Magic Formula Investing Stock Ranking Guide

Core Description

• Magic Formula Investing is a rules-based approach to stock selection that looks for companies that are both “good” (high profitability) and “cheap” (attractive valuation).
• It ranks a chosen stock universe using 2 signals, Return on Capital (ROC) and Earnings Yield (EY), and then buys a diversified basket of the top-ranked names.
• Any potential edge comes from disciplined repetition (screen, buy, hold, rebalance), rather than predicting news, macro cycles, or short-term price movements.

Definition and Background

What Magic Formula Investing means

Magic Formula Investing is a systematic stock selection method introduced by Joel Greenblatt and popularized in The Little Book That Still Beats the Market. Instead of building an individual thesis for each company, the method uses a simple ranking system to identify firms that appear both high-quality and undervalued. In practice, investors run the same screen repeatedly and accept that the strategy may feel uncomfortable during periods when “cheap” stocks remain unpopular.

Why it sits between value and quality

Traditional value investing often starts with low valuation multiples and then asks, “Is this cheap for a temporary reason or a permanent reason?” Quality investing often starts with durable profitability and then asks, “Am I paying too much?” Magic Formula Investing combines both questions upfront: it prefers companies with strong operating economics (quality) and a price that does not fully reflect those economics (value). This “quality + value” blend is one reason Magic Formula Investing is often discussed alongside factor investing concepts.

The intuition in one sentence

If a company can generate strong operating profits with relatively little operating capital (high ROC), and the market price for the whole business is not demanding (high EY), then patient investors may be compensated for buying what is profitable but temporarily out of favor, while accepting that outcomes are uncertain.

Calculation Methods and Applications

The 2 core signals: ROC and EY

Magic Formula Investing typically uses:

• Return on Capital (ROC) as a proxy for business quality and operating efficiency.
• Earnings Yield (EY) as a proxy for how inexpensive the business appears relative to operating earnings.

Because financial statements can be noisy quarter to quarter, many screens use TTM (trailing 12 months) operating results so a single strong or weak quarter does not dominate the ranking.

The key formulas (kept minimal and standard)

A commonly used Greenblatt-style ROC definition is:

\[\text{ROC}=\frac{\text{EBIT}}{\text{Net Working Capital}+\text{Net Fixed Assets}}\]

And Earnings Yield is often expressed as:

\[\text{EY}=\frac{\text{EBIT}}{\text{Enterprise Value}}\]

Where Enterprise Value (EV) is typically computed as market capitalization plus debt-like claims minus cash-like holdings. The key idea is not the algebra. It is that EV attempts to measure the price of the entire business, not just the equity.

Ranking and selection workflow (how the screen becomes a portfolio)

A standard Magic Formula Investing workflow is:

1. Define a stock universe (for example, listed companies above a liquidity threshold).
2. Calculate ROC and EY for every company in that universe, often using TTM EBIT.
3. Rank companies by ROC (higher is better) and by EY (higher is better).
4. Combine ranks (for example, add the 2 rank numbers) and sort by the combined score.
5. Select top names into a diversified basket (many implementations use 20 to 50 stocks).
6. Rebalance on a schedule (often annually), replacing names that fall in rank.

What each metric captures (quick reference)

Common data handling choices (beginner-friendly)

Magic Formula Investing looks simple, but rankings can change materially if inputs are inconsistent. Investors commonly improve comparability by:

• Using TTM figures consistently across all companies.
• Removing non-recurring operating items when they are clearly disclosed (without inventing adjustments).
• Applying liquidity and size filters so the basket is tradable with reasonable spreads.
• Excluding sectors where ROC and EV comparisons are structurally different (many investors exclude financials because debt and working capital behave differently in banking).

Where it is applied in real life

Magic Formula Investing is used in different ways:

• Retail investors may use it as a disciplined shortlist generator, then do basic checks (balance sheet, one-off earnings, business model stability).
• Quant and value funds may use ROC and EY as inputs, but often add risk controls (sector limits, turnover control, liquidity constraints).
• Advisors and model portfolio builders may treat it as a rules-based tilt toward value + profitability rather than a standalone promise.

Comparison, Advantages, and Common Misconceptions

Magic Formula Investing vs. traditional value investing

Traditional value investing often relies on multiple valuation tools (P/E, P/B, cash flow, asset value) plus qualitative judgment about catalysts and downside protection. Magic Formula Investing narrows valuation to EBIT relative to Enterprise Value and pairs it with ROC, which reduces discretion. The trade-off is that it may miss special situations where accounting metrics are temporarily distorted but a strong thesis exists.

