Magic Formula Investing: A Viable Strategy For India?

Joel Greenblatt's Magic Formula is a strategy for investors to beat the market over the long term. It involves buying a good business at a bargain price and is based on two factors: return on capital employed (RoCE) and earnings yield (EY). Greenblatt's formula has been extensively tested and has generated impressive returns in some markets. However, it is unclear if it works in all contexts, and there are doubts about its effectiveness in the Indian market. This paragraph will explore the Magic Formula's applicability in India and discuss its potential limitations.

Joel Greenblatt's Magic Formula

Greenblatt's formula is based on two factors: Return on Capital Employed (RoCE) and Earnings Yield (EY). RoCE measures a company's earnings before tax and interest payments as a ratio of tangible capital employed (net working + net fixed). It reflects the company's ability to turn investments into profits and is a useful metric for comparing companies. EY is calculated by dividing each company's earnings before interest and taxes by the total value of the enterprise.

The Magic Formula strategy was first outlined in Greenblatt's 2005 book, 'The Little Book That Beats The Market', and updated in 2010 as 'The Little Book That Still Beats The Market'. In the original publication, Greenblatt claimed annualized returns of over 30%. The formula has been back-tested and found to have merit, with studies showing it outperformed market averages in Nordic countries, Sweden, Hong Kong, France, and China.

When applied to the Indian context, the Magic Formula starts with the 750 largest companies listed on Indian stock exchanges. It then ranks these companies based on their return on capital and earnings yield. The strategy has been found to outperform the Indian stock market over the period from July 2012 to February 2020, with an average return of 13.9% for a 30-stock Magic Formula portfolio compared to 9.3% for the BSE Sensex. However, it is important to note that no investment formula is foolproof, and the Magic Formula may have lost some of its effectiveness over time.

Magic formula investing strategy

Joel Greenblatt's Magic Formula is a rules-based, disciplined investing strategy that teaches people a relatively simple and easy-to-understand method for value investing. It relies on quantitative screens of companies and stocks and is designed to beat the stock market's average annual returns using the S&P 500 as a benchmark. The formula works by ranking stocks based on their price and returns on capital.

The strategy focuses on two factors: Return on Capital Employed (RoCE) and Earnings Yield (EY). RoCE helps investors understand how much profit is generated for each unit of capital employed, while EY measures a company's earnings before tax and interest payments as a ratio of tangible capital employed. By buying companies with a high RoCE and a high EY, investors can build a portfolio of good companies at bargain prices.

To implement the Magic Formula, investors should aim to include 20 to 30 companies in their portfolio, buying 2 to 5 top-ranked stocks each month to consistently focus on the highest-potential investments. It is important to monitor the portfolio's performance and regularly rebalance by selling off loss-making shares after 51 weeks of purchasing and the winning stocks after 53 weeks. This process should be repeated for a period of five to ten years to generate market-beating returns.

The Magic Formula has been successfully back-tested and has shown good results when compared to the S&P 500. However, it may not work in all market conditions and is not suitable for small-cap companies or certain sectors such as finance and utilities.

Return on capital (RoC)

In the Indian context, the Magic Formula considers the top 750 companies listed on Indian stock exchanges. These companies are ranked based on their RoC, with the company generating the highest RoC receiving a rank of 1. This ranking system helps identify companies with high returns on capital.

The Magic Formula strategy in India involves buying stocks with a high RoC and a high Earnings Yield (EY). RoC and EY are the two critical factors that form the foundation of the Magic Formula. The formula aims to identify businesses that earn higher returns on capital and provide more value relative to the price paid.

While the Magic Formula has produced impressive results in some cases, it is important to note that it may not work in all market conditions. For example, one individual tested the formula in the Indian market for two years and found that it did not outperform the index. However, it is generally recommended to test any investment strategy for a minimum of five years to make a more informed conclusion.

In summary, Return on Capital (RoC) is a key metric used in the Magic Formula Investing strategy, helping investors identify companies with high returns on capital and make informed investment decisions in the Indian market.

Earnings before interest and tax (EBIT)

Earnings before interest and taxes (EBIT) is a financial metric that assesses a company's operational strength and profitability. It is calculated by subtracting a company's expenses (excluding taxes and interest) from its revenue. EBIT is a valuable tool for investors as it reveals whether a company's business model is viable and how efficiently it operates before financing costs are considered.

EBIT is a critical metric for investors considering a potential acquisition as it indicates what the business would earn from its financial structure. EBIT is also useful for benchmarking, allowing managers to compare operational performance against industry peers and historical trends.

EBIT is calculated in two common ways. The first method starts with the company's net income and adds interest and tax expenses:

> EBIT = Net Income + Interest Expenses + Tax Expenses

The second method works backward, starting from the top of the income statement:

> EBIT = Revenue - Cost of Goods Sold (COGS) - Operating Expenses

EBIT is sometimes referred to as operating profit or profit before interest and taxes. It is important to note that EBIT differs from earnings before interest, taxes, depreciation, and amortization (EBITDA), which includes depreciation and amortization of fixed assets. EBITDA can offer a more accurate impression of a company's operating profit, especially for companies with a substantial number of fixed assets.

In the context of Joel Greenblatt's Magic Formula of Investing, EBIT is one of the two ratios used to rank and select stocks for investment. Greenblatt's formula combines Warren Buffet's value investing with Benjamin Graham's deep-value approach. The formula focuses on buying companies with a high return on capital and high earnings yield.

Limitations of the magic formula

The Magic Formula, despite its name, is not a foolproof investment strategy. It is a rules-based, disciplined strategy that is designed to beat the market's average annual returns. However, it has its limitations and potential drawbacks. Firstly, it may underperform the market during certain periods, which can test investor patience. It is also subject to market volatility and swings, like any equity-focused strategy.

The formula also does not account for qualitative factors such as management quality, industry trends, or macroeconomic factors, which can impact a company's performance. Additionally, it may fall into value traps, where high earnings yield and ROC may indicate underlying issues not captured by the metrics. The annual rebalancing process can also incur transaction fees and tax liabilities, impacting net returns.

Furthermore, past performance does not guarantee future success, and as the strategy becomes more popular, critics argue that its effectiveness may diminish due to increased competition. The formula also requires certain exclusions, such as financial companies and utilities, which might limit diversification. It is also important to note that the Magic Formula only applies to large-cap stocks and excludes small-cap companies.

While the Magic Formula has shown promising results in some markets, it is not a one-size-fits-all solution. It may face limitations in certain sectors and markets, and it is important for investors to be aware of these limitations to make informed decisions and adjustments to suit their personal investment profiles.

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