Magic Formula Investing: Why It No Longer Works 🪄📉

Joel Greenblatt's "The Little Book That Beats the Market" has had a significant influence on investors.

The book offers many valuable lessons:

Find great companies at bargain prices
Be patient with your investment results
Use ROIC (Return on Invested Capital) to assess business quality

However, the book's most famous concept—the Magic Formula—no longer works.

🧮 What Is the Magic Formula?

The Magic Formula is a mechanical process for finding good companies at cheap prices.

It uses two simple metrics:

1️⃣ ROIC (Return on Invested Capital)

A measure of company quality
Higher ROIC = more efficient capital utilization

2️⃣ Earnings Yield

A measure of how cheaply a company trades
Higher earnings yield = lower valuation

The Investment Method

Select stocks with the highest ROIC
That also have the highest earnings yield
Buy a large basket of these stocks
Rebalance annually

Simple, right? And it actually worked wonderfully for a time.

📊 It Worked in the Past

According to a Stablebread study, Magic Formula investing dramatically outperformed the S&P 500 from 1988 to 2009.

Investors who followed the Magic Formula during this period achieved remarkable market-beating results.

⚠️ So Why Doesn't It Work Now?

According to the same Stablebread analysis, if you followed the Magic Formula over the last 10 years, you would have dramatically underperformed the S&P 500.

Problem 1: Increased Chance of Value Traps 🪤

Many stocks selected by the Magic Formula as "cheap" may actually be cheap for a reason. These stocks look inexpensive but could be value traps that never recover.

Problem 2: Vulnerability to Cyclical Companies 🔄

The Magic Formula doesn't work well on cyclical businesses. Their earnings fluctuate significantly with economic cycles, so ROIC and earnings yield at any given point may not accurately reflect true business value.

Problem 3: High Turnover = High Taxes 💸

Since this strategy involves buying and selling stocks annually, the portfolio turnover is very high. This increases not only trading costs but also tax drag.

Problem 4: Strategy Self-Destruction 📢

When a simple investing strategy becomes popular, it becomes a victim of its own success.

When many investors follow the same strategy, those stock prices rise, and eventually the strategy no longer generates excess returns.

💡 The Lesson: Don't Rely on "Formulas"

Greenblatt is a fabulous investor, and there's much to learn from his book.

But the key takeaway is this:

There is no "magic formula" to beat the market.

Investing requires not a simple formula, but:

Deep understanding of businesses
Long-term patience
Adaptability to market changes

🎯 A Better Approach

Instead of the Magic Formula, consider these approaches:

1️⃣ Focus on Qualitative Analysis

Does the company have an economic moat?
How good is management at capital allocation?
What's the long-term industry outlook?

2️⃣ Long-Term Holding Strategy

Instead of annual rebalancing, hold great companies for long periods
Minimize taxes and trading costs

3️⃣ Understand Context Instead of Simple Formulas

Don't just look at numbers—understand the business
Consider economic cycles and industry characteristics

📝 Key Takeaway

Joel Greenblatt's book is still worth reading. There's much to learn about the importance of ROIC and the principle of buying good companies at reasonable prices.

However, I no longer recommend following the Magic Formula itself. It worked once, but it's now an outdated strategy.

The true "magic" in investing isn't a formula—it's continuous learning and adaptation. ✨