Get Some Magic in Your Stock Portfolio

Joel Greenblatt, who runs Gotham Asset Management and is a professor at Columbia University, wrote a book in 1997 with a very long title: "You Can Be a Stock Market Genius (Even if You're Not Too Smart): Uncover the Secret Hiding Places of Stock Market Profits." Greenblatt, who was a very successful hedge fund operator (Gotham Capital), wrote a book that was even more popular, "The Little Book That Beats the Market" in 2005 and updated in 2010 about magic formula investing.

What The Magic Formula Is

The magic formula, defined by Greenblatt in the book, helps find a company that is rated highly on two different metrics, Earnings Yield and Return on Capital. While these are both good areas for people who want to beat the market and prove that the "random walk" is not true, the magic formula isn't so clear and does not cover all stocks. The book specifically states that Financials and Utilities are excluded.

Earnings yield is defined as EBIT divided by enterprise value, with the EBIT the latest 12-month period. The balance sheet items are from the most recent balance sheet. Many investors use net income or adjusted net income and compare it to market cap or use EBITDA and compare it to enterprise value. This part of the magic formula makes sense to me and seems relatively easy to calculate.

The Return on Capital is a bit tougher. The book states that EBIT should be compared to tangible capital employed, which it defines as net working capital plus net fixed assets. I like the idea of disregarding intangibles that can distort measures like Return on Equity or Return on Assets. The challenge, though, is that net fixed assets and net working capital are subject to the analyst's choices in many cases.

The book suggests taking a universe of stocks and ranking them by Earnings Yield and Return on Capital. To get the final rank of a stock by the magic formula, the ranks are added to each other and then compared. This suggests that the weighting is 50/50 between Earnings Yield and Return on Capital.

The magic formula, then, helps investors to pick the stocks with the best of these two attributes. Portfolios created by this technique have performed well in the past, and the book did a good job of quantifying it. In the appendix of the follow-up book from 2010, Greenblatt shares two concepts: Buying good companies at bargain prices makes sense and it can take a while for the market to recognize a bargain and for it to play out. 

I like what Greenblatt did with these books. I believe that investors can find great companies at good prices. I spent a lot of time working on figuring out how to identify magic formula stocks for a project with an investment manager who uses the concept in its client portfolios. For those who want to learn more about the magic formula, Seeking Alpha contributor Dividend Yield Theorist shared an article earlier this month that I found fascinating, The New Magic Formula For Investing.

The Stocks That Qualify As Magic Formula Now

Every single day, a list of magic formula stocks changes. Why? Prices change daily!

Those who believe in the concept of investing in companies with high Earnings Yield and Return on Capital , can build their own systems to create universes. They might use a different type of Earnings Yield or Return on Capital than Greenblatt suggested, and they might weight them non-equally.

The good news is that Gotham Asset Management provides a stock screener on its website that allows visitors to get a current list of the top magic formula stocks. :

Visitors must register, but it is free of charge. In the book, Greenblatt suggests buying at least 20 stocks, and the website lets visitors get a list of the top 30 or the top 50. Here is the current top 30 (for market caps in excess of $10 billion) as of March 27th listed alphabetically:

How You Can Use These Ideas

So, investors who want a low-cost way to implement investing by Greenblatt's magic formula can visit the website and get a list of stocks to consider free of charge. The book points out that for tax reasons, the holding period should be about a year for each stock, as losses can be taken and short-term gains can be pushed to long-term by waiting until a full year has passed since purchase. As Greenblatt points out in his book, there is a lot of work involved in managing a portfolio like this.

For those who want to invest by these principles, they can find managers who adhere to these rules. I don't have that list of managers, but surely Gotham Asset Management must pursue this strategy. Gotham Funds has three mutual funds and three ETFs, but it's not clear that they are pursuing this magic formula extensively. More broadly, there are plenty of managers out there that try to find high quality businesses trading at attractive prices.

