces similar long-term results with far less implementation friction. You avoid the turnover costs, the tax inefficiency, and the execution risk. The returns may trail the Magic Formula by a couple percentage points annually, but the risk-adjusted results are often better.
If you want to try the actual formula, start with a screened universe of large-cap and mid-cap stocks with positive earnings. Exclude financials, utilities, and companies with negative equity. Use trailing twelve-month earnings and enterprise value calculated as market cap plus debt minus cash. Rank by earnings yield first, then by return on invested capital. Buy equal weights across the top twenty, hold for a year, rebalance in January. The tax implications matter more than most people expect. Holding periods under one year trigger short-term capital gains rates in most jurisdictions.
The strategy has never claimed to be easy. Greenblatt himself noted that the returns come from being willing to buy unloved companies and wait. That is psychologically difficult. Most investors want to own things that are popular and trending. The formula requires the opposite. You buy boring, unglamorous businesses that the market has temporarily ignored. The returns accumulate slowly over decades, not quickly over months.
I still use a simplified version of the screening process today. I do not follow the full Magic Formula religiously. The core insight about buying good companies at cheap prices remains useful. The exact scoring system needs adjustment for modern markets with different trading mechanics and more efficient pricing. The principle, though, has not changed much since the first edition came out.
