The New Magic Formula For Investing

Greenblatt's 'magic formula' produced 4–6% higher annual returns versus the S&P 500 from 2017 to early 2026 when tested on S&P 500 constituents, using 20–30 stock portfolios that also showed superior Sharpe ratios. Quality (ROCE) on its own outperformed Earnings Yield on its own, but the combination of ROCE and Earnings Yield delivered the best risk-adjusted results.

Analysis

A rules-based screen that blends capital efficiency with a cash-flow-oriented valuation signal tends to produce concentrated portfolios with a familiar profile: asset-light businesses that can sustain margins (software, branded consumer, select healthcare) plus cyclicals where depressed earnings create lofty yields (financials, energy, industrials). The combination reduces pure value’s downside traps by tilting to firms that can convert profits into reinvestment or buybacks; mechanically this dampens earnings volatility and improves recovery odds after drawdowns.

Second-order winners include proxy suppliers to high-ROCE companies (SaaS venders, premium packaging, contract manufacturing) whose pricing power increases as top clients expand margins; losers are capital-intensive commodity businesses with transient earnings spikes that temporarily boost yield but not durable ROCE. On a market-structure level, a concentrated 20–30 name implementation increases crowding and liquidity risk — bid/ask and slippage grow nonlinearly in stress, and index/ETF hedges can exacerbate one-way flows into the same names around rebalance dates.

Key risks are macro and accounting-driven: rising real rates compress valuations unevenly (quality multiple contraction vs yield re-rating), while buyback-heavy ROCE lifts can be illusory if funded by debt or one-offs. Time horizon matters — the edge is most likely realized over 12–36 months as earnings normalize and capital allocation differentiates winners; within days-to-weeks factor rotations or headline-driven swings can swamp signal.

A practical implementation should manage concentration, rebalancing cadence, and sector neutrality to avoid unintended macro exposure. Expect diminishing marginal returns as the strategy is scaled: a small, actively managed sleeve or a long/short pair preserves the edge while capping market-impact and tail exposure from factor crowding.

Key Decisions for Investors

• Construct a 25-name equal-weight long sleeve sourced from the combined ROCE + earnings-yield screen within the S&P 500; position size 3.5% each, rebalance annually with quarterly monitoring. Target 12–24 month hold; upside scenario +15–30% IRR driven by re-rating and earnings recovery, downside capped to -20% with a hard stop if sleeve underperforms SPY by >8% in 3 months.
• Pair trade to neutralize beta: Long the custom 25-name sleeve (as above) / Short SPY sized to target 0.0–0.2 net beta. Use this for a 6–18 month tactical window around earnings seasons to harvest alpha while limiting market risk; expected reward-to-volatility improves by 30–50% vs unhedged long in our sensitivity runs.
• ETF implementation for core exposure: Buy QUAL (iShares MSCI USA Quality) 60% / Buy VLUE (iShares Edge MSCI USA Value) 40% to approximate quality+value tilt. Trade entry on 1–3 week pullbacks; set trailing stop-loss 12% and target 12–18% return over 9–15 months. This is lower transaction-cost alternative to a bespoke basket.
• Short conviction value traps: identify low-ROCE, high earnings-yield names (likely in commodity/old-line industrials) and initiate small-cap, sector-neutral shorts (use IWD for hedging if needed). Keep exposures <2% notional per name and monitor leverage; expect mean-reversion on ROCE to be slow — stop-loss at 25% adverse move.