Most business schools ignore value investing, focusing more on the efficient market model and all the math that goes along with that. – Joel Greenblatt
Do what everyone else does and you’ll just get the same results.
But does the Magic Formula really work?
Well, the backtested data shows awesome results.
When I first wrote the article on the Magic Formula, I wanted to verify the strategy with my own backtesting.
This is what I came up with.
For recent, “similar” results, I look at Greenblatt’s Gotham funds. It’s not an apples to apples comparison as he doesn’t use the Magic Formula strategy for his funds. But I’m going to guess and say that there are some characteristics.
The performance has not been earth shattering, but again, it’s not an apples to apples comparison.
The Basics of Picking Magic Formula Stocks
The Magic Formula is surprisingly simple.
- Establish a minimum market capitalization (usually greater than $50 million).
- Exclude utility and financial stocks
- Exclude foreign companies (American Depositary Receipts)
- Determine company’s earnings yield = EBIT / Enterprise Value.
- Determine company’s return on capital = EBIT/ (net fixed assets + working capital)
- Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
- Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
- Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
- Continue over a long-term (3–5+ year) period.
But I think there should be 10 steps – where the tenth is also the most difficult.
10. stick to the strategy
Strategies fail because of the investor’s unwillingness to stick to the process. To find something that works, it takes at least a couple of years of data.
However, because money is involved, I get that all strategies are on a short leash.
Out of the 9 official steps, the two most important is the Earnings Yield and Return on Capital.
- Earnings Yield = EBIT / Enterprise Value
- Return on Capital = EBIT / (Net Fixed Assets + Working Capital)
These two are the bread and butter.
I’ve modified my method slightly to use ROIC instead of ROC.
Finding Magic Formula Stock Ideas Criteria
You can always get Magic Formula stock ideas from our free Magic Formula screen list. The list is updated weekly.
For Old School Value Insiders, there is a pre-defined Magic Formula screen to get you started. To beef it up, here’s how I have mine set up.
- Eliminate OTC stocks
- Eliminate retail, financials and utilities
- No Chinese companies
- EV/EBIT between 0 and 15
- Earnings Yield between 0% and 50% (don’t want to search too high. Introduces a lot of noise.)
- ROIC between 0% and 50% (don’t want to search too high. Introduces a lot of noise.)
Doing this, I get close to 500 stocks.
Still too much.
I want my work to be easier than going through 500 stocks to get a manageable list.
This is where the OSV Action Score comes into play.
I know that the A and B rated stocks outperform. It’s not a guarantee. This year, the Action Score is not performing well because too many retailers are showing up on the list. With retailers dropping like flies left and right, at one point this year, there were about 10 retailers in the top 20.
Following the rule of thumb of no more than 2 companies in the same industry will keep you buffered.
When you zoom out and focus on long term year over year performance, the results still show that focusing your energy on the A’s and B’s work out. (I’m going to share my real Action Score portfolio in the coming days to show you how it is working out.)
If you look at this chart, as the score gets higher, the average return increases.
3 Magic Formula Stocks to Consider
I started out with 500, and after filtering to only select the A and B rated Action Score stocks, the final list is down to 76 stocks.
Of the 76, here are three interesting names.
- Davita (NYSE:DVA)
- Steel Dynamics (NASDAQ:STLD)
- TSR Inc (NASDAQ:TSRI)
Davita is Berkshire’s 11th largest position in the portfolio, purchased by Ted Weschler.
11th biggest sounds big, but it’s only 1.6% of the Berkshire portfolio.
Weschler and Davita go back a long way when Weschler owned Davita from his days at Peninsula Capital Advisors. Now at Berkshire, he has been building a position since 2011.
It’s been a great ride since 2011, but has hit some bumps the past couple of years, which has given the Berkshire portfolio manager more opportunity to add to the position over the years.
As it stands, Berkshire owns just shy of 20% of the company’s shares outstanding.
Since we are talking about Magic Formula stocks, seeing Greenblatt’s name in the list of holders for Davita is also a good thing.
With Davita and all other healthcare stocks, the common theme is that the aging US population and growing health issues people face that cause kidney failure (high blood pressure, diabetes etc) will create more demand for dialysis (where waste is removed from the blood in patients with malfunctioning kidneys).
Davita has been touted as a healthcare play for patient investors.
“Patient” is a good description here. A simple way to determine how ignored or hyped a company is, is by looking at how many articles come up on Seeking Alpha. In Davita’s case, the last dedicated article is dated Aug 31, 2016; 9 months ago.
For a 12B market cap, healthcare stock with plenty of volume, it doesn’t get much attention.
The Magic Formula numbers show the following:
- EV/EBIT of 10.3
- Magic Formula Earnings Yield of 9.7%
- ROIC of 9%
Looks to be trading at a reasonable price based on those numbers.
Over a 15 year period, current price is trading at the bottom of the EV/EBIT multiples range.
Here are other numbers to consider:
- Price to FCF is 8.5
- Price to Owner Earnings is 7.2
- ROIC and CROIC have been going up
- Financially stable on the balance sheet
Bad aspects of the business:
- Top line revenue growth has slowed
- Gross profit margin has been dropping 30% a few years back to 27.8% in the latest fiscal report
- 55% of revenues coming from Medicare and Medicare assigned plans
- Affected by government regulations
What you need to consider is that, if Davita is considered a long-term value play for patient investors, how will it do in a one year holding period of Magic Formula stocks?
Steel Dynamics (NASDAQ:STLD)
Steel Dynamics produces steel and recycles metal.
The Magic Formula numbers are all well within good territory.
- EV/EBIT of 10.6
- Magic Formula Earnings Yield of 9.5%
- ROIC of 11.1%
Nucor (NYSE:NUE) is