Reblog: The ‘Magic’ Formula to find multibaggers

Magic – That’s what you need to get multibagger returns and beat the market consistently, and that’s what the Magic Formula is supposed to do.

As a result of brilliant marketing, promotion and becoming a New York Times bestseller in 2005, Joel Greenblatt has turned the Magic Formula into a key strategy for many in the value investing and mechanical investing community.

Buy at least 20 stocks from the Magic Formula screener and then re-balance at the end of the year. Do this and you will beat the market, the book says.

Greenblatt wrote The Little Book that Beats the Market for his children who were aged between 6-15 at the time.

It’s written in plain English and 6th grade math to make it easy to follow along. This is the strong point of the Magic Formula theme.

Everything is very easy to understand. The concept is simple, the explanation is simple, but most important of all, the execution for investors is simple enough to do on their own.

In it’s most naked form, the Magic Formula is described by Greenblatt as

a long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices.

The Ingredients to the Magic Formula

Here is the formula courtesy of wikipedia. From beginning to end, it consists of 9 steps.

  1. Establish a minimum market capitalization (usually greater than INR 350 crs).
  2. Exclude utility and financial stocks
  3. Exclude foreign companies (American Depository Receipts)
  4. Determine company’s earnings yield = EBIT / enterprise value.
  5. Determine company’s return on capital = EBIT / (net fixed assets + working capital)
  6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
  7. Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
  8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
  9. Continue over a long-term (3–5+ year) period.

Pay close attention to step 4 and 5 because they are the key driving formulas for it all to work.

  • Earnings Yield = EBIT / Enterprise Value
  • Return on Capital = EBIT / (Net Fixed Assets + Working Capital)

Magic Formula Results:

Starting with $10,000 the Magic Formula would have made you a millionaire by 2009.

The Magic Formula is famous for returning a 30% CAGR. From 1988 to 2004, it did achieve a 30.8% return, but the CAGR declined after that. Though the latest book gives results till 2009 only so, recent results are not known, however the fact remains that this formula really does work magically.

Make a watch list for yourself based on this formula and test it over a period of time to gain conviction.

The original post is authored by Mastermind, Megabaggers and is available here.

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