Magic Formula stocks hit a sweet-spot in the market recovery

Value investing has had a rough ride over the past 10 years. The part-art, part-science discipline of buying stocks that are cheap relative to what they earn or what they own is a well-worn strategy, but it’s also a painful one when it’s out of favour.

Over many decades, research shows undeniable outperformance from value strategies over time. But between periods of market-beating returns, value has spells in the wilderness. It’s these moments of agony that mean many value investors – professionals included – struggle to stick with their strategies. And this is what we’ve seen over the past decade.

Back in 2005, an American investor called Joel Greenblatt came up with a new kind of value strategy that still resonates with investors today. In The Little Book That Beats the Market, he set out an approach that blends value with quality and ranks the entire market for how relatively ‘good and cheap’ each stock is.

With this approach, Greenblatt said investors could easily find companies that might be genuinely underpriced. Sure, the list would often contain broken and unloved shares. And given that this was still a value strategy, there would certainly be disappointments. But his so-called ‘Magic Formula’ would offer a higher probability of success.

A model of the Magic Formula strategy applied to the UK market shows just how good – but also how variable – the results can be. Between 2017 and 2019 it delivered reasonable returns, but like many other strategies, the market crash of 2020 hit it hard. Since then, we’ve seen a steady recovery in the performance of Magic Formula stocks – especially since last autumn. Tracking of quarterly re-balanced portfolio of Magic Formula stocks has seen it deliver an 82.8% return (pre-costs) over the past year.

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How the Magic Formula works

Greenblatt’s strategy uses two simple ratios: the earnings yield as a measure of ‘cheapness’ and return on capital as a measure of ‘quality’.

Earnings yield tells you how much profit a company is making in relation to its underlying value. To take account of varying levels of cash and debt in companies, a widely used way of working it out is to divide what the company earns in operating profit by its total valuation (known as the enterprise value). You can then apply this earnings yield to every company in the market to see which are offering the best value – the higher the yield, the cheaper the company and the more bang you get for your buck.

The return on capital focuses on how good a company is at generating a profit from the investment it makes in itself. Good quality companies are very efficient at delivering high percentage returns from the cash they reinvest to grow. It might be opening new stores, expanding product lines or buying new plant and equipment. The return on capital is the percentage improvement in profits relative to that investment. That makes it a leading indicator of good quality companies that can grow profitably.

Greenblatt’s strategy scores every company on each ratio and then adds the scores together to get a Magic Formula for each one. This means that you can rank the market for companies with the best blend of cheapness and quality and always find results. Here is a selection of the current highest ranking shares…

In the bullish conditions of recent years, the Greenblatt approach produced sometimes scary results. But in the current conditions, it’s detecting a range of larger and more familiar names.

The genius of Greenblatt’s strategy lies in its simplicity. The combination of value and quality puts it in the territory of two of the strongest return-drivers in the stock market. And at any time, this ranking approach will come up with ideas. Like many value strategies, the Magic Formula hits a sweet-spot when the market is in recovery mode. It picks up shares that may be out of favour and underpriced as a result. As the performance of the past 12 months shows, it can deliver very strong returns when the conditions are right.

Stockopedia