Understanding Magic Formula Investing in India: At the peak of his investing career, Rakesh Jhunjhunwala was often referred to as the Midas of investing. While from a distance, the speculators of the Indian market admired him, not many could match his investment success.
A benchmark to understand if you’re a good investor is to compare your personal portfolio’s performance and that of the major indices such as SENSEX and NIFTY. If your average year-on-year return is higher over the last few years, then you can pat yourself for doing a good job in the market.
So what strategies do you use to become a better investor?
One strategy you can learn is the Magic Formula Investing strategy, developed by Joel Greenblatt.
The Man Behind The Plan
Joel Greenblatt is a former hedge fund manager and investor who formulated the strategy and published it in his book in the year 2005, The Little Book That Beat The Market. The book was later revised and published as The Little Book That Still Beats The Market.
Prior to publishing his book, he had written a report “ How the small investor can beat the market” which was published in The Journal Of Portfolio Management.
Greenblatt is the founder and former fund manager of Gotham Asset Management. Gotham Asset Management was one of the backers of Micheal Burry, who wanted to start his own hedge fund in 2000, Scion Capital Management. He graduated from the Wharton School at the University of Pennsylvania.
Joel runs Gotham Funds with partner Robert Goldstein and is currently an adjunct professor at the Columbia University Graduate School Of Business.
What Is Magic Formula Investing?
According to Joel Greenblatt, magic formula investing doesn’t require an individual to have complex knowledge to practice this strategy. He first described it in his book The Little Book That Beats The Market and again in the revised edition called – The Little Book That Stil
In the book, the author prioritizes two key criteria – The Stock Price and the Cost Of Capital.
Instead of doing the fundamental analysis yourself, you can use the stock screener of Greenblatt himself and select the top 30 companies to invest in. That screener has a few filters that are based on –
- Earnings Before Interest and Taxes (EBIT)
- Earnings Per Share (EPS) divided by Current Market Price
- Return on Capital Employed (ROCE)
Profits off stocks are charged differently based on various factors and one of them is if they’re within one year or beyond.
So investors can write off losses incurred by selling off loss-making stocks within a year and just after the one-year mark, they can sell the profitable stocks to get charged a lower tax rate.
Requirements For Magic Formula Investing in India
As Joel Greenblatt is based in the US, naturally his formula only applies to companies that are beyond Rs. 20,000 Cr. This keeps small-cap stocks out of the picture completely. He also has other criteria that should be met in order to make the strategy work better.
They are –
- Ignores the Small Cap category.
- Exclude Financial and Utility Stocks
- Calculate Earnings Yield which is – EBIT / (Net Fixed Assets + Working Capital)
- Calculate Return On Capital Employed (ROCE)
- Rank Companies by Earnings and ROCE
- Purchase two to three positions in the top 20 companies every month.
- Rebalance your portfolio exactly before the end of the Financial Year – Sell Losing stocks before the year ends and winning stocks after the year ends.
- Repeat for 5 to 10 years.
Greenblatt’s recipe for magic formula investing supposedly gave him a 30% y.o.y. return. Although Independent researchers have found different data, they did observe that his strategy has beaten the returns of the S&P 500.
Pros and Cons Of Magic Investing Formula
|1||Easy To Use and Simple||Returns don’t necessarily match Greenblatt’s claims of 30% returns|
|2||Fact-Based Investing that doesn’t rely on emotions||Other variables could also be added into the mix and rebalancing could be done more often.|
|3||Beats the market’s y.o.y returns.|
When Magic Formula Investing in India Doesn’t Work
While Magic Formula Investing in India is generally easy to work with, there are certain situations where it doesn’t work. Firstly, the formula was made to keep the American markets into consideration, and the goal is to beat the growth rate of their indices. Specifically, the S&P 500. The other special cases are –
- Mid Cap and Small Cap Companies. The formula only takes large-cap companies into consideration work.
- Finance and Utility companies are excluded from the formula completely, which constitutes a hefty part of the indices.
- Foreign Companies also don’t make it into the equation.
- Greenblatt uses a few criteria to select stocks and that could be made more specific using dividend yield.
Is Magic Formula Free?
The Magic Formula of Investing is free on multiple websites that use the formula to find companies for value investing. This also includes Joel Greenblatt’s own website that offers it completely for free.
Many investment firms have been known to have followed Greenblatt’s advice in the 1980s and earned handsome returns for themselves and their clients. But trends tend to change and they don’t last forever. Magic Formula Investing is supposed to help with long-term investing and buy “above-average companies at below-average prices.”
Does the Magic Investing Formula work for India? It depends on your investment strategy and the industries that you understand. That’s all for the blog on the Magic Formula Investing in India. Happy Investing!
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