Magic Formula Investing - How does it work?

Have you heard of magic formula investing? Janine Cox from the Wealth Within explains what it is and how you can use it. 

Let’s face it, if a magic formula existed to profit from the stock market everyone would be using it.

There have been many claims about magic formulas in the stock market. The perception of investors is that a magic formula would make investing easy, but who stands to benefit most from these claims? It’s unlikely to be investors.

The greats of the stock market include Warren Buffett and Charlie Munger, and I would suggest that most investors would love to achieve what Warren Buffett and Charlie Munger have. Indeed, many have tried to emulate their approach and dare I say have there are more than a few that have been unable to replicate the results.

We need to remember that they have a massive number of resources behind them, opportunities are canvassed to them, and the average investor cannot emulate that.
The reality is, Warren Buffett and Charlie Munger may hold stock in companies for the long term and do so before their true potential is realised.  However, not everyone is able to stomach the wild swings in the value of your portfolio that can occur whilst waiting for that potential to arrive.

Related article: What is value investing?

What is magic formula investing?

So, where did the term magic formula investing come from? Fund manager Joel Greenblatt wrote The Little Book that Beats the Market in 2005 where he pulled together investment approaches from Warren Buffett’s and Charlie Munger to identify cheap, high quality companies into what he termed a Magic Formula that reportedly achieved around 31% per annum from 1988 to 2004.

Magic Formula Investing is essentially a stock screener. The strategy claims to identify quality companies at low prices and using fundamentals to find companies that are undervalued. While the result was impressive, there is really nothing magic about using company fundamentals to invest. Stock screeners have been around for many decades, and some people have admitted that eventually the formula stopped working and they went back to the drawing board.

Interestingly, the Magic Formula Investing screener disclaimer says “There is nothing “magical” about the formula, and the use of the formula does not guarantee performance or investment success.” It also says investors should hold the stocks for a year and sell any stocks in loss before the one year holding period is reached.
Remember that there are pros and cons with any investment approach. Let’s consider some important points to help you make decisions.

Things to consider before using magic formula investing

Fundamental data

The first is the price charts don’t lie but fundamentals can. The price charts show you what the market thinks about a stock based on what is currently known and the market factors in information six to twelve months in advance. Remember, when the stock market peaked in 2007 and then fell heavily, good companies were still being promoted as having solid fundamentals.

Remember, that performance changes depending on your start and end date.

Bull Markets

The figure quoted above for the performance of the Magic Formula occurred during a bull market when most stocks will rise. The Dow Jones Index rose by around 440% from 1988 to 2004. So, if you bought and held the biggest stocks on the market you would have achieved a compounded annual return of around 46% without dividends. Most investors would be very happy with that.

Now let’s consider what happens when the market changes.

Bear market declines

Any formula that takes away the need for an investor to think, will make them blind to the fact that a bear market will significantly impact their return. In a bear market fundamentals become irrelevant as all stocks can fall by 30, 40, 50 and even 90% from their highs. We saw this in the GFC and recently with the COVID correction. So, allow history to be your guide.

Now let’s consider what was possible from the market when volatility increased significantly from 1 January 1999 to the end of December 2008.

As mentioned, the date you measure performance from and to will have a significant impact on the return. The market spent a lot of time falling during this period, but towards the end the market recovered. In that 10-year period the Dow Jones fell by slightly over 4%. Therefore, the performance of any strategy is likely to fall significantly.

When making a decision about what strategy to use when investing in a stock you should consider how it performs when the market changes direction.

Related article: What is a bear market

Buy and sell rules

Every investment strategy must have proper buy and sell rules. Even good companies should be sold when the time is right, which is when your rules indicate it’s time to sell. The Magic Formula says you hold a stock for a year and sell, and if it falls you sell before the end of the year. While these rules may seem simple, there are a number of reasons why they are not solid rules to follow.

Firstly, the rules ignore a critical point about timing. Many stocks are likely to pull back in price at least once a year and generally in the months of September, October or November we see one or more of those months down and sometime down heavily like this September, and so the fall in these months could wipe out your return.

So, put simply, if you were to buy and sell each year as the formula suggests you might find that you may have been better off entering earlier or exiting a few months later. There is a lot more information investors need to be aware of and choosing a date to sell is never a proper strategy.

The one positive about the Magic Formula is that the strategy includes stock selection criteria and makes investors aware that it is important to have a plan to sell before you invest. In my personal opinion, it ignores that an investment strategy is not complete unless it incorporates both fundamental and technical analysis.

There are technical rules that can be applied to a price chart to help you to manage your risk and careful selection can demonstrate how you can get a better result. Also, when you learn how to use proper rules you will understand why one rule does not work for all stocks.

In the end, you need a strategy that you understand and are confident in using, the strategy that helps you remain patient through the higher risk times when the market falls. It is also the strategy that provides opportunity to profit from the upside when the market turns back up.

Remember that making money in the stock market does not happen by magic, it requires knowledge, skill and experience to profit over the longer term.

Cover image source: ra2 studio/Shutterstock.com