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Magic Formula Investing

Published on January 20, 2007

Magic Formula Investing

January 20, 2007

How to find quality stocks to for creating a profitable stock option trading strategy! Today I would like to introduce you to “The Little Book That Beats the Market. An investment guide for all ages”. It is a recommendation for something that I found brilliant and thought it might be of interest to my readers. I shall share later on how to use it for options trading.

As published on the website: Two years in MBA school won’t teach you how to double the market’s return. Two hours with The Little Book That Beats the Market will. Let Joel Greenblatt, Founder and Managing Partner at Gotham Capital (with average annualized returns of 40% for over 20 years) show you how “beating the market” can be made simple and easy. The Little Book does more than simply set out the basic principles for successful stock market investing, it provides a “magic formula” that is easy to use and makes buying good companies at bargain prices automatic.
Though the formula has been extensively tested and is a clear breakthrough in the academic and professional world, the common sense method is convincingly explained using 6th grade math skills, plain language and humor. Readers will learn how to use this low risk method to beat the market and professional managers by a wide margin. Along the way, readers will also learn: how to view the stock market; why success eludes almost all individual and professional investors; and why the formula will continue to work even after everyone “knows” it.

The Little Book That Beats the Market This is not a get-rich-quick book. He explains what really matters and what’s behind successful investing and it’s so simple that you may not believe it. Magic formula investing is an essential tool in OptionPundit’s Toolbox Please note, it’s a free tool and you can browse their website and get stock list everyday after registering. You don’t have to pay to those “magic investment letters” to get this list.

So how do we use it for options trading? My interpretation is that the screened stocks will go up over the long term so we need to use strategies that are bullish over long term. So put it simply, a strategy that has positive delta, positive theta so we gain from upwards movement in stock and time decay due to long term holding. For instance, long leaps and short current month (same strike) as theta for current month will be higher than leap month so you get positive theta (i.e. Calendar spreads or diagonal spreads). Let me know via comments if you would like to discuss more on how to play this.

Top 25 companies with a minimum market cap. of $1 billion (as of Jan 20,2007)(Companies are listed in alphabetical order)
Name Ticker Market Cap
($ Millions)
Pre Tax
Earnings Yield
Pre Tax
Return on Capital
Price
From
Most Recent
Quarter Data
Barr Pharmaceuticals Inc BRL 5,875.09 10% > 100% 01/19 09/30
Biovail Corp BVF 3,357.05 15% > 100% 01/19 09/30
CGI Group Inc. GIB 2,325.17 10% > 100% 01/19 09/30
Career Education Corp CECO 2,405.30 13% 50 – 75% 01/19 09/30
Deluxe Corp DLX 1,441.08 9% > 100% 01/19 09/30
Fording Canadian Coal Trust FDG 3,166.38 21% > 100% 01/19 09/30
Freeport-McMoran Copper & Gold Inc. FCX 10,628.15 23% 75 – 100% 01/19 12/31
Frontier Oil Corp. FTO 3,001.80 21% > 100% 01/19 09/30
Getty Images Inc GYI 2,412.70 10% > 100% 01/19 09/30
Herbalife Ltd HLF 2,334.36 10% > 100% 01/19 09/30
Holly Corp HOC 2,839.11 14% 75 – 100% 01/19 09/30
K-Swiss Inc KSWS 1,065.38 13% > 100% 01/19 09/30
King Pharmaceuticals Inc. KG 4,254.50 16% > 100% 01/19 09/30
Labor Ready Inc. LRW 1,003.98 12% 75 – 100% 01/19 09/30
Motorola Inc. MOT 46,585.23 12% > 100% 01/19 12/31
Nucor Corp NUE 17,278.01 16% 50 – 75% 01/19 09/30
Pacer International Inc PACR 1,079.85 10% > 100% 01/19 09/30
Palm Inc PALM 1,394.34 13% > 100% 01/19 11/30
Patterson-UTI Energy Inc PTEN 3,775.40 26% 50 – 75% 01/19 09/30
Quest Diagnostics Inc DGX 9,996.69 10% > 100% 01/19 09/30
Southern Copper Corp PCU 16,454.42 16% 50 – 75% 01/19 09/30
Teck Cominco Ltd TCK 14,897.51 21% 50 – 75% 01/19 09/30
Verigy Ltd VRGY 1,051.63 15% > 100% 01/19 10/31
ViroPharma Inc VPHM 1,045.02 12% > 100% 01/19 09/30
Western Refining Inc WNR 1,724.95 19% 75 – 100% 01/19 09/30

Note: See The Little Book That Beats the Market for full instructions. In general, purchase 5 to 7 top ranked stocks every 2 months or 7 to 9 top ranked stocks every 3 months. After 9 or 10 months, this should result in a portfolio of 20 to 30 stocks. Sell each stock after holding for one year (for taxable accounts refer to Step-by-step section of the book) and replace with a new pick. Remember, maintaining a diversified portfolio over a long period of time is an integral part of the Magic Formula strategy.

6 Comments

  • Hendrik Oude Nijhuis says:

    Hi,

    I have read hundreds of books on value investing, Warren Buffett etc, and publish investment tutorials on value investing myself. I highly recommend Greenblatt’s ‘the little book that beats the market’. It could be one of your best investments ever!

    Success in investing,
    Hendrik Oude Nijhuis

  • […] I first mentioned about this book in my posting here on Jan 20, 2007. Let me briefly talk about why I think this is a great book and how I would like to use it for option trading. As per the screening on Feb 3, for >100million market cap, Fording Canadian Coal Trust (FDG) is amongst one of the TOP 25 companies. Here are the key points about FDG: […]

  • […] introduced “The Little Book that beats the Market“. I also gave several examples of real trade on how one can find plays for “option […]

  • Sam says:

    For over a year now I’m doing a test with real money selecting magic formula stocks on European stock markets like Euronext, LSE and Deutsche Borse. Maybe it is of interest to you

  • Kedar says:

    My problem is even though Magic Formula gives me stocks…..I dont have access to those markets….what should I do?
    Does Option pandit also do investments?….or they only provide strategies/inputs?

  • mike mills says:

    I don’t understand why you suggest the spread trades buying the LEAP’s and selling front month options against them because:

    1) The upside is capped.
    2) The strategies are income strategies, not bullish strategies.
    3) If the same strikes are bought and sold, and if you sell ATM or NTM calls, then chance of getting assigned is high. If you sell OTM calls, then the option premium likely will be minimal, so I don’t see how you could eventually get the long for “free” in 2 – 4 months. Additionally, there are usually less strikes available for LEAP’s than front month calls making it more difficult finding strikes that are the same.

    I think the best way to play these would be to use a call ratio diagonal backspread.

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