Advantages

The Magic Formula is a mechanical investing strategy. What does this mean? Mechanical investing refers to following a discrete and objective set of rules to determine what stocks to buy, and in many cases when to sell them. Most mechanical strategies use a stock screen that uses one or more statistical measures to rank stocks. For example, the Magic Formula ranks all stocks over 50 million in market cap by a combination of earnings yield and return on capital. Mechanical investors then buy stocks that are highly ranked based on these statistics. These mechanical strategies also usually provide for a set period of time at which followers then re-run the screen and re-balance their portfolios based on the new screen results.

Why is mechanical investing an attractive way to invest? Here are 5 main reasons:

1. Low cost (if implemented smartly)..

   Mechanical investing usually involves some turnover in your portfolio a few times a year, but this can be handled easily by individual investors. With commission fees very low at most online brokers, implementing these strategies is very low cost. Using a no-commission fee broker like Zecco, it can be done with no fees whatsoever! Compare this to entrusting your money to an investment professional or buying a mutual fund. Advisers can take several hundred dollars a month in commissions, and mutual funds all come with some overhead, called the "expense ratio". The money saved on these fees greatly improves long term investment returns.

2. Historical Performance Means Something.

   Most mutual fund literature touts their 1, 3, 5, and 10 year returns as marketing for potential investment. The truth is, past performance of managed mutual funds means pretty much nothing. Legg Mason Value, run by famous manager Bill Miller, outperformed the S&P 500 for 15 years up until 2005. Since then, abysmal performance has sent the fund's 10 year return below the benchmark. Fidelity Magellan, a star mutual fund when run by manager Peter Lynch, subsequently underperformed the S&P for over 15 years after he left.

   However, with a mechanical investing strategy, historical performance is more meaningful. It is not based on a "hot" stock picker, but on objective measures of valuation and efficiency. They are easy to backtest with historical data. There is never any guarantee that historical results will bear out again in the future. But the likelihood of 50 years or more of market behavior continuing into the future is pretty high.

3. Several Mechanical Strategies Outperform the Market.

   Following the above point, many mechanical strategies have been shown to vastly outperform an investment in the S&P 500 over long periods of time. Most of these are value oriented strategies such as buying low P/E stocks, buying high dividend yield stocks, low price-to-sales ratios, etc.