In "The Little Book that Beats the Market" (No. 5), Joel Greenblatt offers up a "magic formula" that doesn't require weekly homework and would have beaten the market over the past 17 years (if you didn't bail in the down years): Rank big stocks by highest earnings yield and return on capital, then buy the 30 with the best combined score, and replace them each year.
To make this easier, Mr. Greenblatt has put up MagicFormulainvesting.com, which spits out the stocks for free. He didn't return calls seeking comment on his future plans, but a mutual fund based on his formula would be even closer to idiot-proof.
What is the purpose of the magicformulainvesting.com website?
A: The website was conceived after Joel finished writing the book. After searching through the free and low cost stock screening services available, it became clear that the steps necessary to closely emulate the magic formula study on these other sites might discourage many average investors. Since the book was written with the average individual investor in mind, the magic formula site was created to make the process easy and accessible to as many investors as possible.
Q: Since this is a long term strategy, will the site remain free? Will there be other alternatives if the site is discontinued?
A: The site is expensive to maintain. It was established only after the book was written to help out the small investor. There are no current plans to charge for the use of the site. However, if at some point in the future this becomes necessary, we plan to make sure that current users will continue to have access at nominal cost so that even small investors can continue to follow the magic formula strategy. There are also no plans to discontinue the site. However, if this were to happen for any reason, we would try to evaluate alternatives for investors and give instructions to users so that they could continue the magic formula investing process using other free and low-cost sites.
Q: How do you choose among the top-ranked companies?
A: Statistically, it does not matter much which top-ranked companies you choose. You are already choosing among the top few percentiles of top-ranked magic formula stocks. On average, a portfolio of 20 to 30 stocks chosen from these screens should do quite well. In other words, there is no real benefit to doing further ranking of the top 25 companies - all of these companies are "top-ranked" according to the magic formula.
Q: Do I have to follow the instructions you provided to create a magic formula portfolio exactly? Can I buy 30 stocks at once? Do I have to hold stocks for only one year?
A: The instructions were written to help individuals emulate the returns from the magic formula study that appeared in the book as closely as possible. While other strategies may work quite well, these have not been specifically tested by us. Therefore, we feel comfortable recommending the method that we tested in the study.
Q: Why do you suggest owning each stock for only one year - I thought this was a long term strategy?
A: We chose a one year period so that we would not be suggesting a short term "trading" strategy and because it helps us to maximize our tax strategy. Since the magic formula uses last year’s earnings, after one year we like to use fresh data for our calculations. The magic formula "strategy", however, only works over the long term (i.e. 3-5yrs).
Q: I don’t fully understand the complicated formulas used in the magic formula study, on the magicformulainvesting.com website and in the appendix section of the book. Do I have to blindly “believe” that the formulas make sense?
A: First, the “magic” formula isn’t really magic. Similar formulas also work quite well. There have been dozens of studies over the last 30 years showing simple “value” strategies – such as buying stocks with low P/E ratios – can significantly outperform the market. These studies have also shown that even buying stocks with low P/E’s relative to other stocks in the same industry also works quite well.In the case of the magic formula, we are buying stocks with low P/E’s that also achieve high returns on capital.
As for the “complicated” formula, here is the big picture. For “cheap stocks”, the formula uses earnings yield (the inverse of P/E, it is simply earnings divided by market capitalization). However, for the magic formula we make a couple of adjustments. These adjustments account for differing debt levels and tax rates between companies. We feel these adjustments, on average, give us a better estimate of “earnings yield” than a simple P/E or E/P measure. These adjustments are discussed in the appendix section of the book.
For “good stocks”, the formula uses return on capital. Many analysts use a simple return on equity calculation (earnings/equity) or return on assets (earnings/assets) ratio to determine return on capital. As with earnings yield calculations, we make a couple of adjustments that account for differing debt levels and tax rates between companies. We also compare earnings to the total “net working capital” plus “net fixed assets” required to generate operating profits. Intangible assets are excluded as described in detail in the book.
However, these adjustments are not the “magic”. The magic formula would still work well without these specific adjustments. Simply, companies that can be purchased at low P/E’s and that achieve high ROA’s or ROE’s have also significantly beaten the market on a historical basis.
Q: Would you suggest placing an equal dollar amount in each stock purchased or an equal amount of shares?
A: An equal dollar amount.
Q: Do you have plans to include non-U.S. traded stocks on magicformulainvesting.com?
A: Not at present. However, since simple “value” methods using measures such as low price/earnings ratios and low price/sales ratios have been shown to be effective investment strategies in many non-U.S. markets, we would expect that the principles behind the magic formula will also work quite well when applied outside the U.S..
If after one year a stock that I originally purchased is still on the current list of top-ranked magic formula stocks, should I keep it or sell it?
A: That decision is up to you.
Q: If a stock that I purchased from the magic formula list drops off the list a few weeks or months later, should I sell it?
A: If you choose to follow the magic formula strategy, you would hold that stock for a full year.
Q: Aren’t trading costs for owning 20 to 30 stocks that are turned over every year quite high?
A: Yes. Depending upon the amount of capital invested, trading costs per year can be quite high. However, there are discount firms that can help to minimize these costs. For example, Foliofn.com has a $199 flat annual fee that should be able to accommodate all of the magicformulainvesting.com trading. For investors with small amounts of capital that choose to use discount brokers without a flat annual fee, limiting holdings to only 20 stocks (instead of 30) would also help to minimize commission costs. (Magicformulainvesting.com has no affiliation with and does not endorse Foliofn.com or any broker. The example provided is for information purposes only.)
Q: Why might the results of my calculations of earnings yield and/or return on capital differ from the ones found on the magic formula website?
A: There are two likely reasons. First, different databases record or classify data in different ways. For example, one time charges or additions to earnings may be included or excluded depending upon the data source. In addition, some databases are updated more frequently than others. We are comfortable that the database we are using is timely and of high quality.
Second, as described earlier, we have made some common sense adjustments to simple measures of earnings yield and return on capital. These are discussed in the appendix of the book for sophisticated investors. Some common differences in calculations of these ratios are adjustments for “excess cash” (cash not necessary to conduct operations), “net working capital” (generally, current assets less excess cash less non-interest bearing payables), the calculation of “enterprise value” (which subtracts excess cash and includes any preferred stock) and the treatment of “other assets”.
The calculations and database used for the magicformulainvesting.com site are the same as used in the magic formula study found in the book. Since the results in the study were quite robust, this should be comforting to users of magicformulainvesting.com. However, though we have done our best to provide a valuable and accurate site, data provided on this site is for information purposes only and is not guaranteed in any way.
Q: When I go to update my portfolio in 2 to 3 months, do I use an updated screen to select the stocks or do I pick again from the original list?
A: Use an updated screen. The data will have been updated and the results will be better. Of course, any stock that appears on both screens is fine to select.
Q: How often is the data updated?
A: The data is updated daily at 8:00 AM. The date of the closing price used in the calculations is displayed in the "Price From" column. Additionally, the date of the latest quarterly financials is displayed in the "Most Recent Quarter Data" column.
Q: Why do you require an email address? Do you intend to send me spam?
A: We require an email address to stay in contact with our users and inform them of relevant events. We have no intention of sending spam or reselling addresses.
Q: How is XXX calculated?
A: The calculations are explained in detail in the Little Book. |
