Author Joel Greenblatt, in a very simple and efficient manner, have explained that how we can earn more than market returns through use of a simple formula which he calls as “Magic Formula”. As per his analysis of past 17 years from 1988 to 2004 on US Stock Market, using “Magic Formula”, one could have easily earned nearly more than double the average market returns.

The summary of book written here, would only cover the important aspects which are necessary to know and which can be practically applied in the market. (Obviously according to me). So…

Preamble:

One should focus on “Buying above-average Company at below-average price” to earn profits in the long run.

This is the main quote, on which the whole book and its investment thesis are based. One should buy companies which are above-average at a price below-average. I.e. “Buy Good companies at a Bargain Price”.

And all this can be achieved by using just one trick i.e. “Magic Formula”. Magic Formula is basically a combination of two criteria (Factors), which will help us to identify 1) good companies at 2) bargain Price.

What does Good companies mean? And How can we determine what price is bargain price? Simply put, “Good companies are those companies which earn High Return on their Capital” and “Bargain priced is the companies which has very high earnings yield.”

Factors Explained:

Factor 1: High Return on Capital (I.e. Good Company):

A company has invested Rs. 4, 00,000/- in its own business by setting up one single shop. On a yearly basis, the shop earns Rs. 2, 00,000/-. Hence, in one year, half of the amount invested is earned back as profits. This makes a return on capital of 50% (quite high). “When it comes to us, we would rather own a business which earns higher return on capital than one which earns lower.”

Factor 2: High Earnings Yield (I.e. Bargain Price):

Earnings Yield is simply the share price relative to profit per share a company earns. So, if price of a share is Rs. 10/- and company earns profit of Rs. 1/- (Rs. 2/-) per share. It means that earnings yield is 10% (20%). Hence, higher the earnings yield, better is the per share amount we receive relative to current share price, and that too in the first year itself. “Therefore, Higher the Earnings yield, better the company”.

Combining two Factors:

If a company has ability to generate high return on capital even for its additional investments, then company, in turn can give higher growth rate in earnings as well. Say, company has earned profit of Rs. 2, 00,000/- on investment of Rs. 4, 00,000/- making Profit per share at say Rs. 1/- and 10% earnings yield. When, this Rs. 2, 00,000/- profit is again reinvested next year into business and it earns same returns on capital i.e. 50%. Then, for the next year, company would earn profit of Rs. 3, 00,000/- (50% of Rs. 4, 00,000/- initial investment and Rs. 2, 00,000/- additional investment) which would come to Rs. 1.5/- per share (i.e. 15% earnings yield) and a growth of 50% in earnings yield as well i.e. from 10% to 15%.

“Hence, a higher level of return on capital, and also capacity to reinvest additional funds at such higher level of returns leads to even higher growth rate in Earnings Yield.”

Way to Apply these Factors:

Now, we got the two factors of “Magic Formula”, how can we use it to practically apply in the market?

We can do it quite easily and with the help of any website which allows us to filter stock based on our two factors criteria. But before focusing on how to apply, let’s understand what way to apply those two factors.

Firstly, select universe of stock, on which you need to apply the Magic Formula. That universe can be top 1000 listed companies, or companies with market cap of more than $ 50M, etc. Then we start shortlisting companies based on the two factors.

Factor 1:

Once universe of stocks are selected, say you selected top 1000 companies in India. Then, filter those companies based on highest to lowest returns on capital. And, the company with highest return on capital will be ranked 1, and so on till rank 1000^th.

Factor 2:

Similarly, filter companies and rank them based on highest earnings yield. Therefore, company with highest earnings yield will get rank 1 and so on.

