Magic Formula Investing is an investment strategy developed by Joel Greenblatt, a hedge fund manager and professor, which aims to systematically identify and invest in high-quality companies that are undervalued by the market. The strategy is designed to be simple and accessible to individual investors, relying on a formulaic approach to select stocks with a high potential for long-term outperformance.

Key Components of Magic Formula Investing:

1. Quality and Value Criteria: The magic formula combines two key financial metrics to rank companies:
   • Return on Capital (ROC): This measures the efficiency of a company in generating profits from its capital. A high ROC indicates a company is using its capital effectively to produce strong returns.
   • Earnings Yield: This is the inverse of the price-to-earnings (P/E) ratio and represents the earnings generated by a company relative to its share price. A high earnings yield suggests that a company may be undervalued relative to its earnings.
2. Ranking Process: The strategy involves ranking a large universe of stocks based on their ROC and earnings yield. Each company is assigned a rank for both metrics, and these ranks are then combined to form an overall ranking. The companies with the best combined rankings are considered the most attractive investments.
3. Diversification: Greenblatt’s strategy recommends investing in a diversified portfolio of the top-ranked stocks. Typically, investors would select the top 20 to 30 stocks from the rankings and hold them in their portfolio.
4. Annual Rebalancing: The portfolio is generally rebalanced once a year, with underperforming stocks being sold and new top-ranked stocks being added. This allows the portfolio to continuously reflect the most promising opportunities according to the formula.
5. Long-Term Focus: Magic Formula Investing is designed for long-term investors. Greenblatt suggests holding the stocks for at least one year to allow the market time to recognize the value of the selected companies, and to potentially benefit from favorable tax treatment on capital gains.
6. Simple Implementation: One of the appeals of Magic Formula Investing is its simplicity. The strategy does not require complex analysis or deep financial expertise. It can be implemented by individual investors using publicly available financial data and simple ranking techniques.

Performance and Criticism:

• Historical Performance: Greenblatt’s research and backtesting suggest that the magic formula has historically outperformed the broader market over long periods. However, like all strategies, it may underperform in certain market conditions or over shorter time frames.
• Criticism and Limitations: Critics argue that the strategy may not always work in all market environments, and its simplicity might overlook other important factors. Additionally, the magic formula tends to favor smaller companies, which can be more volatile and carry higher risks. Some also caution that the strategy might become less effective if it becomes too widely adopted.

In summary, Magic Formula Investing is a rules-based strategy that seeks to identify and invest in high-quality companies that are undervalued by the market. By combining simplicity with a focus on key financial metrics, it offers a straightforward approach for individual investors to potentially achieve superior long-term returns.