Moody's Magic Formula

Do you want to invest in stocks but find that you have too many demands on your time to research companies? You have a demanding job, want to spend time with your family, and have a hobby or two.

If you want low-fuss investing options that aren't mutual funds or exchange-traded funds, you should consider a mechanical investing strategy. One of my favorites is Joel Greenblatt's Magic Formula. You can read all about it in his book The Little Book That Beats the Market. This is a great book because it is short, easy to read, and it will help you make money.

Is it cheap?
Value investing is a proven strategy and the first part of the Magic Formula is to screen for stocks that are cheap. The valuation metric that Greenblatt uses in his book is the earnings yield, which he defines as EBIT / enterprise value. EBIT is the profitability (i.e., earnings) of the business before interest payments and taxes. Enterprise value reflects the market value of the company's stock -- its market capitalization -- plus the company's net debt. A company that is generating $1 of EBIT for every $10 of enterprise value has an earnings yield of 10%. For a stable business, the higher the earnings yield the cheaper the stock. The Magic Formula requires an earnings yield greater than 10%.

Is it a good business?
Sometimes stocks are cheap for a good reason. The business may be falling apart, for example. You wouldn't want to buy shares of a company that is statistically cheap if it is on its way to going out of business. This is why the second part of the Magic Formula is to screen for healthy businesses. Greenblatt recommends using return on assets greater than 25%. What that means is that for every $4 in assets -- things like inventory and manufacturing plants, for example -- the company is able to generate $1 in after-tax profit. As a general rule, low ROA is a sign of a poor business and high ROA is a sign of a strong business.

Putting the formula into practice

Source: Capital IQ, a division of Standard & Poor's, and author calculations. Dollar amounts in millions.

Here's an example of the Magic Formula applied to financial services companies. With an earnings yield of 12.1% and a ROA very close to 25% -- let's not split hairs here since this is a wide-moat business -- credit ratings company Moody's is right on the verge of meeting the criteria of the screen. FactSet Research Systems is also close on the ROA measure but falls well short on the earnings yield requirement. Both McGraw-Hill and Morningstar fall well short of the Magic Formula criteria. Even if you like these businesses, you wouldn't buy them with this mechanical strategy.

The Foolish bottom line
The advantage of the Magic Formula for the time-pressed investor is that all you need to do is run the screen and buy the stocks. You don't need to do all the time-intensive fundamental analysis most stock pickers do. Instead of figuring out if you trust management, analyzing the competitive landscape, or poring over financial statements, you get to spend your free time enjoying the activities you like.

Since there is no guarantee that any individual stock that meets these screening criteria will make you money, you need to buy a basket of stocks ranging from five to 30 companies. Once purchased, you hold them for a year to get long-term capital gains tax treatment. After one year has passed, you sell them all and run a new screen. Rinse and repeat.

Like many strategies, this mechanical approach doesn't work every year. Assembling your basket of stocks is the easy part. The hard part is psychologically sticking with the strategy when it's underperforming. That's an important part of making this approach work and you have to be honest with yourself before you get started about whether you have the patience to stick to this strategy year in and year out. It does work, but you have to give it time. If you've used the Magic Formula before or are thinking of giving it a try, share your thoughts with the Fool community in the comments box below.