Magic Formula Investing: Does Greenblatt's Method Work?

Joel Greenblatt's magic formula investing is one of the simplest systematic approaches to picking stocks. Laid out in his book "The Little Book That Beats the Market," the strategy ranks companies by just two metrics - earnings yield and return on capital - and invests in the highest-ranked names. Greenblatt's backtested results showed annualised returns of roughly 30% over a 17-year period, far ahead of the S&P 500. But can UK retail investors actually replicate those returns?

How the Magic Formula Works

The magic formula combines two financial metrics to find companies that are both cheap and high-quality:

Earnings Yield is calculated as EBIT (Earnings Before Interest and Taxes) divided by enterprise value. This measures how much profit you get for each pound of the company's total value. It is similar to the inverse of the P/E ratio, but uses enterprise value instead of market capitalisation, which accounts for debt.

Return on Capital (ROC) is calculated as EBIT divided by the sum of net working capital and net fixed assets. This measures how efficiently a company turns its invested capital into profits. High ROC companies tend to have durable competitive advantages.

Greenblatt's method ranks all eligible companies on each metric separately, then adds the ranks together. A company that ranks 5th on earnings yield and 3rd on ROC gets a combined score of 8. The stocks with the lowest combined scores go into the portfolio. You hold 20-30 positions, rebalance annually, and repeat.

Does the Magic Formula Actually Beat the Market?

Greenblatt's original backtest (1988-2004) showed the formula returning about 30.8% annually versus 12.4% for the S&P 500. That is a staggering outperformance. However, several caveats apply.

Out-of-Sample Performance Has Been Weaker

Since the book's publication in 2005, the formula's real-world returns have been less impressive. Several independent studies and live fund results suggest the outperformance shrinks to low single digits once you account for transaction costs, taxes, and the fact that many investors cannot stick with the strategy during its inevitable losing streaks. The value premium - the tendency for cheap stocks to outperform expensive ones - is well documented in academic literature, but capturing it in practice is harder than backtests suggest.

Behavioural Discipline Is the Real Bottleneck

The magic formula will underperform the market in roughly one out of every three years. During those stretches, the temptation to abandon the strategy is strong. Greenblatt himself has written about this problem: when he offered investors a choice between a managed version of the formula (where they could not override it) and a self-managed version (where they could), the self-managed investors earned significantly less because they kept second-guessing the picks. This is a pattern Carl Richards calls the behaviour gap - the difference between investment returns and investor returns.

The UK Market Adds Complications

Applying the formula to UK-listed stocks introduces additional challenges. The London Stock Exchange has fewer large-cap companies than the US market, which reduces the pool of eligible stocks. Smaller companies on the AIM market may appear in the formula's output but carry higher liquidity risk. You also need reliable financial data - platforms like SharePad, Stockopedia, or the free data from the LSE website can help, but screening tools built specifically for Greenblatt's formula are mostly US-focused.

How to Apply the Magic Formula as a UK Investor

If you want to test the magic formula with real money, here is a practical approach:

Screen for eligible companies. Use a screening tool that lets you rank by earnings yield and return on capital. Filter out financials and utilities (as Greenblatt recommends) and focus on companies with a market capitalisation above 50 million pounds to avoid illiquid micro-caps.

Hold in a tax-efficient wrapper. Since the formula requires annual rebalancing, the resulting capital gains could be significant. Holding your magic formula portfolio inside an ISA eliminates capital gains tax entirely. A SIPP works too, though you will not be able to access the funds until age 57 (rising from 55 under current rules).

Build the portfolio gradually. Greenblatt suggests buying a few positions each month over the course of a year, then selling each batch after 12 months. This staggers your entry points and reduces the risk of buying everything at a market peak.

Expect to underperform for stretches. The formula's edge comes from mean reversion - cheap, high-quality companies eventually get re-rated by the market. But "eventually" can mean two or three years of lagging behind an index fund. If you cannot tolerate that, a passive approach with low-cost index funds is a better fit.

Magic Formula vs. Passive Index Investing

For most UK retail investors, the honest comparison is not "magic formula vs. doing nothing" but "magic formula vs. a global index fund." A global tracker like Vanguard FTSE Global All Cap charges around 0.23% per year and gives you exposure to thousands of companies worldwide. It requires no screening, no rebalancing decisions, and no emotional discipline beyond staying invested.

The magic formula demands active work, carries concentration risk (20-30 stocks versus thousands), and requires you to hold your nerve during underperformance. The potential reward is higher long-term returns, but only if you execute the strategy consistently over a decade or more. For investors who want to understand what intrinsic value means and are comfortable with individual stock analysis, the magic formula is a reasonable starting framework.

Frequently Asked Questions

What is the magic formula in investing?

The magic formula is a systematic stock-picking strategy created by Joel Greenblatt. It ranks companies by two metrics - earnings yield (how cheap the stock is) and return on capital (how efficiently the company generates profits) - then invests in the highest-ranked names. The goal is to buy good companies at bargain prices.

Does the magic formula work in the UK?

The underlying principles - buying cheap, high-quality companies - apply to any market. However, the UK's smaller stock universe and the dominance of a few sectors (financials, energy, mining) mean the formula produces a less diversified portfolio than it does in the US. Results will depend heavily on the time period and how strictly you follow the rules.

How many stocks should a magic formula portfolio hold?

Greenblatt recommends holding 20-30 stocks at any given time. This provides enough diversification to reduce company-specific risk while keeping the portfolio concentrated enough that the formula's stock selection adds value over a broad index.

Can I use the magic formula inside an ISA?

Yes. Holding a magic formula portfolio in a Stocks and Shares ISA is the most tax-efficient approach for UK investors. All gains and dividends within the ISA are free from capital gains tax and income tax, which matters because the annual rebalancing generates taxable events that would erode returns in a general investment account.

Is the magic formula better than index investing?

It depends on your temperament. The magic formula has historically produced higher returns than broad market indices, but only for investors who follow it consistently through good years and bad. Most investors would be better served by a low-cost index fund, which delivers market returns without requiring active decision-making or emotional resilience during underperformance periods.

Conclusion

Greenblatt's magic formula is a well-reasoned, evidence-backed approach to value investing. The maths behind it is sound: buying profitable companies at low prices tends to work over long periods. But the gap between backtested returns and real-world results is wide, and the strategy demands a level of discipline that most retail investors underestimate. For UK investors willing to put in the screening work, hold through rough patches, and keep costs low inside an ISA or SIPP, the magic formula remains a credible alternative to pure passive investing. For everyone else, a simple global index fund is the safer bet.

Further Reading:

The Intelligent Investor - Benjamin Graham - The foundational text on value investing that underpins Greenblatt's approach, covering margin of safety and disciplined stock analysis. (Affiliate link - we may earn a small commission at no extra cost to you.)

The Little Book of Common Sense Investing - John Bogle - The strongest case for why most investors should choose index funds over stock-picking strategies like the magic formula. (Affiliate link - we may earn a small commission at no extra cost to you.)

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Magic Formula Investing: Does Greenblatt's Method Work?

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