Combining Factors:

Now, only one factor cannot be enough for a company to get shortlisted. To say, company with highest earnings but not good returns on capital is still an average company. This is because, the growth in earnings will be very slow (remember, high return on capital means high earnings growth rate as well and vice versa) and hence we might not get attractive returns. Hence, we need to get blend of both the factors. And this is done by adding up the rank of both the companies. i.e. A company which has 10^th rank based on return on capital but 250^th rank on earnings yield will get score of 260 (250+10). All those companies which does utility business will be excluded from the analysis. Hence, companies of insurance, banking and finance sectors will not be part of the shortlisted companies. This is done because, the business models, ratios and other specifics are way too different than normal companies and hence shortlisted results will not be effective. And thereafter removing the utility companies, the top 20-30 companies with lowest added score are the final shortlisted companies eligible for investment as per Magic Formula.

Investing as per Magic formula i.e. Portfolio Creation:

Then, as Magic Formula says. We need to allot our funds to these companies. Say, you decide to have 20 companies in your portfolio. You might choose to invest in all 20 companies at once, or you can even invest 5 companies each month over 4 months’ time (and the combinations you prefer). Hence, your portfolio will assign all the funds to the companies over time period of 4 months. (Preferably, each company assigned equal amounts i.e. 5% each for all 20 companies making it to 100%).

Thereafter, you should replace each of these companies every year with another set of companies. So, the 5 companies you invest in 1^st month will be replaced by another set of 5 companies in 13^th month (exact a year). Those another set of 5 companies (which will replace the old ones) will be shortlisted by applying same filter we used before to get top 20-30 companies. Similarly, next 5 companies bought in 2^nd month are replaced by another set of 5 companies in 14^th month and so on.

The timing of holding a company for one year can also be adjusted so to get additional tax benefits. So, when a company is held for less than one year (called short term) in India, the profits are taxed at 15%. When, we hold the company for more than a year (long term), they are generally not taxed for profits up to Rs. 1, 00,000/-. Hence, we can sell shares of companies which are in loss just prior to a year’s completion so that their loss can be adjusted with any other incomes. And we can sell shares of companies which are in profits just few days after a year to enjoy tax free profits up to Rs. 1,00,000/-. This process will keep on repeating, and over a long term horizon, we will see our profits compound to a huge amount.

What author did, and the back tested returns:

Author, Joel Greenblatt, has selected from all listed companies of US, a universe of 1) largest 3,500 companies 2) 2,500 companies and 3) 1,000 companies.

He, then applied the two factors and ranked them as the way described above. The portfolio of companies were created to test their results using Magic Formula criteria. He made 4500 different portfolios for testing the returns for a 17 year period starting from 1988 to 2004. The result of this testing were: 1) largest 3,500 companies yielded us annual return of an astonishing 30.8% 2) largest 2,500 companies yielded us 23.7% annual returns and 3) largest 1,000 companies yielded 22.9% annual returns. During the same time, i.e. 1988 to 2004, the markets average returns are 11.7%. Hence, we would have nearly doubled our returns as compared to markets average, by using Magic Formula.

Some useful Pointers:

On the course of doing above analysis, there were many observations noted, issues/problems discovered, and conclusions made. I have made a short list of pointers below to explain you:

• Prices of stock fluctuates by a huge margin. Sometimes you can see value of company doubling or even coming to half in few years. Hence, markets gives us always an opportunity, over time, to find bargain priced companies, when value reduces.
  
  
• Author tested 4500 Magic Formula Portfolios so that there is enough sample, and the results achieved of 30.8% is not just a matter of chance.
  
  
• The main purpose of creating “Magic Formula” Portfolio is to earn above market returns over time. Hence, there might be cases when some companies in your portfolio go bankrupt, and some companies might even grow 10 times. Magic Formula still works over the whole portfolio on an average over long run and it is not affected by individual companies. This is the benefit of keeping 20-30 companies in a portfolio, we attain “Diversification Benefit”.
  
  
• Magic Formula requires you to have patience for longer time frame for it to work. Sometimes, the portfolio created using magic formula does not earn you a penny for straight 2-3 years. Hence, it requires you to have a long horizon for your portfolio to work. Long horizon is generally more than 5 years’ time.
  
