If you found this page you most likely already know about the Magic Formula investment strategy developed by Joel Greenblatt and described in his excellent book called The Little Book that Still Beats the Market.
It is also the book that got me started with quantitative investing.
Your step by step guide
In this article I show you exactly how (step for step) you can implement the Magic Formula investment strategy in your portfolio.
We will also show you how you can improve your Magic Formula returns through a LOT of testing we have done, so keep reading.
Magic Formula ideas in your home market - not just in the USA
This article will also show you how to find Magic Formula investment ideas, not only in the USA, but in all the main markets world-wide including your home market.
First a bit of background information…
Finds quality undervalued companies
The Magic Formula helps you find good quality companies that are trading at an attractive price.
It does this by looking for companies with a high earnings yield (companies that are undervalued) and a high return on invested capital (ROIC) (quality companies).
It then ranks the companies on ROIC (where 1 is the company with the highest ROIC), and by earnings yield (where 1 is the company with the highest earnings yield).
To get the Magic Formula rank the ROIC rank and earnings yield rankings are added together.
The best ranked Magic formula company is the one with the lowest Magic Formula rank (the lower the better).
It’s all done for you
If this sounds like a lot of work do not worry - we have done it all for you. This means you can get a list of the best Magic Formula companies with a few mouse clicks.
Keep reading and I will show you exactly how.
The Magic Formula also works in Europe
You know the Magic Formula works in the USA as Joel proved in his book and on his website.
But does it also work outside the USA?
In 2012 that is exactly what we wanted to find out when we tested the Magic Formula investment strategy in Europe over the 12 year period from June 1999 to June 2011.
This is what we tested
The back-test universe was about 1500 companies in the 17 country Eurozone markets during our 12-year test period (13 June 1999 to 13 June 2011). We excluded banks, insurance companies, investment funds, certain holdings companies, and REITS.
We included bankrupt companies to avoid any survivor bias, and excluded companies with an average 30-day trading volume of less than €10 000. For bankrupt companies, or companies that were taken over, returns were calculated using the last stock market price available before the company was de-listed.
This is what we found:
Magic Formula returns in Europe from June 1999 to June 2011 by company size.
Source: Quantitative Value Investing in Europe: What works for achieving alpha
As you can see companies with the best Magic Formula rank, quintile 1 (Q1) in the above table, did a lot better than companies with the worse Magic Formula rank (Q5).
And it did this for small, medium and large companies.
The best ranked Magic Formula companies all substantially outperformed the market which returned only 30.54% over the same 12 year period.
The best Magic Formula companies did up to 152.3% better than the market.
Others have also tested the Magic Formula in Europe and it works
A lot of people also wanted to find out if the Magic Formula works in their home market and, not surprisingly, it does.
Here are some other research studies we have come across:
It does, and it was proved in 2013 by Topias Kukkasniemi in his 68 page master’s thesis The Use of Systematic Value Strategies in Separating The Winners From The Losers: Evidence From The Finnish Markets at the Lappeenranta University of Technology in Finland.
Topias tested the Magic Formula on the Finnish stock market over the 13 period from May 1997 to May 2010 and found that the strategy does outperform the market.
From 1995 to 2014 the Magic Formula definitely worked in Belgium, Luxembourg and the Netherlands as it would have given you an average yearly return of 7.7% better than the market over the 20 year test period, an impressive return.
OK so it works – how do I get Magic formula ideas
Now for the interesting part where I show you how to get Magic Formula investment ideas for your portfolio.
I have set it up for you
I have already saved a Magic Formula screen for you so all you have to do is load it.
Here is how you do it:
After loading the screener click the My templates button then click the Load a template menu item as shown below:
Then click on the Magic Formula saved screen in the Predefined templates tab.
Once you have selected the Magic Formula screen scroll to the bottom of the page and click the Load button.
Select your countries
You then have to select the countries where you would like to search for Magic Formula investment ideas.
The following countries are included in the screener: Countries included in the screener
To do this click the drop down list item below Countries and check all the countries you would like to select.
Select traded value and market value
Next you have to enter the minimum daily trading volume and the minimum market value of the companies you want to screen for.
Please note the numbers you enter are in thousands, this means if you enter $100 it is equal to $100,000.
That is all you have to do.
When you are done click the Filter button to get your Magic Formula investment ideas.
This is what you screen looks like
Dependent on what you selected your screen will look something like this:
But the Magic Formula can be improved - a lot
As I already mentioned you can improve the returns of the Magic Formula a lot, up to 600.5% in the testing we have done.
We tested the Magic Formula investing strategy with 13 other ratios and as you can see in the table below the returns of the strategy can be substantially improved.
Magic Formula returns when combined with a third ratio in Europe from June 1999 to June 2011.
Look at column Q1
Look at the returns in column Q1, it shows the returns generated by first selecting the 20% best Magic Formula investing companies combined with the ratios in the column called Factor 2.
Best combination +783% was Momentum (600.5% improvement)
This means you could have earned the highest return of 783.3% over the 12 year period if you invested in the best ranked Magic Formula companies that also had the highest 6 month price index (share price momentum).
This is a 600.5% improvement over the best return of 182.8% you could have earned if you used only the Magic Formula to get investment ideas.
Other great combinations
Other good combinations from the table above are:
- Magic Formula and 12m Price index (momentum) +472.3%
- Magic Formula and Price to Book +460%
- Magic Formula and ERP5 +384.4%
- Magic Formula and 5yr average Earnings Yield (EBIT/EV) +294.8%
How to combine the Magic Formula with other ratios
With the screener it is very easy to combine the Magic Formula with other ratios or indicators. The following screen shots will show you exactly how.
To start load the Magic Formula saved screen, select the Countries, Daily Trading Volume and minimum Market Value as shown above.
How to add 6 month Price Index (momentum)
To add 6m Price Index (6m momentum) to the screen click the drop down list below Secondary Factor and, under the heading Momentum click in the Price Index 6 m menu item.
Then move the slider below Price Index 6m so that you select the top 20% to 30% of companies with the best six month Price Index.
Then click the Filter button so the screener can find the companies you are searching for.
In the same way you can add:
- 12m Price index (momentum)
- Price to Book
- 5 year average Earnings Yield (EBIT/EV)
Or other good factors you can experiment with are:
- Free cash Flow yield – to select companies cheap compared to the cash they generate
- Debt to Equity – To select companies with a low amount of debt
- Gross Margin - Novy-Marx (the best quality ratio we have tested)
and many more (you can see all ratios and indicators you can use in the Glossary)
You can save all your screens
Once you have changed the basic Magic Formula screen to fit your investment style you can save it so that you can call it up at any time.
You can save as many screens as you like.
To save your screen click the My template button, then the Save to template menu item.
In the pop-up box give your screen a name and a short description so you can remember what the screen does.
All this costs less than a lunch for two
How much can a tool like this cost, you may be thinking?
To make it affordable, and give you a great return on your investment, even if your portfolio is still small we have made the price of the screener surprisingly low.
It costs less than an inexpensive lunch for two each month (Click here for more information).
Don’t hesitate, you have nothing to lose. If you are not 100% satisfied you get your money back – guaranteed!
Your Magic Formula analyst
Wishing you profitable investing
Tim du Toit
PS: Why not sign up now, while this is fresh in your mind?
Please note: This website is not associated with Joel Greenblatt and MagicFormulaInvesting.com in any way. Neither Mr Greenblatt nor MagicFormulaInvesting.com has endorsed this website's investment advice, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com.
Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website.
Article by Tim du Toit, Quant Investing