Magic Formula Investing vs. quality investing

Quality investing can focus on stability, governance, moat strength, and conservative balance sheets, sometimes tolerating high prices. Magic Formula Investing enforces valuation discipline through EY. However, Magic Formula Investing does not automatically screen for low leverage, stable margins, or earnings smoothness, so “high ROC” is not the same as “low risk.”

Magic Formula Investing vs. multi-factor models

Multi-factor portfolios often balance value, quality or profitability, momentum, size, and volatility with explicit risk constraints. Magic Formula Investing is a simpler rules-based proxy for “value + quality” using only 2 signals. That simplicity can be helpful for learning and consistency, but it also means fewer built-in controls for concentration, drawdowns, and regime shifts.

Advantages (why investors keep revisiting it)

• Discipline over storytelling: The rules reduce emotional decision-making and headline-driven trading.
• Simple, scalable screening: ROC and EY can be computed for large universes without building a forecast model.
• May reduce some classic value traps: Pairing cheapness (EY) with profitability (ROC) aims to avoid the lowest-quality “cheap” names.
• Process clarity: You can verify whether you followed the method because the steps are explicit.

Limitations and practical risks (what can go wrong)

• Cyclicality and extended underperformance: A Magic Formula Investing portfolio can lag for years, especially during momentum-led or growth-led regimes.
• Accounting noise: EBIT can be distorted by one-offs. Capital bases can be distorted by acquisitions, write-downs, or intangible-heavy business models.
• Sector and industry clustering: Even with 30 to 50 stocks, holdings can cluster in similar business types if the screen favors them.
• Implementation friction: Bid-ask spreads, taxes, and turnover can reduce realized results versus clean backtests.

Common misconceptions to correct early

“Magic Formula Investing always beats the market”

The method does not guarantee outperformance. It is a systematic way to seek exposure to profitable, lower-valuation companies, while accepting that results may vary and may not appear within a specific time horizon.

“A high Earnings Yield means it’s safe”

A high EY can indicate undervaluation, but it can also reflect deteriorating fundamentals, litigation risk, high leverage, or cyclically peak earnings. Magic Formula Investing is a screening method, not a safety label.

“If I hold 30 stocks, I’m automatically diversified”

Diversification depends on economic exposure, not just the number of names. If many holdings share the same drivers (commodities, rates, regulation, inventory cycles), correlations can be high.

“Backtests prove what will happen next”

Backtests can help you understand behavior (turnover, drawdowns), but real-world performance depends on data quality, trading costs, taxes, and market regimes.

Practical Guide

Step 1: Define an investable universe

Start by defining what you can realistically trade. Many Magic Formula Investing implementations:

• Exclude illiquid stocks to reduce slippage.
• Use a minimum market cap or volume threshold.
• Optionally exclude financials and utilities if ROC and EV comparisons are not meaningful for your process.

The goal is not to maximize the number of names. It is to ensure the screen produces candidates you can execute and monitor consistently.

Step 2: Collect consistent inputs (TTM and the same currency base)

Use one consistent time basis (often TTM) and ensure you are not mixing restated and non-restated figures across companies. For Enterprise Value inputs, verify that debt and cash are categorized consistently. Small classification errors can move a stock many places up or down in a ranking.

Step 3: Calculate ROC and EY, then rank

Compute ROC and EY for each company, rank each metric from best to worst, and combine ranks into one composite score. A simple combined-rank method is easy to audit and can reduce the temptation to optimize the formula after seeing results.

Step 4: Build the basket (portfolio construction basics)

A typical Magic Formula Investing portfolio uses equal weights or near-equal weights to avoid 1 or 2 names dominating results. Investors often select 20 to 50 stocks to diversify idiosyncratic risk while still expressing the ranking signal. If you cannot manage that many positions, consider whether concentration risk becomes too high for a rules-based approach.

Step 5: Rebalance with a schedule you can follow

Many investors rebalance annually. Some stagger entries and exits over months to reduce timing risk and spread trading and tax events. The key is consistency. If you change the schedule whenever results feel uncomfortable, you may capture volatility without capturing the intended long-horizon exposure.

Step 6: Add light “sanity checks” without breaking the method

Some practitioners add limited checks that do not turn the process into discretionary stock picking, such as:

• Excluding companies with clearly distressed financial statements (for example, near-term solvency concerns).
• Removing obvious one-off EBIT spikes where filings show earnings are non-recurring.
• Enforcing a liquidity rule so execution remains realistic.

