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Imagine a value investing strategy that claims to have returned investors a 30% Compound Annual Growth Rate (CAGR) over 26 years. If you had invested ₹1 lakh into this strategy, it says you would have turned into over ₹9 crore! Sounds incredible, right? That’s the Magic Formula investment technique. In this article, we will dive deep into this investment strategy, exploring its origin, the nine key rules it follows, backtesting data, and its relevance in both the U.S. and Indian markets.

The Origins of the Magic Formula

Joel Greenblatt, a renowned asset manager since the 1980s, wrote a book titled The Little Book That Beats the Market, where he presented the magic formula for value investing. Greenblatt is a professional investment manager with an impressive $6.3 billion in Assets Under Management (AUM). His magic formula is said to be a simplified version of the value investing strategies used by legends like Warren Buffett and Charlie Munger.

In his book, Greenblatt outlines how investors can generate market-beating returns by following a set of simple rules. His confidence in the strategy led to a follow-up book, The Little Book That Still Beats the Market, further emphasising its relevance. The formula has been consistently applied for over two decades and claims to outperform traditional market benchmarks.

What is the Magic Formula?

The magic formula is a stock-picking strategy based on two financial metrics: earnings yield and return on capital (ROC). The strategy focuses on buying good companies at bargain prices, similar to Warren Buffett’s approach, but Greenblatt simplifies the process into an easy-to-follow method.

The key idea behind the formula is to select companies with a high earnings yield (indicating that the company is undervalued) and a high return on capital (showing that the company is efficiently using its capital to generate profits). These two metrics help identify companies that have strong earning potential and are available at a relatively cheap price.

Why Use the Magic Formula?

Greenblatt wanted to simplify stock picking to make it understandable even to a teenager. The book is written in simple language and provides a clear framework to follow, making value investing more accessible to beginners. As Greenblatt famously said, “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

In short, the magic formula provides a structured way to invest in the stock market, ensuring that investors are not making random picks but are following a tested and data-driven strategy.

The Nine Rules of the Magic Formula

Now that we have a basic understanding of the magic formula, let’s break down the nine rules that form the foundation of this strategy:

1. Market Cap Greater Than $50 Million

The formula requires that you only assess companies with a market cap greater than $50 million. In the Indian context, this translates to about ₹400 crore. However, we’ll focus on companies with a market cap of over ₹1,000 crore to account for inflation and currency depreciation.

2. Exclude Utility and Financial Stocks

Greenblatt’s strategy excludes utility and financial companies. Although he doesn’t provide a specific reason, it is likely because these industries tend to carry high debt levels, which may misrepresent/skew the financial metrics the formula relies on.

3. Avoid International Companies

The formula excludes international companies. Since there are very few foreign companies listed in our country, this rule is easily applicable in the Indian market.

4. Calculate Earnings Yield

Earnings yield can be calculated as earnings per share divided by the current share price, or using the formula EBITDA divided by enterprise value. The goal is to understand the company’s earnings capacity, essentially evaluating how well it is managing its profits relative to its price.

5. Calculate Return on Capital (ROC)

Return on capital measures the company’s profitability relative to the capital invested in the business. This metric reveals how efficiently the company is using its resources. Think of Coca-Cola, which can generate high profits with relatively low capital due to the brand’s long-standing moat. This rule is designed to simplify Buffett’s approach to analysing a company’s earnings potential.

6. Rank Companies Based on Earnings Yield and ROC

Once you’ve calculated the earnings yield and return on capital for each company, rank them accordingly. Companies with the highest combined earnings yield and ROC should be prioritised.

7. Invest in Top 20-30 Companies

After ranking the companies, invest in the top 20-30 based on their earnings yield and ROC. In the second edition of the book, Greenblatt introduced a small tweak: invest only in companies with a price-to-earnings (P/E) ratio greater than five. This helps to avoid low-quality or overly volatile stocks.

8. Rebalance Your Portfolio Annually

Greenblatt suggests rebalancing your portfolio once a year. He also introduces a useful tax-saving tip: sell loss-making stocks in the 51st week to account for short-term capital losses, which can be offset against other gains. Hold profitable investments for over 52 weeks to benefit from lower long-term capital gains taxes.

9. Stick to the Strategy for 5-10 Years

Finally, the magic formula requires patience. You need to stick to this strategy for at least five to ten years to see the compounding effect and generate significant returns. Short-term fluctuations in the market can cause temporary losses, but the long-term benefits are where the real value lies.

Backtesting the Magic Formula

Backtesting of the magic formula has shown positive results in different markets. Studies have consistently proven that the strategy outperforms the market over time, especially in non-bearish market conditions. Greenblatt’s own backtest of the U.S. market suggests that the formula has outperformed benchmarks like the S&P500 by a significant margin.

