In 2009 Joel Greenblatt published The Little Book that Beats the Market in which he details Magic Formula Investing, a method that has since garnered a lot of attention. Greenblatt’s formula is said to beat the S&P 500 96% of the time and produce a 17-year average annual return of nearly 31%.
Greenblatt’s formula depends on several critical components, but the concept boils down to building the right investment portfolio and maintaining that portfolio over a long period of time. By following the components of Magic Formula Investing, you will be able to build the right portfolio.
The essential steps to build your portfolio include:
* Selection of stocks with a minimum market capitalization of $50 million or more.
* Exclude stocks of financial organizations and utilities.
* Exclude shares of foreign companies.
Choosing the right stocks that meet the minimum market capitalization can be achieved by following a few additional steps. First you need to determine the annual profit yield of the company. You also need to know the return on capital of the business.
You will select your stocks by ranking all those above the market capitalization threshold, taking into account those with the highest yield and return on capital. You may not be able to invest in stocks that rank in the top 5 or 10 results of this system; however, you should invest in stocks that are in the top 20-30 in order to take advantage of the magic formula.
Additionally, there are other steps that need to be incorporated into your investing methods in order to adhere to Greenblatt’s formula. You will want to track the performance of your stocks over a twelve month period. Top performers will rack up 2-3 positions per month over the course of a year.
Each year, you will need to rebalance your portfolio, which may include selling underperforming stocks as well as outperforming stocks. Those that have performed poorly in recent months are expected to sell a week before the one-year ownership mark. The ones that performed well should be sold a week after that mark.
By consistently maintaining these methods over a 3-5 year period, you will follow Greenblatt’s Magic Formula Investing.