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Magic Formula investing is based on a simple yet powerful way of searching for undervalued stocks. According to Joel Greenblatt’s The Little Book That Beats The Market, portfolios of stocks selected quantitatively based on MFI criteria have handily outperformed the S&P 500 over the past couple of decades.

Magic Formula Performance vs. S&P 500, 1988-2004

CAGR, 1988-2004
Magic Formula (all companies)
31%
Magic Formula (largest 1000 companies)
23%
S&P 500
12%

Source: Joel Greenblatt, The Little Book That Beats the Market.

WHY WE LIKE MAGIC FORMULA INVESTING

Advocated by “super investor” Joel Greenblatt. Greenblatt invented MFI as a do-it-yourself version of the approach he has espoused while amassing one of the most impressive investment track records of all time. While reliable data on Greenblatt’s complete track record is not available, some estimates put his annualized returns over the past couple of decades at well north of 20%. From 1985-1994, Greenblatt managed the Gotham Partners hedge fund, reporting annualized returns of 50% (after expenses, before performance fees). Gotham returned all outside capital in January 1995.

Simple. The MFI screen ranks companies based on only two variables: “cheapness” (pre-tax unlevered earnings yield) and “goodness” (return on capital employed). The two rankings are given equal weight in the final compilation of the MFI Top 100. This simple process stands in stark contrast to most quantitative screening methods, which rely on multiple variables and are difficult to replicate.

Makes sense. Few investors would prefer a bad business to a good one, and few would purposely ignore the price they pay for a stock. MFI seeks out good companies that are available at good prices. The result is a list of businesses that offer both a high earnings yield and a relatively high probability that capital reinvested in the business will generate high returns. It makes intuitive sense that such stocks should outperform.

WHY MAGIC FORMULA WILL CONTINUE TO WORK

“Institutional imperative” makes adherence to MFI difficult. Institutional managers care not only about investment risk but, perhaps more acutely, about career risk. Many managers cannot afford to follow a winning strategy if it involves enduring long stretches of relative underperformance. It is much safer from a career standpoint to be “wrong” when everyone else is losing money than to be “wrong” when everyone is making money. During the 1988-2004 period studied by Greenblatt, MFI handily outperformed the S&P 500, yet the strategy experienced two non-overlapping three-year periods of underperformance. While most fund managers may be able to endure a quarter or a year of underperformance, they may be left with few investors after a two- or three-year period of subpar results. It is therefore extremely difficult to stick with MFI when the going gets tough.

Investors have a hard time turning off their emotional biases. Even a quick peek at the list of candidates generated by the MFI screen – available at www.magicformulainvesting.com – is likely to make an investor’s stomach churn. Many companies on the list are either in out-of-favor industries or have major company-specific issues, such as regulatory scrutiny, accounting problems, executive turnover, or deteriorating operating momentum. While many investors may agree conceptually that buying good companies when they are out of favor is a path to long-term outperformance, a much smaller number would actually be willing to follow such a strategy.

As a quantitative method, the MFI screen is perfectly sanguine about picking a headhunting firm during a recession or a laser eye surgery provider when the media is calling into question the safety of laser eye surgery. Professional investors legitimately want to use the MFI list as a starting point from which to do further research and ultimately make a subjective judgment regarding an investment opportunity. Unfortunately, the subjective judgment is frequently tainted by emotional bias. As a result, the investor may dismiss the headhunting firm by thinking, “Of course it’s cheap, we’re in a recession!” Similarly, the investor may dismiss the laser eye surgery company by thinking, “Of course it’s cheap, they might go out of business!”

MFI never runs out of investment candidates. Several value investment strategies have become de facto obsolete over time. For example, whereas Ben Graham successfully searched for so-called “net nets” more than a half-century ago, such companies have become virtually extinct today. The few companies whose current assets exceed the sum of their equity market value and total liabilities are typically either depleting those current assets at a rapid pace or there are other reasons why theoretical liquidation values might not be realized. As a result, today’s professional investors cannot build their businesses around “net nets.”

By contrast, MFI simply ranks public companies relative to each other. There is no absolute cheapness requirement, whether it be “net net” or that book value exceed market value. As a result, MFI will always provide investors with an investable list of relatively attractive public companies.

Investors tend to remain skeptical of winning strategies even after long periods of outperformance. Investors have been taught – you might say “brainwashed” – that markets are efficient and there is no free lunch. As a result, they struggle with the notion that a simple quantitative strategy can systematically outperform the best efforts of large numbers of securities analysts and portfolio managers. For example, stocks that trade at a low multiple of price to book value have outperformed the broader market in a statistically significant way for a long period of time.

