In this article, we will take a look at the 11 best magic formula stocks to buy now. To see more such companies, go directly to 5 Best Magic Formula Stocks to Buy Now.
Magic Formula investing strategy was first described by legendary value investor Joel Greenblatt in his 2005 book entitled The Little Book That Beats The Market. When Greenblatt says he has a formula that beats the market, the world listens, since he has an impeccable track record. Greenblatt’s hedge fund Gotham Capital posted compound annualized returns of over 34% from 1985 through 1994. The magic formula investing strategy was apparently too simple. According to this strategy investing in top-ranked large cap stocks with strong high earnings yield and a high return on invested capital (ROIC) beats the market.
Magic Formula: Too Simple to be True?
Joel Greenblatt was aware that this strategy sounded too good and simple to be true. That’s why in his book he repeatedly asks the reader the question that what is the guarantee, if any, that this magic formula investing strategy actually works and is not just a random fluke? After sharing a lot of historical data to prove how the magic formula investing strategy actually works over longer periods of time, Greenblatt begins to address the question about the timelessness of this strategy.
“…In order for the magic formula to make us money in the long run, the principles behind it must appear not only sensible and logical, but timeless. Otherwise, there is no way we’ll be able to “hang on” when our short-term results turn against us. As simple as it may seem, knowing that two plus two always equals four can be a pretty powerful concept. No matter how many people tell us differently, no matter how long they tell us, and no matter how smart all those people appear to be, we are unlikely to waver in our conviction. In a similar way, our level of confidence in the magic formula will determine whether we can hang on to a strategy that may be both unpopular and unsuccessful for seemingly long periods of time.”
The Link Between Return on Capital and Earnings Growth
Greenblatt then goes on to establish the link between high return on capital and earnings growth. He expands his concept of return on capital and says if a business is posting high return on capital and plans to invest all or major chunk of those returns to expand the same business, there’s a high chance that the business in question will keep growing its earnings. The magic formula investing strategy, Greenblatt emphasizes repeatedly, does not promote investing in companies with average return on capital let alone poor return on capital. The strategy makes a ranking system that looks for top companies with highest return on capital and earnings yield. This way, if a business has high return on capital and earnings yield that means the business has some kind of advantage over its competitors that it can maintain in the future as well.
Joel Greenblatt repeatedly acknowledges that the magic formula investing strategy might not work in several instances and performs poorly in many situations especially when the holding period is short. He emphasizes the importance of holding stocks and why it’s easier said than done:
“Most people just won’t wait that long. Their investment time horizon is too short. If a strategy works in the long run (meaning it sometimes takes three, four, or even five years to show its stuff), most people won’t stick with it. After a year or two of performing worse than the market averages (or earning lower returns than their friends), most people look for a new strategy— usually one that has done well over the past few years. Even professional money managers who believe their strategy will work over the long term have a hard time sticking with it. After a few years of poor performance relative to the market or to their competitors, the vast majority of clients and investors just leave! That’s why it’s hard to stay with a strategy that doesn’t follow along with everyone else’s.”
Value underperformed for several years before it made a comeback with a vengeance when inflation, rate hikes and highly volatile geopolitical situation started to crush the global financial markets. While Joel Greenblatt has always been a fan of value investing, he’d already started to adapt a hybrid investing strategy to take up passive investing to make up for value underperformance. In a 2017 report, Bloomberg reported how Gotham Asset Management was inculcating index trading. The report at the time quoted Greenblatt who said:
“It’s a hybrid that answers a lot of the questions that active management has failed to answer,” he said. “This strategy will dwarf them over time.”
The Bloomberg report said that Greenblatt’s hedge fund introduced Gotham Index Plus in 2015. The intention behind this step was simple: instead of putting all capital in active management, put some in the S&P 500 index and then invest in stocks they consider undervalued and short those they believe will fall.
11 Best Magic Formula Stocks to Buy Now
Joel Greenblatt of Gotham Asset Management
Our Methodology
For this article, we used Joel Greenblatt’s Q1’ 2023 portfolio and picked his top 11 stock holdings.