Those who manage their own investments can build a model to replicate the magic formula or to tweak it. I use Koyfin, which is not that expensive, and I have built a screening tool. I have long believed that stocks with low valuations can make sense, and one of the metrics I use is price to tangible book value. I look for companies that trade with low enterprise value relative to adjusted EBITDA.

Calculating these things is quite simple in my view, as the accounting statements reveal the capital structure and historical earnings. The challenge for investors is the future! Many companies have analyst projections, so investors can work with them to assess the metrics ahead.

I have been using stock screeners for quite a long time. I really liked a company StockVal and used it regularly, but it was acquired by Reuters Group in 2001. It was closed down when Reuters merged with Thomson in 2008. There are lots of stock screening systems out there, but after a long search, I am glad that I found Koyfin.

For this article, I have created a new screen that merges two of my existing screens. I am looking for companies that have reasonably low price-to-tangible book values and seemingly reasonable valuations. Here are the parameters I used for this screen:

• Stocks must trade on the NYSE,NYSE Arca or NASDAQ

• Market cap above $10 billion (722 stocks qualify at this point)

•  EV/EBIT below 16X but above 6X (185 names)

• Return on Capital above 9% (103 names)

103 names that me these criteria is more names than the top 30 from the Magic Formula Investing Website, but I have allowed Financials (14 qualified) and Utilities (zero qualified ). Of the 30 that were listed above, 8 did not make my screen, including CGI Inc., CVS Health, Omnicom Group, Pfizer, Solventum, The Cigna Group, The Kraft Heinz Company and Zoom Communications.

There were 4 Communications Services names, 14 Consumer Discretionary names, 11 Consumer Staples names, 8 Energy names, 14 Healthcare names, 14 Industrials names, 15 Information Technology names, and 9 Materials names. The entire group of 103 names had an average EV/EBIT ratio of 12.0X, ranging from 6.7X to 12.0X and an average ROC of 15.55%, ranging from 9.03% to 43.84%. While I had wanted to screen on price to tangible book but did not do so, the highest reported value was 68.1X, with a low of 1.5X excluding the negative tangible equity names. The year-to-date price returns are between -46.2% and 81.5%, with an average of -2.2%.

I think that investors are well served by doing a lot of digging on stocks in which they invest, and this group of 103 stocks includes a few that I include on my personal watchlist, including Adobe (ADBE), which I just added to that list recently and which bought some yesterday, Altria (MO), Bristol-Myers (BMY), Carlisle (CSL), Deckers Outdoor (DECK), EOG Resources (EOG), NetApp (NTAP), PayPal Holdings (PYPL), Sysco (SYY), T. Rowe Price (TROW) and Williams-Sonoma (WSM). I like TROW, which my wife owns. 

The market is beaten up, and reducing this group to those that are down 21% or more year-to-date leaves some interesting stocks:

I highlighted the nine names that are in the current list of 30 stocks on the Magic Formula Investing screen. There was one Financial stock that made this list, PYPL, and it is interesting in my view.

Information Technology stocks are weak in 2026, but within that sector there is a big divergence. Semiconductor stocks are generally soaring, while software stocks are getting hammered. Of these 17 names, 4 are software stocks, including the one that I own, ADBE. I also own State Street SPDR S&P Software & Services ETF (XSW), which I wrote about in late February and explained why I like it. That article may be limited to Seeking Alpha subscribers, but I wrote on my blog at Seeking Alpha a piece on XSW that is open to the public, Buying Beaten-Up Software Stocks.

So, this screening process can help investors who want to focus on companies with relatively high Return on Capital and/or low valuation. 

Conclusion

I think that the ideas that Joel Greenblatt has shared for the past several decades are very strong, and I praise him and his firm for sharing the website that they offer. I am not trying to outdo him and come up with a more magical formula. What I am trying to do is to show readers how they can incorporate Greenblatt's thinking into their stock-hunting process.

As his book points out well, magic formula investing won't work all the time. I focused in this article on beaten-up stocks, but sometimes the winners keep winning. I did minimize market cap at $10 billion, but there are likely some great opportunities below that level in market cap. While I like the idea of magic formula investing, it is not the exclusive way to invest.