In a field where complexity often reigns supreme, Joel Greenblatt’s “Magic Formula” stands out for its remarkable simplicity. Using just two variables to select stocks, this approach has produced impressive returns while challenging conventional wisdom about what it takes to beat the market.
The Formula Unveiled
At its core, Greenblatt’s Magic Formula combines just two fundamental factors:
- Return on Capital (ROC): A measure of how efficiently a company uses its assets to generate earnings
- Earnings Yield: A gauge of how much a company earns relative to its enterprise value
The strategy ranks stocks on these two metrics and combines the rankings to find companies that are both highly profitable and reasonably priced. Think of it as “buying good companies at bargain prices,” as Greenblatt himself describes it.
The Track Record
The results speak for themselves. In Greenblatt’s back-testing from 1988 through 2004, the Magic Formula generated average annual returns of 30.8% compared to the S&P 500’s 12.4%.
Why It Works: The Counter-Intuitive Truth
Perhaps the most fascinating aspect of the Magic Formula is why it continues to work even after being widely published. According to Greenblatt, the strategy’s effectiveness stems from an unlikely source – its periodic underperformance. The formula typically underperforms the market in five out of every twelve months and can lag for extended periods.
This inconsistency actually helps preserve the strategy’s edge. Most investors lack the patience to stick with an approach that doesn’t work all the time, creating a persistent opportunity for those who can maintain discipline through the down periods.
Implementation Guidelines
To implement the strategy, Greenblatt recommends:
- Focus on the largest 3,500 U.S. stocks
- Exclude utilities, financials, and foreign companies
- Build a portfolio of 20-30 stocks gradually over time
- Hold positions for one year (with some tax-optimization adjustments)
- Commit to the strategy for at least 3-5 years
The Human Factor
While the formula itself is simple, following it isn’t always easy. The strategy requires overcoming significant psychological barriers – particularly during periods of underperformance. As Greenblatt notes, “The hard part is continuing to believe that the magic formula still makes sense even when friends, experts, the news media, and [the market] indicate otherwise.”
Conclusion
Greenblatt’s Magic Formula offers a compelling reminder that successful investing doesn’t necessarily require complex algorithms or countless variables. Sometimes, the most sophisticated approach is also the simplest. The real challenge lies not in understanding the strategy, but in maintaining the discipline to follow it through both good times and bad.
For investors willing to embrace its simplicity and stay the course through periodic underperformance, the Magic Formula continues to offer a promising path to market-beating returns. As Leonardo da Vinci once said – and as Greenblatt’s strategy exemplifies – “Simplicity is the ultimate sophistication.”
Further Research