The aim is to reduce avoidable, data-driven mistakes, not to override the ranking because a narrative sounds more persuasive.

Case Study (hypothetical, for education only, not investment advice)

Assume an investor uses Longbridge ( 长桥证券 ) tools and external financial statements to screen a U.S. large- and mid-cap universe and selects 30 stocks by combined ROC and EY ranks, equal-weighted.

Two example candidates from the ranked list (numbers are simplified and hypothetical):

• Company A (industrial services)
  • TTM EBIT: \$420 million
  • Net Working Capital + Net Fixed Assets: \$1,800 million
  • EV: \$5,250 million
  • ROC ≈ 23.3%, EY ≈ 8.0%
• Company B (specialty manufacturer)
  • TTM EBIT: \$260 million
  • Net Working Capital + Net Fixed Assets: \$1,600 million
  • EV: \$3,250 million
  • ROC ≈ 16.3%, EY ≈ 8.0%

Even with the same EY, Company A ranks higher on ROC, so it may score better in the combined rank. The investor buys the basket, holds for 12 months, then re-ranks using updated TTM data. Some stocks drop out because ROC falls (profitability weakens) or EY falls (valuation rises), and replacements are added from the new top ranks. The investor tracks turnover, trading costs, and whether the basket becomes overly concentrated in one industry, adjusting only universe rules (such as liquidity thresholds) rather than applying discretionary “story-based” overrides.

Resources for Learning and Improvement

Books and primary sources

• The Little Book That Still Beats the Market (Joel Greenblatt): a clear introduction to the rationale and the rules behind Magic Formula Investing.

Terminology and concept refreshers

Investopedia-style references can help confirm definitions for EBIT, Enterprise Value, Return on Capital, and rebalancing mechanics. This can help avoid mix-ups such as using net income when EBIT is intended.

Research context (to set expectations)

Academic and practitioner research on value and profitability or quality factors can help explain why ROC and EY might work over long horizons, why underperformance happens, and why transaction costs and turnover matter. Focus on work discussing robustness, trading frictions, and regime dependence, rather than only headline backtest returns. When using any external data or statistics, cite the original source.

Tooling and process hygiene

Brokerage screening features (for example, within Longbridge ( 长桥证券 )) can help with consistent filtering and watchlists, but it is important to validate key inputs with audited filings when something looks unusually strong or unusually inexpensive.

FAQs

What is Magic Formula Investing?

Magic Formula Investing is a rules-based stock selection approach that ranks companies using Return on Capital (ROC) and Earnings Yield (EY) to identify businesses that appear both profitable and attractively valued, then holds a diversified basket and rebalances on a schedule.

Does Magic Formula Investing guarantee outperformance?

No. The strategy can underperform for multi-year periods. It aims to gain systematic exposure to profitability and valuation characteristics, but outcomes depend on market regimes, implementation costs, taxes, and whether the rules are followed consistently.

How many stocks are typically held in a Magic Formula Investing portfolio?

Many implementations hold roughly 20 to 50 stocks to reduce single-stock risk. Holding too few can make results dominated by a small number of names, while holding too many can dilute the ranking effect and increase complexity.

How often should I rebalance?

Annual rebalancing is common. More frequent rebalancing can increase turnover and costs. Some investors stagger trades over time to reduce timing risk. The key is using a schedule you can follow without frequent rule changes.

Why do many screens exclude financials and utilities?

For banks and insurers, leverage and working capital are part of the operating model, so ROC and EV comparisons can be less meaningful. Utilities often have regulated returns and heavy fixed assets that can systematically distort ROC rankings.

What are the biggest practical pitfalls?

Common pitfalls include treating high EY as “safe,” ignoring sector concentration, relying on noisy EBIT without checking one-offs, underestimating transaction costs and taxes, and abandoning the process during inevitable periods of underperformance.

Can I add extra filters on top of Magic Formula Investing?

Yes, but each filter changes the strategy’s behavior. If you add filters, keep them limited and based on clear economic or implementation reasons (liquidity, obvious accounting distortions, extreme financial distress), not because they merely improve a backtest.

Conclusion

Magic Formula Investing can be understood as a repeatable framework: rank companies on ROC and EY, buy a diversified basket, and rebalance with discipline. Its simplicity is a key feature, but it can be misused if investors ignore accounting quality, trading frictions, concentration risk, and the possibility of extended underperformance. When approached as a long-horizon process rather than a prediction tool, Magic Formula Investing can be a structured way to study how profitability and valuation interact in real-world stock selection.