This strategy is based on the investing principles described in Joel Greenblatt’s classic “The Little Book That Beats the Market”. The model selects U.S. stocks by combining value and quality — Greenblatt’s so-called Magic Formula. The backtest presented here runs from 1998 through mid-2025 and is implemented using QuantConnect’s algorithm framework.

This post is part of my ongoing series where I test and share classic factor investing strategies from renowned books. If you haven’t seen it yet, check out my previous post on the PSR & Relative Strength strategy from “What Works on Wall Street”.

The Magic Formula is elegantly simple. It ranks stocks based on two key metrics:

Return on Assets (ROA) – to identify high-quality businesses.

Price-to-Book (PB) ratio – to identify cheap stocks.

The core idea is: buy good companies at bargain prices.

In this implementation, the universe is filtered to include only 1000 Large U.S. stocks traded on NYSE or NASDAQ, with at least 6 months of trading history, and a market capitalization over $50 million. Financials are excluded due to their non-comparable accounting structures. From there, we calculate the ROA and PB ratios for each stock, rank them accordingly, and select the top 25 candidates once per year.

The result is a low-turnover, long-only portfolio that rebalances annually in December, allocating capital equally across all selected stocks.

Over 27+ years, this simple strategy delivered strong risk-adjusted returns:

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This strategy turns a $100,000 portfolio into more than $2.6 million, with only one rebalance per year and minimal trading costs. The very low turnover (0.37%) and simple structure make it a great candidate for tax-efficient and low-friction investing.

Strengths

  • Combines value and quality into a single, intuitive framework
  • Annual rebalance keeps turnover and transaction costs minimal
  • Uses liquidity and listing filters to reduce noise and execution issues
  • Conceptually straightforward and easy to explain
  • Performs well across multiple decades and regimes

 

Limitations

  • Suffers from high daily drawdowns in bear markets (–56.7%)
  • Sharpe Ratio of 0.454 suggests moderate risk-adjusted returns
  • Excludes macro or momentum signals, so it may underperform in growth-driven or speculative environments
  • Sector tilts can emerge due to clustering in "cheap" industries

 

Joel Greenblatt’s Magic Formula is a brilliant reminder that simple beats complex — especially when it comes to investing. This strategy’s consistent performance over decades, combined with its low complexity and cost-efficiency, makes it a reliable base model for long-term investors.

While it may experience painful drawdowns, its long-term alpha, robust compound returns, and strong fundamentals continue to validate the underlying logic.

If you have thoughts, optimizations, or want to collaborate on ensemble modeling — feel free to reach out or follow me on X @CabedoVestment.

Happy trading!