A study conducted in India in 2022 by professors from the University of Delhi revealed that the magic formula worked well in the Indian market. Over a period from July 2012 to 2020, the BSE Sensex gave returns of around 99.8%, while Greenblatt’s magic formula returned more than 1% CAGR during the same period.

This shows that the magic formula is not only relevant in the U.S. market but can also be applied successfully in India. With backtested data supporting its credibility, the magic formula stands as a proven, easy-to-implement value investing strategy.

How to Use the Magic Formula Screener in India?

To implement magic formula investing effectively, you can use online tools such as screener.in. This stock screener platform allows you to filter companies based on specific criteria aligned with the Magic Formula’s rules. Here’s how you can set up the screener:

1. Set a market capitalisation filter of greater than ₹1,000 crore.
2. Set a return on invested capital (ROIC) filter of greater than 25%.

After applying these filters, you’ll generate a list of potential quality companies to evaluate. The next step involves exporting this data into an Excel sheet for further analysis.

Once you have your list of companies, the next step is ranking them based on their ROIC and earnings yield. Use Excel’s rank function to assign ranks to each metric. After ranking, add up the ranks to derive a combined score that reflects both the earnings yield and ROIC. The companies with the lowest total rank are your best candidates for investment.

With your ranked list in hand, it’s essential to conduct a thorough analysis of each company. Look for any “shady” companies that might not align with the quality standards outlined in the Magic Formula. For instance, while a company may appear at the top of the list, further investigation might reveal potential red flags.

As emphasised in the rules, it’s crucial to rebalance your portfolio annually. This involves selling off underperforming stocks and maintaining a long-term investing outlook. Adhering to magic formula investing over a 5 to 10-year horizon can help mitigate short-term volatility and potentially yield higher risk-adjusted returns.

Disadvantages of the Magic Formula

While the Magic Formula presents a structured approach to systematic value investing, it’s not without its drawbacks:

Return Expectations: The promised 30% CAGR may not be replicable in the current market environment, particularly in India.
Complexity of Smaller Companies: Some smaller market cap companies may have less transparent financials, making them harder to analyse.
Market Conditions: The formula tends to outperform during bullish markets but may lag in bearish conditions.

Conclusion

Joel Greenblatt’s magic formula is a time-tested value investing strategy that simplifies stock picking for long-term investors. By focusing on high earnings yield and return on capital, the formula helps investors find good companies at reasonable prices. The nine rules of the formula make it easy to implement, even for beginners, and the strategy has been backtested successfully in both the U.S. and Indian markets.

If you’re looking for a simple yet effective stock-picking method, the magic formula could be a great starting point for your investment journey!

Watch: How To Spot Hidden Stock Gems: Easy Value Investing Screener

Disclaimer: We are not SEBI-Registered Investment Advisors. The investment strategy mentioned in this article is purely for educational purposes. Please do your own research before investing!

Investing in the stock market can help you create wealth over the long term. However, it requires careful analysis and research to find good stocks. One must know how to effectively apply their knowledge of fundamental analysis to identify high-quality stocks. In this article, we present 5 best steps to find quality stocks to invest in for the long term.

Step 1: Identify a Stock

How do we choose high-quality stocks from the thousands of companies listed on the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE)? Here are five ways to identify stocks and find if they are the right ones for us to invest in for the long term:

1. Friends and Social Circles

Take notes from friends and family who invest/talk about stocks and do more research on them. You may also run into online posts or articles about good companies that you can add to your watchlist.

2. General Observation

If you notice a brand or product performing well and gaining popularity, you can verify if that company is listed on the stock exchange. If yes, you can add them to the list. Even when you go to a supermarket, you can see what products have high demand and customer base and note them down for further analysis.

3. Using Stock Screeners

You can also use stock screeners like screener.in and Tickertape, which have good preset screeners to filter or compare companies based on their fundamentals. Apart from the inbuilt filters, such as financial ratios and growth in net profits, you can also create custom filters.

4. New Sectoral Trends and Rule Changes

You can always check which industries benefit from regulatory changes and take note of the listed companies in those sectors. General observation often allows us to identify sectoral trends in many cases.

For example, the electric vehicle (EV) sector is trending because the future is moving towards green mobility. You can identify the companies directly or indirectly linked to the industry benefiting from this trend, such as battery manufacturers, electric vehicle (EV) companies, and other relevant firms.

5. Your Circle of Competence

A circle of competence is the subject area that matches a person’s skills or expertise. If you are working in the IT sector, you can analyse the business models of IT companies and identify the best ones in this sector. On the other hand, if you’re working in the medical field, you can identify good-performing pharmaceutical companies.

Utilizing all the methods above is unnecessary; their sole purpose is to help us identify companies for further study or in-depth analysis.

Step 2: Understand the Business

After identifying various companies or stocks, it’s essential to gain a comprehensive understanding of their businesses.

