You have 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. I will also show you how you can improve your returns through a LOT of testing we have done, so keep reading.
Magic Formula ideas in your home market – not just in the USA
I will also show you how to find Magic Formula ideas, not only in the USA, but in all the main markets world-wide including your home market.
First a bit of background information…
What exactly does the Magic Formula do for you?
It helps you find good quality companies that are trading at an attractive price. And 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 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 it 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 it 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 rank (Q5).
And it did this for small, medium and large companies.
The best ranked companies all substantially outperformed the market which returned only 30.54% over the same 12 year period. In fact, the best 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:
Does it also work in Finland?
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.
Does it work in Belgium, Luxembourg and the Netherlands?
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.
For the full article and all screenshots click the following link to go over to our screener website: How to implement the Magic Formula investment strategy
Your magic formula analyst
Tim du Toit
PS For the full article and all screenshots click the following link to go over to our screener website: How to implement the Magic Formula investment strategy