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.

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Magic Formula Stocks

Magic Formula Performance 1988-2009

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.

Magic Formula OSV Backtested Results

Magic Formula OSV Backtested Results

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.

S&P500 vs Gotham Funds

S&P500 vs Gotham Funds – source: morningstar

The Basics of Picking Magic Formula Stocks

The Magic Formula is surprisingly simple.

  1. Establish a minimum market capitalization (usually greater than $50 million).
  2. Exclude utility and financial stocks
  3. Exclude foreign companies (American Depositary Receipts)
  4. Determine company’s earnings yield = EBIT / Enterprise Value.
  5. Determine company’s return on capital = EBIT/ (net fixed assets + working capital)
  6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
  7. Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
  8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
  9. 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.

Moving on.

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.

magic formula stocks

Magic Formula Stocks Screen Settings

  • 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.

Action Score Average Return Chart

Action Score Average Return Chart

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 (NYSE:DVA)

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.

Davita EV/EBIT range

Davita EV/EBIT range | Click to Enlarge

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 a strong competitor, but Steel Dynamics has been the winner the past few years.

If you look at Steel Dynamics side by side with other competitors, it offers better value. Click the image to enlarge and see it side by side.

STLD Valuation Comparisons

STLD Valuation Comparisons

When it comes to liquidity and efficiency, Steel Dynamics wins 2 out of 6, but comes in a close second for a couple. So it’s up there as one of the best.

STLD Liquidity & Efficiency Performance

STLD Liquidity & Efficiency Performance

I removed Friedman Industries (NYSEMKT:FRD) from the group as it was the worst performer.

The biggest and real downside to Steel Dynamics is that it is a cyclical and commodity company. Holding a cyclical company for 1 year can be a losing proposition. Combine that with a commodity and it could be a double whammy in a worst case scenario.

I had it last year with Cal-Maine which was rated an A, but due to the cyclical nature of the business, it was sold at a loss at the end of the year for the annual rebalancing.

TSR Inc (NASDAQ:TSRI)

I was hesitant to include TSR with the recent run up.

TSR was one of the A rated Action Score stocks I bought when re-balancing at the beginning of the year.

With the run up, it’s gone from an A rated to a B rated stock as the value score has dropped.

TSRI Value Score

TSRI Value Score

It get’s a D value score because of how it compares when ranked alongside the other stocks in the universe. There are plenty of other stocks with better Value Score metrics.

However, on an individual basis, I value TSRI higher than a D.

Now TSR is a tiny microcap with a market cap is $14.7M. Small enough to turn off most investors. But the small cap space is where I’ve had success in picking Magic Formula stocks and other value strategies. I’ve followed TSR since 2013 as it’s been a net net until as recent as last year.

TSR is a staffing company providing contractual programming services to clients. There’s no moat here. Don’t expect a high quality company.

Insiders own 54% and institutions own 12.6%.

Definitely flying under the radar – just the way I like it.

On May 17, Zeff Capital offered $6.15 per share to buy out the company. Somebody sees value.

Factor in the first one time special dividend of $1 per share since 2012, and TSR is a shareholder friendly company that is now confident in their operations.

Magic numbers come out to be:

  • EV/EBIT of 11.6
  • Magic Formula Earnings Yield of 8.6%
  • ROIC of 4.3%

TSR may have more room, but with the run up, the upside may be capped.

I’m not using their latest FCF figure as it looks to be a really good year. If I adjust the FCF down to $900k and run a quick DCF with 0% growth and 7% discount rate, the fair value comes out to the $8 range.

But if you believe that 7% of a discount rate is too low, a 9% discount rate gives a fair value of $7.46 which puts it at today’s prices.

The Easy Way to Find Magic Formula Style Stocks

This is just 3 stocks out of the 76 in the shortlist.

Frankly, I haven’t heard of most of the names on the list.

That’s the point though. While others are seeking noise and opinions on stocks that are talked about everywhere, this is how I get my ideas and stocks to buy.

I like stocks with high insider ownership.

When I used to ride the train to school, I would get on a slightly earlier train so that I could get a seat before the traffic picked up.

It’s the same thing. You can try and ride an overcrowded train, or grab a seat on a cool A/C train before the throng of people get on board.

Adjusting the Magic Formula will help you pick some new, under the radar stocks.

To get started with creating your own short list of Magic Formula Stocks or other value stocks, check out the live demo to see how Old School Value works.

Disclosure: Long TSRI

Article by Jae Jun, Old School Value