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what is up everyone I'm rose and welcome back to my channel in this video I'm going to talk all about the magic formula which is a super powerful investing strategy that has earned twenty to thirty percent returns over the last few decades just to give you an idea a 30 percent average annual return you can turn ten thousand dollars into a million in just 18 years the best part you don't need to be a stop genius to do this the magic formula is actually a really simple strategy that anyone can follow and it was described in detail in this great little book right here the little book that still beats the market written by Joel Greenblatt so if you're interested in making a 20 to 30 percent return on your money with the magic formula then keep watching hey and before we get started have you subscribed to my channel yet it's not what are you waiting for my channel is all about stock investing for beginners and you're gonna learn a ton about how to intelligently put your money to work so make sure to subscribe and hit the notification bell for new videos like this every week so let's dive straight in first I'll explain what the magic formula is and how it works then I'm gonna give you some background info on why it works and finally I'll walk you through how to implement it on your own the magic formula is a stock investing strategy developed by superstar hedge fund manager Joel Greenblatt his fund Gotham capital has an annual track record of 40% returns which is really hard to do basically Joel Greenblatt is a fucking legend in the investment world he explains everything you need to know about magic formula investing in his little book the little book that still beats the market and I'll summarize the key takeaways of the book for you in this video I've also linked to the book below in the description so you can check it out for yourself alright the magic formula is a system that ranks all the publicly traded companies in the u.s.
in order of best investment - worst investment then using this ranking you buy the top 20 to 30 stocks and there's actually no rocket science involved this ranking system uses just ooh key metric so what are these two metrics I'll tell you what they are and then I'll explain each one in more detail the first metric is return on capital and the second metric is earnings yield return on capital is the percentage of a company's earnings relative to the capital spent to generate those earnings for example company a is a store that sells widgets it costs a million dollars of capital to build the store and hire employees and do all the stuff to get into business let's say that this store generates annual net profits of $100,000 so company a has a return on capital of 10% or $100,000 divided by the capital of 1 million on the other hand Company B is a similar store that sells widgets as well let's say it also costs a million dollars to get the store up and running but unlike company a Company B generates $500,000 of annual profits that's a return on capital of 50 percent so which would you rather invest in Company A or Company B the answer is obviously Company B the higher the return on capital the better because it means this business knows how to maximize profits given a fixed amount of resources sure great companies have great products with the O growth potential all that good stuff but all of those factors are very subjective and kind of qualitative the only way to know for sure whether a company is a good investment or not is to look at the numbers and the best number to look at is return on capital by definition great companies generate high returns on capital so that's the first metric the magic formula uses to rank the best stocks the second metric is earnings yield earnings eals compares a company's earnings to its purchase price for example going back to my widget examples Company A that earns $100,000 a year and let's say that the owner is willing to sell you the company for five million is it a good deal well it depends what is that five million gonna get you if you buy company you're gonna be entitled to its earnings of $100,000 a year on a purchase price of five million dollars that's an earnings yield of two percent and on the other hand let's say that you have the option to buy Company B and it's going for the same price of five million dollars but as you know Company B has earnings of five hundred thousand dollars in other words an earnings yield of ten percent so what's a better deal for you Company A or Company B the answer is again Company B even though they're both trading at the same price of five million dollars Company B is actually a better deal than Company A because you're gonna get more earnings for the same purchase price in other words more bang for your buck the higher the earnings yield the better and that is the second metric used by the magic formula to rank stocks when you screen stocks through these two metrics you end up with stocks of great companies at bargain prices that is what investing is all about it's common sense right you don't want to buy shitty companies you want to buy great companies and you want to buy those great companies not just that any price but at bargain prices you want the best of both worlds you want great companies bargain prices and so the magic formula is a simple systematic way to do just that when used to somatically buy stocks of above-average companies at below average prices you're bound to do really well in its book Greenblatt compares how a magic formula investing strategy performed relative to the S&P 500 over a 21-year period between 1988 and 2009 hopefully it comes out with an updated edition with more recent numbers but you can still get the idea the magic formula investing strategy generated twenty three point eight percent over that period compared to the S&P 500's nine and a half percent that means if you started with $10,000 in 1988 with the magic formula you'd have eight hundred eighty five thousand dollars by 2009 compared to 67 thousand dollars if you just stuck with the and p500 amazing right so what's the catch ah there's always a catch if it was that easy everyone would be doing this and we'd all be bajillion errors so like anything worth doing the magic formula works but it's a long-term investing strategy if you're looking to get into the rich then you're probably not gonna stick with this formula because it takes at least three to five years to work even though the magic formula outperforms the market over the long term it might actually underperform the market for small stretches of time unfortunately most people aren't patient or confident enough to keep the face at stick with the strategy long enough to enjoy those amazing 23.8% returns don't be one of those people if you're going to invest with the magic formula