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Magic formula investing tells you how to approach value investing from a methodical and unemotional perspective. Developed by Joel Greenblatt—an investor, hedge fund manager, and business professor—the formula applies to large-cap stocks but doesn't include any small or micro-cap companies. Key Takeaways Magic formula investing is a successfully back-tested strategy that can increase your chances of outperforming the market.

The strategy focuses on screening for companies that fit specific criteria and uses a methodical, unemotional process to manage the portfolio over time. The strategy, which is value-based, was developed by investor and hedge fund manager Joel Greenblatt and published in The Little Book That Beat the Market in The magic formula excludes certain types of companies, such as those with a small market capitalization, foreign companies, finance companies, and utilities.

Greenblatt, founder and former fund manager at Gotham Asset Management, is a graduate of the Wharton School at the University of Pennsylvania. He is an adjunct professor at Columbia University's business school. In the book, Greenblatt outlines two criteria for stock investing: Stock price and company cost of capital.

Instead of conducting fundamental analysis of companies and stocks, investors use Greenblatt's online stock screener tool to select the 20 to 30 top-ranked companies in which to invest. Company rankings are based on: Their stock's earnings which are calculated as earnings before interest and taxes EBIT.

Their yield, calculated as earnings per share EPS divided by the current stock price. Their return on capital measures how efficiently they generate earnings from their assets. Investors who use the strategy sell the losing stocks before they have held them for one year to take advantage of the income tax provision that allows investors to use losses to offset their gains. They sell the winning stocks after the one-year mark, in order to take advantage of reduced income tax rates on long-term capital gains.

Then they start the process all over again. Magic formula investing only factors in large cap stocks and doesn't include small cap companies. The remainder will all be large companies but excludes financial companies , utility companies , and non-U. The following points outline how the formula works: Set a minimum market capitalization for your portfolio companies. Ensure you exclude any financial or utility stocks when you choose your companies.

These are stocks in foreign companies. Rank selected companies by highest earnings yields and highest return on capital. Buy two to three positions each month in the top 20 to 30 companies, over the course of a year. Each year, rebalance the portfolio by selling off losers one week before the year term ends.

Sell off winners one week after the year mark. Note Bigger returns matter, especially over long periods, due to the power of compounding. Others who ran their own experiments were not able to duplicate Greenblatt's high returns but still yielded positive results. As a result, investing experts agree that the strategy of magic formula investing outperforms the indexes. In most cases, though, it doesn't seem to beat indexes by as much as Greenblatt indicated when he introduced the concept in his book, The Little Book That Beats the Market.

There are two ratios in the magic formula. EV is preferred to share price because EV also factors in the company's debt. The second ratio focuses on the earnings relative to tangible assets.