Understanding Magic Formula Investing

Magic Formula investing is a technique that is commonly used by traders who want to select winning stocks. Joel Greenblatt, a hedge fund manager, developed the strategy in order to simplify the process of picking stocks for individuals. The basic idea behind this strategy is that you look for companies that are undervalued in the marketplace. Here are the basics of the Magic Formula investing strategy.

Buying Stock

With this particular method, individuals do not necessarily focus on a particular sector or industry in the market. Instead, they are simply focused on finding companies that fit the criteria of the Magic Formula. This gives traders plenty of opportunities to find and buy undervalued companies. They do not have to focus in on a select group of stocks.

Return on Invested Capital

At the heart of the Magic Formula is a valuation multiple called "return on invested capital" (ROIC). The ROIC is a metr ic used to look at how much money a company can make on each dollar that it invests. When a company is very efficient at doing this, it is most likely going to succeed. For each dollar that investors put into the company, they can make a certain amount of money.

Earnings Yield

In addition to looking at the return on invested capital, you have to look at the earnings yield of a company. Many companies could potentially be efficient at making profit on the money that is invested in them, but if the stock price of those companies is not low, you are not interested in them when following the Magic Formula. You have to be able to find companies that are undervalued and are performing well. In order to determine if the stock prices are undervalued, you will use a valuation multiple called earnings yield. To do this, you will simply take the inverse of the price earnings ratio. This means that you will take 1 divided by the price earnings ratio of the stock. If you find an earnings yield that is high relative to other investment opportunities like bonds, then you have a company that is undervalued in the marketplace.

Stock Qualifications

The stocks that are chosen also have to fit certain criteria to be considered. In order to make the strategy work for you, you also have to choose a market capitalization to work with. For example, the originator of this formula used a minimum market capitalization of $50 million. This means that if any companies were below that market capitalization, they would be eliminated from consideration.

You also have to eliminate any utility or financial stocks. In addition to this, you will eliminate any foreign stocks or American depository receipts from consideration.

Long-Term Strategy

When employing the Magic Formula investment strategy, you should plan on using it for a longer period. This is not something that you can do over the course of one or two years. You should plan on utilizing the strategy for at least three to five years in order to be successful. 

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