plan to stick with it for at least three years even if your friends are making more money in sexier stocks like Amazon and Tesla the key here is patience now I want to touch on why the magic formula works the average newbie investor has no idea how to evaluate stocks most investing beginners invest in the hot stocks that everybody is talking about and they don't really know why it's a good investment other than the fact that other people are saying it's a good investment if you buy individual stocks without crunching some numbers and forming a solid argument for why it's a good investment then you're just gambling your investing based on hope greed FOMO I mean and all of these emotions have no place in your investing decisions as Joel Greenblatt says in his book choosing individual stocks without any idea of what you're looking for is like running through a dynamite Factory with a burning match you may live but you're still an idiot but you know what researching individual stocks is a lot of work that's what Warren Buffett does he reads a ton and he usually only has about eight to ten high conviction stocks in his portfolio most people aren't cut out for that that's why most people are advised to diversify their investments as much as possible with something like an SP 500 index fund but the magic formula is something in between warren buffett and an SP 500 index fund the formula screens through thousands of stocks and you buying only the top 30 stocks so it's still very diversified because 30 is still a high enough number that you're not overly exposed to one stock but it's not as diversified as an SMP 500 funds which has 500 stocks in it so the magic formula gives you better results than an S&P 500 index funds because it has diversification but it's also excluded most of the mediocre stocks personally I think the magic formula is brilliant because it gives you the best of both worlds it takes the emotion out of investing decisions because it's basically purely quantitative just based on these two metrics but it also doesn't require me to do a ton of research and value companies all day although I do also invest in individual stocks I invest about a third of my money using the magic formula because it's a great way to always have some money working for me in the stock market even when I don't have any investment ideas of my own hopefully by now you're convinced that the magic formula is awesome and that you should totally try it now I want to walk you through how to implement it on your own so here's how it works first you have to buy 30 magic formula stocks over a period of one year and you spread it out over the year in order to spread out your int entry points into the stock market then you hold each stock for one year and then you sell it so the end result is that you'll always be rotating through 30 stocks in your portfolio and always selling each stock after a holding period of one year so here's how to do it step-by-step first you need a brokerage account with money in it this can be an IRA or a non retirement brokerage account whichever you prefer ideally it's at a discount brokerage like fidelity or Robin Hood where you pay little to no trading commissions because you'll be buying a lot of stocks and the commissions can really add up then step number two is to go to magic formula investing calm and create an account so you can use their stock screener this website was developed by Joel Greenblatt specifically to help magic formula investors implement the strategy so you use the stock screener to generate a list of the top ranked companies in the screener I'll just put fifty million dollars as a minimum market cap but if it makes you more comfortable to invest in larger companies feel free to use a hundred million dollars or higher after you click get stocks you'll get a list of the companies that have the highest returns on capital just like we talked about and the highest earnings yields so these companies have the best of both worlds and they're all ranked also the magic formula is based on buying equal dollar amounts of each stock so since the full portfolio has 30 stocks if you have $30,000 total then you'll want to buy $1,000 worth of each stock after you buy your first five stocks then wait two months and then buy five more keep doing this every two months and 12 months later you should have 30 stocks in your portfolio so you bought stocks in batches of 5 and you did that six times over 12 months if that makes sense after 12 months the first batch of 5 stocks that you bought has now been in your portfolio for 1 year and remember the magic formula wants you to hold each stock for just one year so this is where it can get a little bit tricky you have to keep track of when you bought each stock and make sure you sell it after exactly a holding period of one year I keep a simple spreadsheet it's not that hard yeah it does involve a little bit of work but it's definitely a lot less work than researching individual stocks I don't know about you but if it means I can make juicy returns of 2030 percents I'm game because I didn't want this video to turn into an hour-long tutorial I know this is a pretty brief walkthrough of how to implement but if you're serious about doing it then definitely check out joel Greenblatt's book for detailed instructions or if you want to see me do an in-depth tutorial with screencasts and my spreadsheets and all that then type tutorial in the comments below to let me know so that's basically with Joel Greenblatt's magic formula is all about and by now I hope you have an understanding of why it works so well and why it's a good idea for most people as Joel Greenblatt explains most people have no business investing in individual stocks on their own so the magic formula is an easier more accessible way to invest in the stock market I think the key takeaway here is that picking great businesses at bargain prices is the absolutely fundamental concept of smart investing so whether you implement the magic formula or not you can still use these concepts to make better investing decisions for example rather than buying the 30 stocks on rotation the way the magic formula wants you to do you can also maybe use it as a handy stock screener so you can just use that ranking of 30 stocks as a starting point for stock that you might want to do more research on did you like this video if so then please give it a thumbs up and if you have any questions at all about the magic formula feel free to ask me in the comments or DM me on instagram @ investing with Rose to learn more about money and investing make sure to check out these two videos right here and if you're new to the channel I really love it if you subscribe always remember to go after your dreams unapologetically and to live life on
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