Economists Eugene Fama and Kenneth French have studied this phenomenon extensively (latest data is available at www.kennethfrench.com). Ironically, even after having observed this contradiction of the efficient markets hypothesis (EMH) for many years, Fama, in true professorial fashion, tried to explain it away by invoking the EMH adherents’ favorite axiom: If a strategy outperforms, it must be riskier! Unfortunately for Fama, the strategy of buying stocks with low price-to-book multiples also exhibited relatively low volatility. Volatility, of course, is the EMH adherents’ favorite definition of risk. Undeterred, Fama concluded that low price-to-book stocks must be riskier in other ways… The continuing lack of disappearance of the low price-to-book “anomaly” suggests that investors may not flock to MFI even after many years of demonstrated outperformance.

OUR PROPRIETARY TOP 10 SELECTION PROCESS

The Manual of Ideas has developed a process that seeks to improve upon the already impressive performance of the magic formula screen. The MF 100 is an unranked list of the 100 most attractive companies based on earnings yield and return on capital employed. We highly recommend Joel Greenblatt’s MFI website.

MOI’s methodology recognizes that not every equity investment should be approached with the same set of questions. Security analysis should be tailored to the type of opportunity examined. For example, an investor analyzing a company that trades at a large discount to net cash and tangible book value might inquire whether the company can be liquidated without major asset impairments, not whether the company’s long-term competitive position is favorable. On the other hand, an investor analyzing a company that trades well above book value and at a high multiple of earnings must examine prospects for sustained rapid earnings growth.

The performance of the MFI screen can be improved if one asks questions that take into account the nature of magic formula selections. Of particular concern is the fact that MFI favors firms exhibiting high returns on capital employed. Such companies are generally not cheap based on the liquidation value of their assets. Instead, they might be cheap based on current and prospective earning power. As a result, a crucial determination when evaluating MF selections is whether they exhibit above-average returns on capital for transitory reasons or for reasons that have some permanence. Warren Buffett calls this moat; others may know it as sustainable competitive advantage. It is also crucial whether a business operates in a growing industry that allows the company to reinvest a portion of free cash flow at high rates of return.

The MOI seeks out companies whose earnings yield is likely to increase over time if the stock price remains unchanged. Such companies not only sustain high returns on capital, but also grow earnings by reinvesting cash in the business. As they generate high returns, such companies need to reinvest only a portion of FCF in order to achieve respectable growth. As a result, they generally have cash available for dividends and stock repurchases. Buybacks executed at “good” prices accelerate EPS growth and value creation.

In order to narrow down the list of 100 MF companies to the ten most promising investments, we use a scoring methodology to rank the companies. We then consider the scoring results and a number of increasingly subjective criteria to narrow down the list to ten investments. In addition to “positive” criteria, such as sustainability of competitive advantage, management quality and industry growth, our selection methodology takes into account the following negative criteria, among others (as Charlie Munger might say, “Invert!”):

  • Pro forma adjustments: We eliminate companies that would not be on the MF list if their financial statements were adjusted to reflect true operating performance (may include companies recently engaged in large M&A).
  • Capital reinvestment: We avoid companies with virtually no opportunity for high-return reinvestment of capital (typically companies in industries in long-term decline).
  • Threats to key revenue source: We avoid companies dependent on a specific customer or contract, if loss of latter has become a real possibility (circumstances may include acquisition of major customer, ongoing re-bid process for large contract, or loss of patent protection).
  • Cyclicality: We avoid capital-intensive businesses that generate high ROIC only during cyclical upswings in their respective industries.
  • Faddishness: We avoid companies providing a product or service that has a reasonably high likelihood of being a fad.
  • Insider selling: We avoid companies with heavy recent insider selling, particularly if such selling occurred at prices roughly equal to or below the current market price.
  • Alignment of interests: We avoid companies with major CEO conflicts of interest or corporate governance abuses.
  • Value proposition: We avoid companies that offer a questionable value proposition to their end customers.
  • M&A rollups: We avoid companies that have meaningful integration risks due to major reliance on acquisition-driven growth.

Disclaimer: Copyright 2008 by BeyondProxy LLC. BeyondProxy and its affiliates may have positions in and may make purchases or sales of the securities discussed in this report. It is the policy of all Related Persons to allow a full trading day to elapse after the publication of this report before purchases or sales of any securities discussed herein are made. No Related Person held a position in securities discussed in this report as of the date of publication. Use of this report and its content is governed by the Terms of Use described in detail at http://www.manualofideas.com/terms.html.

Source: Why Joel Greenblatt's 'Magic Formula' Outperforms, and How to Do Even Better