1. Read annual reports

Annual reports provide a comprehensive overview of a company’s financial performance, strategies, and objectives. They typically include financial statements, management discussions, and analysis. These reports are essential for investors, stakeholders, and analysts to assess the company’s profitability, growth potential, and overall financial health. They serve as a valuable source of information for decision-making and evaluating investment opportunities.

2. Gather data from media reports and interviews

Another method to understand the company’s business is by listening to its founders and management. Watch interviews with the management and founders in which they talk about their company and its business. Read news articles about them.

3. Learn everything you can about the company, business, and competitors

If the company you are analysing has a moat or a unique selling proposition (USP), it’s a bonus. [Moat refers to a business’s ability to maintain competitive advantages over its competitors to protect its long-term profits and market share.]

You can also refer to the questions given below to understand more about a business. After getting answers to these questions, you will have enough information about a company to understand its business.

If you don’t understand a company’s business even after all this, it’s better that you don’t invest in it.

Step 3: Ensure Quality

1. Read annual reports

Reading the annual report can give you an idea about a company’s quality.

2. Read financial statements

Financial reports like a profit & loss statement and balance sheet help analyse a company’s spending decisions and debt levels.

3. Study financial ratios

Ratio analysis unveils a company’s performance and growth trajectory over time. It would be beneficial to compare a company with others in the same industry or sector. Additionally, comparing a company’s ratios with industry standards provides a better understanding of its position and performance.

You can use the checklist below to analyze quantitative and qualitative factors. The table below is only for reference. You should also consider other checklist points for better analysis.

Thus, we should check both quantitative and qualitative factors while ensuring quality.

Step 4: Check Valuation

After completing the steps mentioned above and compiling a list of high-quality stocks, the next crucial step involves evaluating the value of the companies on that list. Valuation is a quantitative process of determining the fair value of an asset, investment, or firm. In this step, we compare the market value and intrinsic value of the company and determine if it is undervalued or overvalued. The market value of a company is what it is currently worth according to the market. It is calculated using the formula below:

The market value is the value the market (retail investors and institutions) gives a company. However, the company also has a true value, which is called its intrinsic value. If the market value of a company exceeds its intrinsic value, the stock is overpriced or overvalued. On the other, if the intrinsic value surpasses the market value, it is undervalued.

After finding the intrinsic value of a company, we have two methods of investing:

1. Growth Investing

Buy a stock if it has a high growth history/potential and fits all your checklists. In growth investing, we ignore the intrinsic value of a company. If a company has been continuously growing for the past few years and still has high growth potential, we can buy its stock despite its overvaluation. For example, Hindustan Unilever has always been overvalued in the past, but it kept on growing despite its overvaluation.

2. Value Investing

Buy a stock if its current market price is lower than its intrinsic value. We choose not to buy overvalued stocks. Veteran investor Warren Buffet and his mentor Sir Benjamin Graham are renowned value investors.

Both growth investing and value investing can yield good returns. Growth investing is comparatively easier than value investing. However, if done right, value investing can build you a fortune!

There are many methods to value a company and find its intrinsic value. You can use Dividend Discount Model (DDM), Present Value Methods, etc to value companies.

Step 5: Make a Decision

After completing all these steps, your next action will be to make an informed decision. First, we identified a few stocks, understood their business, ensured the quality, and valued the companies. The final step is to decide whether to add that stock to your portfolio. While building a portfolio, it should be well diversified. So, we should avoid adding multiple stocks from the same industry to our portfolio.

When to Invest?

The two ways in which people invest in stocks are:

1. Lump Sum Investment

When we invest a huge amount into stocks all at once, it is called a lump sum investment. People usually do this when they receive bonuses or a large sum. However, the drawback of this method is that we cannot maintain a better average price. If we make a lumpsum investment and the stock keeps on falling, we cannot take advantage of this price discount as all the money was invested in a single go.

2. Systematic Investment Plan (SIP)

SIP is a method of investing a fixed sum regularly into a portfolio. Most salaried people have a regular income every month. Out of this, they invest a certain percentage as SIP. A better average price can be maintained in this method as the purchase price will be lower and higher sometimes.

In value investing, we only buy the stock when the intrinsic value is lower than its actual market value. Only a lump sum investment is possible here. On the other hand, with growth investing, we can invest in SIPs. One can perform technical analysis and buy the stock when its price dips or at regular intervals, such as monthly or weekly.

We should always invest in a portfolio of high-quality stocks while investing for the long term. If we invest in a single stock or sector/industry, there won’t be any diversification. When that particular industry starts performing poorly, our portfolio also dips substantially. Success in long-term investment is not finding or selecting that single multibagger stock. Rather, it is finding out and investing in a well-diversified portfolio.

Disclaimer: The information or any examples mentioned in this article are purely for educational purposes. Please do your own research before investing in stocks for the long term.