Magic formula investing is a term used to describe an investment strategy that involves the organized and intentional use of basic value investing principles. The idea is to follow a prescribed formula that increases the potential for earning returns while managing to keep the level of financial risk as low as possible. The technique involves careful selection of investments based on specific criteria as well as evaluating the potential of those companies over a period of three to five years. Proponents of magic formula investing claim a high rate of success, provided each step in the process is followed to the letter.
To fully employ the magic formula investing strategy, an investor needs to provide a relatively high amount of capital for the scheme. This is because the basic approach is built on the idea of identifying 20 to 30 investment opportunities that are highly likely to yield significant earnings within three to five years. For this reason, the number of individual investors who can implement this approach may be somewhat limited. Corporate investors are more likely to have the reserves to manage a strategy of this type without creating undue financial hardship.
One of the key elements in the magic formula investing approach is the selection of companies as potential investments. In general, utility stock options are excluded from consideration. The same is also true with stock options associated with financial corporations. Investment in foreign companies is also discouraged as part of the process. While these prohibitions do seem to exclude a number of viable investment opportunities, the fact is that a significant number of domestic companies remain, with many being worth consideration as part of the investment strategy.
After narrowing the range of companies, the process of qualifying each potential investment begins. This begins with determining the minimum amount of market capitalization that each business must possess in order to be considered for the portfolio. One of the first steps is to determine the earnings yield of the company under consideration, along with the return on capital that the company currently experiences. This provides valuable information regarding the financial stability of the business, and makes it easier to assess the potential for growth in the future.
After investigating a number of investment possibilities, the process of ranking those potential investments begins. Here, the idea is to arrange each company based on both the earnings yield and the return on capital, with the company with the highest yield and return being first on the list. Once completed, the list will feature include anywhere from 20 to 30 investment opportunities, and the investor can begin the task of acquiring shares of stock in each of these companies.
The magic formula investing process does allow for the gradual acquisition of shares in each of the targeted companies. For example, the investor may choose to select two or three for purchase each month, gradually expanding the portfolio over the course of a year. The idea is to own stocks in each of the companies on the list within twelve months of making the purchase of shares in the first company on the list.
While the hope is that the companies selected as part of the magic formula investing strategy will perform as anticipated, monitoring the upward and downward movements of the shares is very important. One common recommendation is to dump shares that are not performing up to expectations just before owning them for a year, and replacing them with shares of another stock that meets the criteria but demonstrates more potential. In this way, it is possible to adapt to changing market circumstances and maintain the ability to earn decent returns without deviating from the basic magic formula investing approach.