  
• Because there comes 2-3 years straight period of no returns. Investors, individuals usually switch to another strategy or don’t have patience to keep sticking to same strategy for long horizon. So, it is important to have good level of patience. And, if you can’t wait, it is better not to invest using Magic Formula.
  
  
• You can invest on someone’s tip, invest all by yourself, and invest in Index Funds, Hedge Funds or even Mutual Funds. But, comparing returns over all, Magic Formula has done pretty well without having risk of failure.
  
  

You might want to invest all by yourself, but still Magic Formula will be useful. Analyse only those companies shortlisted by Magic Formula and then invest as per individual analysis. This technique is more better and high chances of creating better returns.

How to apply Magic Formula:

Author, has done his part of research on US Stock Markets. And hence, there is one website created to filter out stock directly using the two factors. https://www.magicformulainvesting.com/, this website helps you to get direct list of stock as per Magic Formula Criteria. But, it is again, based in US.

How can we do it ourselves? The “How” to apply Magic Formula is explained below:

We have to select any good website based on stock markets, which can help us in filtering out stocks as per our two factors. There are many websites available in the market and one such is www.screener.in.

Then, we have to set criteria to filter our companies.

Criteria 1: Top 1000 companies in India by Market Cap, or companies with Market cap of more than 1,000 Cr. (So on)

Criteria 2: Sort companies with highest EBIT/ (Net Working Capital + Net Fixed Asset) i.e. proxy for return on capital. And assign them rank.

Criteria 3: Sort companies with EBIT/Enterprise Value i.e. proxy for earnings yield. And assign them rank. Then, combine the ranks of both the factors and find the lowest combined ranked company. And this is the way you find top 20-30 companies eligible for investing as per Magic Formula.

Why EBIT, Enterprise Value and Net Working Capital + Net Fixed Assets taken as the factors:

Enterprise Value is the value of whole company, if we were to buy it. We take enterprise value so that we can find the true value of business we are investing in it. The profits we earn, should be compared with the total value of business.

EBIT is the operational profit of the company. There are many companies which do not take loans and many which take them huge. Hence, interest expenses for each of these companies will vary. Also, company might be subject to different tax percentage as well. Taking EBIT (Earnings before interest and taxes), we compare only operational profit of the company and does not consider the interest and tax component. This will help us in analysing apples to apples. Net Working Capital + Net Fixed Assets is the total of funds which company uses to run its business. Hence, return on capital component will use this as denominator.

Applying Magic Formula in Indian Markets:

An astonishing 30.8% returns would have been achieved in US if we have invested by the concept of Magic Formula. But, what would be the results in Indian Context?

An excellent research was conducted by Ahmed Madha and the same is published here “https://financialtales.home.blog/2020/05/04/joel-greenblatts-magic-formula-in-the-indian-context-does-it-work/”.

By filtering the stocks as per criteria mentioned above, Ahmed Madna, by different ways have tried to calculate the average returns using Magic Formula in Indian context. His study spreads from 2002 till 2019 (so latest analysis).

The result of this analysis was, over last 18 years, Magic Formula Portfolio would have generated returns of 35.4% CAGR. Hence, investing Rs. 1 Cr. at this rate for 18 years would have resulted in Rs. 235 Cr.

On comparing with market average returns, Nifty 50 during the same period gave CAGR of 12.7%. Nifty 500 generated a CAGR of 13.5%. Nifty Midcap 100 generated CAGR of 14.6%.

Hence, it is clearly visible how Magic Formula works in the market. In Indian markets, using this formula would have earned you nearly 3 times the nifty 50 average returns during the same period. I recommend you to read the article shared above.

Closure:

Well, if you read this summary very closely and after understanding and implementing each point. You would probably find a lot of queries. But, to explain those would turn this article into a mini book. Hence, if the commentary above excites you, I strongly suggest you to read the book. Also, implementing the principles for current market scenario would be great learning.

Also, for your ease, i have just reproduced the chapter by chapter commentary by the Author in short version. Kindly do check out here.

Thank you all for your patience in reading this short summary.