Using the “Magic Formula”

by Larry

Holmes

Disclaimer

This is not personal investment advice or a recommendation to buy or sell any particular security and

past performance in not necessarily an indication of future performance

Disclaimer

All personal investment decisions should be made in the context of your own financial planning goals

and tolerance for risk

Disclaimer

I am not affiliated with Joel Greenblatt or his firm and I don’t benefit

financially from the sale of his books

The Little Book That Beats The Marketby Joel Greenblatt

• The founder and a managing partner of Gotham Capital

• Average annual returns of over 40% for over 20 years

There’s a crazy guy named Mr. Market

“… if you stick to buying good companies … and to buying

those companies only at bargain prices … you can end up

systematically buying many of the good companies that crazy

Mr. Market has decided to literally give away.”

-- The Little Book That Beats The Market (p. 45)

Question: What’s a good business?

Question: What’s a good business?

Answer: One with a high return on capital

Question: What’s a bargain price?

Question: What’s a bargain price?

Answer: A business with a high earnings yield

Okay, so what’s the Magic Formula?

Return on Capital

EBIT / (Net Working Capital + Net Fixed Assets)

Earnings Yield

EBIT / Enterprise Value

“… what would happen if we decided to only buy shares in good businesses

(ones with high returns on capital) but only when they were available at bargain prices

(priced to give us a high earnings yield)?”

“What would happen? Well, I’ll tell you what would happen…

We would make a lot of money!”

-- The Little Book That Beats The Market (p. 51)

From 1988-2004, “owning a portfolio of approximately 30 stocks

that had the best combination of a high return

on capital and a high earnings yield

would have returned approximately

30.8 percent per year.”

-- The Little Book That Beats The Market (p. 52)

Note: The S&P 500 index returned 12.4 percent per year

Question: Why will the Magic Formula

continue to work after everybody knows about it?

Question: Why will the Magic Formula

continue to work after everybody knows about it?

Answer: Because it doesn’t always work

“The magic formula portfolio fared poorly to the market

averages in 5 out of every 12 months tested.”

“For full-year periods, the magic formula failed to beat the market averages once every four years.”

“For one out of every six periods tested, the magic formula did

poorly for more than two year in a row.”

“During those wonderful 17 years for

the magic formula, there were even

some periods when the formula did worse than the overall market for

three years in a row!”

-- The Little Book That Beats The Market (p. 70)

Step 1

Step 2

magicformulainvesting.com

Step 3

Follow the instructions to get a list of the best businesses

selling at a bargain price

Step 4

Buy five to seven of the top-ranked companies

Note: Smaller accounts may want to use brokers like foliofn.com

Step 5

Repeat Step 4 every two to three months. After nine or ten months you should have a

portfolio of 20 to 30 stocks

Step 6

Sell each stock after holding it for one year. Use the proceeds to buy more Magic Formula stocks

according to Step 4

Step 7

Continue the process for many years

Note: Don’t even think about evaluating performance for at least three to five years

Step 8

Send Joel Greenblatt a note and say thank you!