Simplifying Magic Formula Investing

Investing is an activity which is usually thought of as complex, especially when it comes to value investing. Value investing is the process of identifying stocks with inherent value and buying them at a price lower than their intrinsic value. Value investors believe that the stock price will increase to reach the inherent value or possibly grow beyond that, leading to a gain due to capital appreciation.

To accomplish this, one certainly needs substantially strong reasoning and conviction before investing their money in a potential value stock. Value stocks can be selected by doing thorough research on the multitude of variables that can potentially impact the long-term trajectory of the stock’s price.  Building this strong basis behind one’s investment decisions can be effortful. However, one can follow the approach laid down by a noted investor and writer, known as Magic Formula Investing.

The approach of Magic Formula Investing involves obtaining quantitative metrics of the stocks and then ranking them on the basis of a few rules which need to be followed to obtain this rank.

Key components of the Magic Formula

The Magic Formula Investing approach is a set of rules which need to be followed to obtain a list of stocks which have inherent value. These rules are listed as below:

• Firstly, one needs to select a list of large-cap stocks. This means that the stocks are of companies which have a significant market-capitalization, let’s say Rs. 20,000 crore or more.
• After this, one needs to exclude any financial and utility stocks from this list.
• Now, two ratios need to be calculated for each stock in this list, namely, the Earnings Yield and the Return on Invested Capital. The earning’s yield is calculated using the formula EBIT/ EV (Earnings before Interest and Taxes/Enterprise Value). The return on invested capital is calculated using the formula EBIT/ (Net Fixed Assets + Working Capital).
• After calculating the above two ratios for every single stock in the list, one needs to rank all these stocks according to the highest earnings yield and the highest return on capital. Now add the rank of both ratios and put them in ascending order.
• Once you obtain this subset after filtering the list using the above rule, one may purchase top 2 or 3 stocks from that list every month of an entire year.
• After one year, one needs to rebalance the portfolio. This is done by selling the losers before the year ends and selling the winners after the year ends. This is done with the objective of getting the advantage of reduced income tax liability due to realizing long-term capital gains.
• Then, this entire process needs to be repeated over a period of at least 5 to 10 years.

How to use the Magic formula?

Let’s understand this with a hypothetical example. Suppose you have a list of 20 companies as per the parameters mentioned above.

We have written the rank of these companies based on ROIC and Earnings yield, i.e. companies with the highest value will rank one and so on. Then we add both ranks and get the combined rank. The companies which have the lowest combined rank are the chosen ones. So in this example, if you want to invest in the top 5 stocks, you can invest in Company 2, Company 5, Company 7, Company 9 and Company 8.

Let’s now get a more nuanced understanding of using the Earnings Yield ratio and the Return on Capital ratio while following this methodology.

Earnings Yield & Return on Capital

The Earnings yield ratio compares the earnings before interest and taxes (EBIT) relative to the enterprise value of the company. The reasoning behind using this ratio is that EBIT is able to capture and compare the earnings of companies liable to different taxation rates. As for the reasoning behind using the Enterprise Value, it is also able to factor in the company’s debt into consideration.

The Return on Invested Capital ratio is obtained by the following formula: EBIT/ (Net Fixed Assets + Working Capital). This ratio compares the earnings relative to the tangible assets. This ratio effectively calculates the return on the capital that is employed in the business instead of the return on total capital.

From the outset, it may seem like these 2 ratios may not be enough to get a complete look at the company, but if one were to breakdown the components of each of these 2 ratios, it will be understood that they incorporate multiple aspects which throw light on how the company is functioning, namely its EBIT, the company’s debt burden, and total capital.

Advantages and Disadvantages  

The primary advantage of using the Magic Formula Investing approach is its simplicity. The only requirement is that one needs to follow a set of rules and gauge whether the investment decisions they will make on the basis of this are fitting into their risk-return profile or not.

When it comes to the disadvantages, one should be cognizant of the fact that the ratios which are used in this approach make use of past metrics. And since past performance is not indicative of future performance and returns, one cannot ensure that the company will sustain and/or grow the current operational or financial performance levels.

The approach also does not factor in events like market downturns, geopolitical turbulence, governmental policy changes impacting the entire market or the particular sector in which the company operates amongst a host of other factors which are instrumental in determining the performance of the companies in one’s portfolio.

Conclusion

All in all, it can be said that this approach of Magic Formula investing is rather non-complicated as compared to other value investing methodologies and helps one in following a disciplined and rule-based approach to making investment decisions and being patient about generating returns, due to the fact that this strategy needs to be followed for at least 5 to 10 years.

However, one should also keep in mind that this is not a perfect strategy and is subject to the impact delivered to one’s portfolio which are not factored in by the Magic Formula Investing approach.

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