Magic Formula: Does the magic really work in the context of Indian capital markets?

Authored by Arindam Samanta, Principal Officer, Shree Rama Managers LLP

Over centuries, enthusiastic investors across the globe have tried to outsmart Mr. Market whose moods frequently swing between phases of exuberance and despair.

Being a Fund Manager and Principal Officer of a SEBI-registered PMS Company, I have constantly striven to give my best efforts to discover new strategies that work for markets most of the time.

In this quest for quality strategies, we applied the principles of Magic Formula as propounded by Joel Greenblatt in his book, “The Little Book that Beats the Market” on the Indian capital market and tried to ascertain whether the investment strategy can be utilized to outperform the market or not.

Understanding the Magic Formula

According to Greenblatt, there are two factors for selecting above-average companies- Return on Capital and Earnings Yield.

Greenblatt defines Return on Capital as:

𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐸𝐵𝐼𝑇/ 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

where

𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑛𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑛𝑒𝑡 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡.

Greenblatt defines Earnings Yield as: 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑦𝑖𝑒𝑙𝑑 = 𝐸𝐵𝐼𝑇/ 𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑣𝑎𝑙𝑢e

By ranking companies based on Return on Capital and Earnings Yield separately, two Ranking lists can be obtained. These rankings are then combined. According to Greenblatt, the top twenty companies with the lowest combined score can be considered to be the most attractive for investment.

Words of Appreciation and Criticism

Several researchers across the world have affirmed that the Magic Formula has delivered greater returns than the market index.

For example, while Larkin’s study (2011) found the Magic Formula effective in the context of the US Markets for the period 1998 to 2006, Pearson and Selander (2009) tested the formula on the Nordic region from 1998 to 2008 to discover that the portfolio had a CAGR of 14.68 per cent which was significantly higher than the MSCI Nordic for the same period (9.28 per cent).

The response has been mixed as far as the Indian scenario is concerned.

In ‘Black Testing Magic Formula on Indian Stock Markets: An Analysis of Magic Formula Strategy’, the magic formula was applied to check the performance of Indian companies for a period of 8 years (1st July 2012 to 1st February 2020). It was found that the CAGR of BSE Sensex was 9.31 per cent against 13.89 per cent of the 30-stock Magic Formula portfolio.

However, Dr Jaspal Singh and Kiranpreet Kaur did not find any profitability of using the Magic Formula in the Indian context after studying the impact of this investment strategy on the stocks listed on the Bombay Stock Exchange for a period of 15 years i.e., 1996 to 2010.  

What our study reveals

We introduced a unique angle while filtering information about 909 non-banking companies listed on the National Stock Exchange which traded between 2013 and 2023.

We calculated EBIT from the Income Statement while Net working Capital, Net Fixed Assets, and Enterprise Value were calculated from the Balance sheets of each financial year starting from FY 2013-14. (Source: www.moneycontrol.com).

After calculating the Return on Capital and Earnings Yield, for each year, we eliminated companies with negative EBIT, negative EV, and Negative WC.

Assuming that the audited financial statements will be available by 30th June, we rebalanced the portfolio every year on the same day. We sold the company from the portfolio only after a year or more.

It was found that for the period June 30 2014 to June 30 2023, the CAGR of Magic Formula was 14.21 per cent while that of Nifty 500 was 10.28 per cent.

However, in 3 out of 10 Financial years, the portfolio underperformed the benchmark.

Graph 1: The Cumulative return of the portfolio and nifty 500 (Excess: Cumulative portfolio return - cumulative nifty 500 index return

 Graph 2: The annual return (June end to next year’s June end) of the portfolio and Nifty 500.

Final words…

On the basis of our study, it is clear that we can’t outperform the market in the short term with publicly available information. But if you are confident to stick to a long-term strategy, you will certainly get great returns. In order for the magic formula to work properly, we need a large number (say 500 or more) of listed companies that file their financial statements on a timely basis to the exchange.

On the whole, the Magic Formula definitely has the potential to wield magic in the context of the Indian Capital markets!

References:

Greenblatt, J., 2006. The Little Book That Still Beats the Market. New Jersey: John Wiley & Sons, Inc.

Larkin, P. (2011). Can Individual Investors Capture the Value Premium? Journal of Business and Economics Review JBER, 81(2), pp.227-231.

Blij, R. (2011). Black-testing magic: An Analysis of the magic formula strategy. Master. University of Tilburg.

Persson, V and Selander, N. (2009) Back Testing The Magic Formula in the Nordic Region. Available at Accessed in November 2013.

Olin, T. (2011). Value Investing in the Finnish Stock Market. Master. Aalto University.

Howard, W.F. (2015). An investment strategy based on return on capital and earnings yield. Masters Dissertation. Stellenbosch University.

Disclaimer: The opinions expressed above are personal and may not reflect the views of DSIJ.