As we enter another volatile year in the markets, investors face a crucial question: How do you outperform the S&P 500 in an inflation-driven environment? The days of simply buying the index and expecting reliable growth are over. Purchasing power is eroding, and broad-market investing has underperformed against assets like gold, which outpaced the S&P 500 in 2023.
So, what’s the answer? A selective, rules-based approach known as the Magic Formula.
What is the Magic Formula?
Originally developed by legendary investor Joel Greenblatt, the Magic Formula is a straightforward method for identifying undervalued stocks with strong earnings power. It screens for companies that rank highly in two key metrics:
✅ Earnings Yield – A measure of a company’s profitability relative to its valuation, using EBIT (Earnings Before Interest and Taxes) instead of traditional net income. This removes distortions from debt structure and tax strategies.
✅ Return on Capital (ROC) – A crucial indicator of a company's efficiency in generating profits from its investments. The higher the ROC, the more effectively a business is using its capital to drive growth.
Stocks that score well on both metrics have the potential to outperform broader market indices over time. Instead of blindly investing in the S&P 500—which has been eroding purchasing power—this strategy provides a systematic way to find value in a market full of overpriced assets.
Adapting the Magic Formula for Today’s Market
While Greenblatt’s traditional method suggests buying 30+ ranked stocks and holding them for a year, this strategy can be refined for greater precision and risk management:
🔹 Market Cap Filter – Focus on stocks with a market cap of $1 billion+ for more stability.
🔹 Excluding Financials & Utilities – These sectors are heavily distorted by debt and interest rate movements, making valuation unreliable.
🔹 Sector & Fundamental Diversification – Instead of being concentrated in one industry (e.g., energy, tech, or China-based stocks), the portfolio is balanced across multiple sectors to reduce risk.
🔹 Technical & Earnings-Based Entry – Instead of blindly buying stocks from the screen, the strategy waits for:
- Earnings beats and raised guidance
- A strong stock price reaction post-earnings
- Technical breakouts confirming momentum
This approach ensures that investments are not just undervalued but also strategically timed for maximum upside potential.
🔍 Stock Picks Using the Magic Formula
Here are three standout stocks that currently align with the Magic Formula criteria:
1️⃣ PayPal (PYPL) – A Turnaround in the Making
Why PayPal?
PayPal has been one of the most beaten-down tech names in recent years, dropping from its 2021 highs of $310+ to the $80-$90 range. However, this presents a major value opportunity.
✅ Earnings Yield: Trading at a P/E of 12, PayPal is significantly undervalued compared to its historical averages.
✅ Return on Capital: High ROC driven by strong cash flows and a stable business model.
✅ Revenue Growth: Revenue has increased from $25B in 2021 to $31.5B in the trailing 12 months.
✅ EPS Growth: Recovering from a difficult 2022, with projected acceleration in 2024.
Entry & Risk Management Strategy
📈 Breakout Play: The stock has recently broken through key resistance at $85, signaling renewed investor confidence.
📊 Hedging Strategy: For those entering before earnings, a protective put at $85 could serve as insurance.
🎯 Price Target:
- Short-Term: $100
- Medium-Term: $150
2️⃣ Alibaba (BABA) – A Contrarian Play on China’s Recovery
Why Alibaba?
Alibaba has long been seen as China’s Amazon equivalent, but regulatory concerns and a slowing economy have significantly impacted the stock. As one of the highest-ranked stocks under the Magic Formula criteria, BABA presents a deep value opportunity.
✅ Earnings Yield: A forward P/E of 9, making it one of the cheapest large-cap tech stocks.
✅ Return on Capital: High ROC, backed by strong cash flows and low debt.
✅ Growth Potential: The Chinese government has eased tech restrictions, which could fuel a strong rebound.
Entry & Risk Management Strategy
📉 Current Support: Trading near $82, a key historical floor.
📈 Earnings Play: Upcoming results could trigger a 20% rally if they exceed expectations.
🛡 Risk Management: Given China’s volatility, a protective put at $82 is advisable.
🎯 Price Target:
- Short-Term: $105
- Medium-Term: $120+
3️⃣ Nice Ltd. (NICE) – A Hidden AI & Cloud Play
Why Nice Ltd?
Nice Ltd. is an Israel-based cloud software company specializing in AI-driven business solutions. It has flown under the radar but has some of the strongest fundamentals in the Magic Formula screen.
✅ Earnings Yield: Higher than 90% of software companies, indicating undervaluation.
✅ Return on Capital: Strong cash efficiency and minimal debt levels.
✅ Industry Growth: Positioned to benefit from rapid AI and cloud adoption.
Entry & Risk Management Strategy
📉 Consolidation Phase: Trading in a tight range ($160-$165), setting up for a potential breakout.
📈 Momentum Confirmation: Entry is best above $175, signaling a confirmed breakout.
🎯 Price Target:
- Short-Term: $200
- Medium-Term: $260
🔍 Building a Portfolio Using the Magic Formula
Step 1: Screen & Select Candidates
- Use a stock screener with filters for Earnings Yield & ROC.
- Exclude financials and utilities for better consistency.
- Diversify across multiple sectors rather than focusing on one.
Step 2: Buy 2-3 Stocks per Month
- Instead of deploying all capital at once, scale into positions over time to reduce risk.
Step 3: Hold for 6-12 Months
- Traditionally, the Magic Formula suggests holding for a year, but taking profits earlier if targets are met is also an option.
Step 4: Rebalance Quarterly
- If a stock’s earnings weaken or guidance declines, exit and replace it with a new top-ranked stock.
Step 5: Use Options for Hedging
- For high-volatility stocks, protective puts limit downside risk while keeping upside potential intact.
The Bottom Line: Why Magic Formula Investing Matters in 2025
The Magic Formula isn’t just about stock picking—it’s about building a system for long-term outperformance.
📈 By focusing on undervalued companies with high returns on capital, investors align with businesses that generate strong profits efficiently—a key to long-term success.
📉 In today’s inflationary environment, passive investing isn’t enough. A rules-based approach like the Magic Formula helps investors identify real opportunities rather than overpaying for index exposure.
💡 Now’s the time to act. Start screening for Magic Formula stocks, enter selectively, and position yourself for alpha in 2025.