A New, Easy Way to Use the Magic Formula

If you read articles from Rising Star Jim Royal, you probably know about the Magic Formula. If you don't (on either account), you probably should. I recently found a new screener (yes, another) that offers all the detailed criteria you need to get into the gritty details of the formula and profit greatly from Joel Greenblatt's wisdom.

The foreword to Greenblatt's The Little Book That Beats the Market states that the best thing about it is that most people won't believe it, and that's probably true. The book details what he calls the Magic Formula, a deceptively simple strategy that from 1988 to 2004 would have returned an average return of 30.8% annually, with only one down year.

Sounds crazy, right? But the formula actually relies on two simple ideas: finding profitable companies, and buying them at low prices.

Here's how it works:

• Start with companies that are based in the United States, and eliminate any financial or utility companies.
• Set a minimum market cap. Some studies have shown that Magic Formula results are skewed more toward smaller caps, so I set my minimum at $300 million.
• Screen for companies with returns on assets of at least 25%.
• To weed out any anomalous results, screen out companies with a P/E below 5 and any companies that reported earnings in the last couple of weeks.
• From this list, buy the top five to seven stocks ranked by lowest P/E. Repeat every two to three months until you have about 20 to 30 stocks.
• Sell each stock after one year, adding a few days on winners for tax efficiency.

To do this, I used Screener.co, which allows you to screen by all of these criteria -- even the earnings-report filing date -- and also allows screening by P/E excluding extraordinary items, to further weed out anomalies. You can then export the results to a spreadsheet to keep track of them. These are the first seven stocks that the screener came up with, which you'd buy if you started the strategy today:
 

Company	Return on Assets	P/E (Excluding Extraordinary Items)
Power-One (Nasdaq: PWER  )	31%	6.16
Nanometrics (Nasdaq: NANO  )	29%	6.32
Veeco Instruments (Nasdaq: VECO  )	27%	6.35
The Medicines Company (Nasdaq: MDCO  )	27%	6.54
Rubicon Technologies (Nasdaq: RBCN  )	28%	7.11
ITT Educational Services (NYSE: ESI  )	54%	7.29
Aeropostale (NYSE: ARO  )	29%	7.44

Source: Screener.co.

There's no guarantee that the Magic Formula will continue to work going forward, but it's certainly a great example of how investing doesn't need to be overly complicated and how simple concepts can still be profitable.

For more Foolishness:

• The Magic Formula for Teck Resources
• A Foolish View of a Magic Formula
• Beyond "The Little Book That Beats the Market"