What is magic formula investing in value investing?

In today's fast-paced world of online investment, everyone wants to uncover the hidden gems of the stock market. Value investing is a time-tested method that presents potential opportunities like buying a fantastic product on sale - you get high value at a low price. One powerful strategy within value investing is the Magic Formula – a systematic approach to finding undervalued stocks.

Understanding value investing

The core principle of value investing is simple: find companies whose stock prices are trading below their intrinsic value. Intrinsic value reflects a company's true worth based on its financials, business model, and potential. When market sentiment drives down prices temporarily, a gap opens up for the savvy value investor to purchase quality stocks at a discount.

It uses two key metrics to achieve this:

• Earnings yield: This measures a company's earnings power relative to its market value (enterprise value). A high earnings yield suggests the company is priced attractively compared to the profits it generates.
• Return on capital (ROC): A high ROC indicates that the company can effectively deploy its capital to generate returns for investors.

How does magic formula investing work?

Here's a simple breakdown of the process:

Screening:

• Start by screening the online investment universe for stocks that meet specific criteria.
• Typically, select companies above a certain market capitalisation.
• Exclude sectors like utilities and financials.

Ranking:

• Rank the remaining companies based on earnings yield and ROC.
• Companies with high rankings on both metrics are more favourable.

Buying:

• Select the top 20-30 ranked companies.
• Invest equal amounts in each one.

Rebalancing:

• Rebalance your portfolio annually.
• Sell stocks no longer meet the criteria.
• Replace them with newer top-ranked companies.

Why use the magic formula?

• Simplifies value investing: It offers a concrete, rules-based system that removes potential emotional biases in stock selection.
• Emphasis on quality: Prioritises companies with strong earnings and efficient capital use.
• Potential for higher returns: Undervalued stocks often bounce back as the market recognises their worth.

Things to remember before employing this strategy

• Not a get-rich-quick scheme: Value investing, even with the Magic Formula, requires patience and a long-term view.
• Research is essential: Understanding the companies behind the numbers is crucial.
• Diversification is key: Building a well-diversified portfolio using an equity fund remains paramount for managing risk.

Important considerations for Indian investors

• Sector concentration: The strategy might lead to a portfolio tilt towards certain sectors.
• Data availability: Focus on companies with reliable financial data within the online investment space.
• Transaction costs: Factor in brokerage, taxes, and other fees affecting potential returns.

Cautions

• No guarantee: Past performance is not indicative of future results, and markets can be unpredictable.
• Short-term fluctuations: Requires a long-term perspective as stock prices of undervalued companies may initially experience drops.

Is the magic formula right for you?

The magic formula can be a helpful tool for Indian investors interested in value investing. If you're prepared to delve into company financials, believe in the power of long-term investment, and want a structured approach to identifying undervalued stocks, it could be worth exploring.