Manual of Ideas Offers Insights into ‘Magic Formula’ Approach

Published on July 6, 2010

Not so long ago, anyone with an interest in researching investment opportunities had to go through the laborious process of locating physical copies of SEC filings, newspaper reports, articles, and other information that today can be obtained in a matter of seconds.  However, today’s abundance of data carries a significant downside when it comes to looking for informed opinions:  Where can an investor turn to for reliable and trustworthy analysis?  Of the many “systems” for investing available today, which if any offers worthwhile prospects for the investor?

Magic Formula:  Intuitive, Simple, and Effective

Joel Greenblatt

One of the most compelling investing systems developed in recent years is Joel Greenblatt’s ‘Magic Formula’ approach which is documented on the website as well as Mr. Greenblatt’s The Little Book That Beats the Market. The formula ranks stocks based on two very simple and easily calculated figures:  earnings yield and return on capital.  The idea is to look for businesses that are both “good” and “cheap” on a quantitative basis.  The formula has a proven track record with a compound annual rate of return of 14.5 percent from October 1999 to the end of 2009 compared to a slightly negative annual return on the S&P 500.

The Catch:  Possibility of Heartburn and Career Risk

Anytime a system produces excellent historical returns, intelligent investors must ask why the system should continue working in the future now that the details have been publicized.  Is it not reasonable to assume that the magic formula will be less effective going forward now that investors have been exposed to it?

It turns out that the formula is likely to keep working in the future for at least two reasons:

First, high quality companies rarely trade at “cheap” prices unless there are serious perceived problems facing either the company specifically or the general industry in which it operates.  These problems cause investors to call into question whether returns will be as strong going forward.  If not, valuations may fall permanently to reflect the company’s diminished prospects.  Stated differently, the companies are usually out of favor and often fall within Benjamin Graham’s concept of “unpopular companies” which we discussed in a recent article.

Second, the magic formula approach does not work in all market environments and can often underperform for several consecutive years.  Most individual investors cannot stand this since they will occasionally lose bragging rights at the 4th of July picnic.  Most professional investors cannot underperform for several years and expect to keep their job or their assets under management.

Most Investors Look for Qualitative Judgments

In general, the magic formula approach calls for investing in a basket of companies that qualify based on the screens.  While some of the companies will actually end up having problems and are not as “cheap” as they appear from the historical record, many will turn in performances that eventually cause the market to remove the pricing discount.  Diversification will increase the chances that a purely quantitative approach using the magic formula will prove successful over long periods of time.

However, as much as the quantitative approach might be proven based on the track record, many investors simply are not comfortable using the magic formula without applying qualitative standards as well.  In other words, investors may prefer to use the magic formula as a starting point in the idea sourcing process rather than mechanically investing in the names that the formula turns up.

Manual of Ideas Adds Value to the Magic Formula

The Manual of Ideas is well known in the value investing community for providing publications that reveal actionable investment opportunities.  Portfolio Manager’s Review is a monthly publication that uses a proprietary idea generation process to identify 20 to 25 investment opportunities with a focus on the best three to five ideas.  Each issue typically has a specific theme.  In recent months,  themes have included a review of the portfolios of several superinvestors, a “deep value” report on Ben Graham style investing, a focus on investing in companies with “brand value”, and more.

The latest issue of Portfolio Manager’s Review focuses on equity ideas that score highly based on Joel Greenblatt’s magic formula screening methodology.  The report also adds additional quantitative criteria, some of which is forward looking in nature.  Most importantly, the report adds qualitative judgments as part of the process.  21 investment candidates are discussed in detail and five are identified as top candidates for consideration. Additionally, the top 100 magic formula stocks are presented in several ranked tables with links to the company websites and SEC filings.

It seems logical to think that a careful application of qualitative criteria should improve upon the magic formula’s already impressive quantitative results.  The risk is that an investor may be swept up in prevailing negative sentiments regarding a company and rule out opportunities that offer a high probability of excellent returns.  There is no substitute for conducting your own due diligence for every investment and this must include reading the SEC filings, industry sources, and following the news.  In addition, exposure to the analysis, insights, and opinions of other analysts and investors can act as a check against ruling out companies prematurely and also as a way to question your own investment thesis.

The Manual of Ideas has posted several free sample issues of Portfolio Manager’s Review.  All of the free samples are well worth reading, particularly the Ben Graham style deep value report published in April.  These reports should give a reader a feel for the type of analysis that is offered before making a decision to subscribe.

Disclosure:  The author of this article is an occasional contributor to the Manual of Ideas blog.

Manual of Ideas Offers Insights into ‘Magic Formula’ Approach