What is the Magic Formula Investing? 

If you have spent any time scrolling through investing podcast playlists or YouTube, you have probably run into someone claiming they have cracked the formula for beating the market. 

Magic formula investing is one of the rare cases where the name is not just clickbait, instead, it is a real, documented method, and it comes from someone with the track record to back it up.

It was created by Joel Greenblatt, a hedge fund manager who ran Gotham Capital. He wrote it all down in a book called The Little Book That Beats the Market.

Let us get into what it looks like when you try to apply this formula in India.

The Rationale

Greenblatt’s idea is similar to what Warren Buffett has been saying for years: buy good businesses, but do not pay too much for them.

The problem is that figuring out what is “good” and what is “cheap” can be difficult. You may start doubting your choices or get tempted to buy stocks that are trending on social media.

Magic Formula Investing removes much of this guesswork and uses two simple numbers to rank companies and find the ones that score the best. There’s no need to rely on opinions, gut feelings, or market hype. The data does the sorting for you.

What are those 2 Numbers?

1. Earnings yield

You can think of it as a cousin of the P/E ratio. It is calculated using EBIT divided by enterprise value instead of net profit divided by market cap. A high earnings yield tells you: this business is generating a lot of operating profit relative to what you would have to pay to own the whole thing, debt included.

2. Return on capital

This is meant to capture quality rather than price. It is EBIT divided by the sum of net fixed assets and working capital, explaining how efficiently a company turns the money invested in its operations into profit.

Once you have calculated both for a basket of companies, you rank every company twice and add the two rankings together. 

A lower combined rank means the stock is closer to “cheap and good at the same time.”

How Does the Formula Work?

The Magic Formula Investing follows a few simple rules:

1. Choose larger companies: Only consider companies above a certain market value. Greenblatt originally used $50 million, but this limit should be adjusted depending on the market you are investing in.
2. Leave out financial companies and utilities: These businesses have different types of balance sheets, which can make the formula less useful for them.
3. Rank the companies: Rank the remaining companies based on the two key metrics used in the Magic Formula. Then combine their rankings to find the companies with the best overall scores.
4. Pick around 20-30 stocks: Invest in the top-ranked companies. Instead of buying all of them at once, buy a few each month. This helps avoid putting all your money into the market on a single day.
5. Hold for about one year: Keep each stock for roughly a year before reviewing or replacing it.
6. Sell and replace the stocks: The strategy has specific rules for when to sell winning and losing stocks. This can also help with tax planning, depending on the country and your tax rules.
7. Repeat every year: Keep following the same process for several years. The Magic Formula is designed as a long-term strategy, ideally over 5–10 years, rather than something that is expected to work every few months.

Why Follow Such Strict Rules?

The strict rules are not meant to make investing complicated. They are designed to stop you from making emotional decisions based on short-term market movements.

You do not try to predict the market or chase trends. You simply follow the same process every year and let the numbers help you choose the stocks.

Does the Magic Formula Work in India?

The Investing Magic Formula was originally created for the US stock market, so Indian investors cannot simply copy the strategy exactly as it is. Some parts need to be adjusted for the Indian market.

1. Adjust the market-cap limit: Greenblatt used a $50 million market-cap cutoff in the US. For India, this needs to be changed to a suitable market-cap limit in ₹ crore, depending on the stocks being screened. The strategy can be applied to a broad universe such as the BSE 500 or Nifty 500.
2. Exclude banks and NBFCs: Financial companies such as banks and NBFCs are usually left out. Their businesses work differently, so measures like EBIT and enterprise value do not work in the same way for them.
3. Indian tax rules are different: Greenblatt’s original strategy includes specific rules for selling winning and losing stocks over a one-year period. These rules were designed around the US tax system and do not apply to India. Indian investors should consider the Indian tax rules before following this part of the strategy.
4. The core idea remains the same: The main principle still works: Look for good companies that are available at attractive prices. Following a fixed, data-based process can also help investors avoid emotional decisions when the market becomes volatile.
5. Backtests can give different results: Some Indian investors and finance platforms have tested versions of the Magic Formula using Indian stocks, including BSE 500 companies. Results can vary depending on the period and the exact rules used, so past performance should not be treated as a guarantee of future returns.

Read Also: The Art of Value Investing: Meaning and Strategies

Advantages of Magic Formula Investing

1. It keeps things simple: You mainly look at two numbers to find and rank companies.
2. It takes emotions out of the decision: You are less likely to buy a stock just because everyone is talking about it or sell one because the market has fallen.
3. It looks for value: The idea is to find good businesses without paying an unnecessarily high price for them.
4. It saves time: Instead of going through every company in the market, the formula gives you a smaller list to work with.
5. It encourages patience: This is not a strategy built around making money quickly. You give your investments time to play out.

Limitations of Magic Formula Investing

1. No check on accounting quality: It does not adjust for related-party transactions or aggressive earnings management, which is a bigger risk among smaller BSE/NSE names than in the US market it was built for.
2. Ignores leverage: High-debt companies can screen well on the formula and still run into debt-servicing trouble later.
3. Liquidity issues: It tends to surface small/micro-caps, which come with wide spreads and execution problems for retail investors.
4. No read on promoter behaviour, an India-specific gap: It won’t flag high promoter pledging or falling promoter stakes, both of which are common red flags here.
5. May not beat the market every year: There will be periods when the stocks picked by the formula simply do not perform as expected, which can be frustrating

Is Magic Formula Investing Right for You?

The Magic Formula may work well for someone who wants a structured way of picking stocks and does not want to make decisions based on every market move. It can also be useful if you are comfortable holding investments for a longer period and can stick with the strategy even when it goes through a rough patch.

But if you are looking for quick gains or enjoy actively buying and selling stocks, this probably is not the approach for you.

And there is one important point to remember: a stock ranking highly on the formula does not automatically make it a stock you should buy. The formula is a starting point, and not a replacement for doing your research work.

Conclusion 

Now you know what is the magic formula investing. It is based on a straightforward idea: find good businesses, pay a reasonable price for them, and be patient. What makes the strategy interesting is that it gives investors a set of rules to follow instead of leaving everything to gut feeling. You don’t have to keep guessing what the market will do tomorrow or jump onto whatever stock is trending this week. That does not mean the strategy will always work. Some picks will disappoint, some years will be difficult, and the formula itself may need to be adapted for markets like India.

The real takeaway from Greenblatt’s approach is probably bigger than the formula itself: having a plan and sticking to it can be more useful than constantly trying to outsmart the market.

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