Joel Greenblatt increased his stake in Johnson & Johnson (NYSE:JNJ) by 18% in the first quarter, ending the period with an $18 million stake in the company. Johnson & Johnson (NYSE:JNJ) has upped its dividend consistently for over six decades now, making it a highly attractive stock among hedge funds as well as individual investors.
A total of 86 hedge funds tracked by Insider Monkey had stakes in Johnson & Johnson (NYSE:JNJ) as of the end of the first quarter, up from 84 funds in the previous quarter. The biggest stakeholder of Johnson & Johnson (NYSE:JNJ) was D E Shaw with a $609 million stake in the company.
ClearBridge Large Cap Value Strategy made the following comment about Johnson & Johnson (NYSE:JNJ) in its first quarter 2023 investor letter:
“The tech-dominated quarter was a headwind for both defensive and cyclical sectors, with shares of health care holdings such as UnitedHealth Group (UNH), Elevance (ELV) and Johnson & Johnson (NYSE:JNJ) declining after a strong 2022.”
Merck & Co., Inc. (NYSE:MRK) shares have gained about 16% over the past one year. Joel Greenblatt’s hedge fund owns an $18 million stake in Merck & Co., Inc. (NYSE:MRK). Goldman Sachs recently said that the healthcare sector has several promising industries that can outperform this year.
Merck & Co., Inc. (NYSE:MRK) was owned by 75 hedge funds in Insider Monkey’s database of 943 hedge funds. The biggest stakeholder of Merck & Co., Inc. (NYSE:MRK) during this period was AQR Capital Management of Cliff Asness which owns a $298 million stake in the company.
Pfizer Inc. (NYSE:PFE) ranks 9th in our list of the best magic formula stocks to buy now. Joel Greenblatt’s hedge fund owns an $18.5 million stake in Pfizer Inc. (NYSE:PFE) as of the end of the first quarter of 2023. Pfizer recently invested $25 million in gene-edited cell therapies company Caribou Biosciences (NASDAQ:CRBU).
As of the end of the first quarter of 2023, 73 hedge funds tracked by Insider Monkey had stakes in Pfizer Inc. (NYSE:PFE). The biggest stakeholder of Pfizer Inc. (NYSE:PFE) was Cliff Asness’s AQR Capital Management which had a $380 million stake in the company.
With close to four decades of dividend growth Exxon Mobil Corporation (NYSE:XOM) is one of the notable stocks extremely popular among hedge funds. A total of 73 hedge funds in Insider Monkey’s database of 943 funds had stakes in Exxon Mobil Corporation (NYSE:XOM). The biggest stakeholder of Exxon Mobil Corporation (NYSE:XOM) during this period was Rajiv Jain’s GQG Partners which owns a $2.15 billion stake in the company.
In May, Goldman Sachs downgraded Exxon Mobil Corporation (NYSE:XOM) to Neutral from Buy with a $125 price target.
Meta Platforms, Inc. (NASDAQ:META) shares have been on an absolute tear this year, gaining about 135% year to date through July 11. Meta Platforms, Inc. (NASDAQ:META)’s Threads app is breaking all records and has garnered 100 million users in just a matter of few days.
Joel Greenblatt is enjoying these gains from his Meta Platforms, Inc. (NASDAQ:META) investment as his hedge fund had a $26 million stake in the company. Overall, 220 hedge funds tracked by Insider Monkey had stakes in Meta Platforms, Inc. (NASDAQ:META) as of the end of March 2023.
Joel Greenblatt’s Gotham Asset Management has a $27 million stake in Berkshire Hathaway Inc. (NYSE:BRK-A) as of the end of the first quarter of 2023. Berkshire Hathaway Energy recently announced that it will buy Dominion Energy's (NYSE:D) 50% stake in the Cove Point LNG plant in Maryland in a deal valued at $3.3 billion. Last month, Berkshire Hathaway Inc. (NYSE:BRK-A) disclosed that it bought another 2.1 million of Occidental Petroleum, raising its stake in the company to 25%.
Out of the 943 hedge funds tracked by Insider Monkey, 108 hedge funds had stakes in Berkshire Hathaway Inc. (NYSE:BRK-A). The biggest stakeholder of Berkshire Hathaway Inc. (NYSE:BRK-A) was Bill & Melinda Gates Foundation Trust with a $6 billion stake in the company.