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In the last post I showed that the Magic Formula is a good screen for finding ideas.

I originally started writing that article believing that the Magic Formula was just hype and exaggeration. But hey, my thesis turned out to be incorrect and I’m fine with that. To refresh your memory, here are the results that I discussed.

Magic Formula CAGR from 1999 to 2009

  • Joel Greenblatt’s Magic Formula: 18.57%
  • Back-test Magic Formula: 17.33%
  • Back-test Magic Formula (including slippage and fees): 13.74%
  • S&P 500: 0.87%

If Greenblatt included slippage and fees into his own Magic Formula, that would bring his numbers down to the 14% range.

I also firmly believe that testing a strategy over 10 years is completely adequate. I receive some comments that the back-test needs to be lengthened in order to be valid, but I have to disagree.

Think of it this way. If your personal track record over 10 years is stellar, are you going to claim it as proven or still too early to tell?

2013 Magic Formula Performance YTD

Here is a look at how the strategy has been performing so far this year.

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It’s just surpassed the market this year, but according to the stats below, with such high volatility, the alpha of this strategy is negative by a large margin.

magic formula stats

This is a strategy that requires you to buy the stocks, and then keep your eyes closed for the whole year unless you can stomach the wild ride.

Here are stocks that passed the screen at the beginning of the year and make up the 2013 portfolio.

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Top 5 Picks

This is the magic formula so I’ll just present the two numbers that matter.

  • Earnings Yield = EBIT / Enterprise Value
  • Return on Capital = EBIT / (Net Fixed Assets + Working Capital)

No. 1 PDL BioPharma (NASDAQ:PDLI)

As the name suggests, PDLI is a bio pharmaceutical company.

  • Earnings Yield = 28.3%
  • Return on Capital = 189.6%

Earning royalties from a drug is a hugely profitable business. Since 2008, PDLI hasn’t performed any R&D so it’s all royalties since then.

Best of all, revenue has continued to increase since 2008 while SG&A has decreased. FCF is being milked by the company. This gives the company an operating margin of 93%.

Financial statements is bare bones. Check it out for yourself.

No. 2 Bridgepoint Education (NYSE:BPI)

BPI is a for-profit education company in a despised industry.

Very profitable mind you, but there are external risks always in play in this industry. You know it’s a risk when the president is out to get you.

Since July of 2012, Bridgepoint’s Ashford University has been under review and in danger of losing its accreditation. Uncertainty surrounds the company, which is bringing down the valuation.

Despite the uncertainty, BPI has been able to increase revenues from

  • Earnings Yield = 64.4%
  • Return on Capital = 45.5%

No. 3 InterDigital (NASDAQ:IDCC)

IDCC is a company that is in the business developing wireless patents and then selling them.

In 2011, IDCC spiked to $70 a share as speculation about monetizing its patents took a frenzy. That transaction didn’t go through but the company still owns a great deal of IP.

Book value is $12.30/share compared with a $48 share price at the moment. That’s a good amount of assets making up the valuation.

In 2012, revenue doubled along with nice increases in net income and free cash flow over the past few years.

  • Earnings Yield = 23%
  • Return on Capital = 58.8%

No. 4 ITT Educational Services (NYSE:ESI)

The second for-profit education company in the top 5.

Here’s a video analysis and valuation of ESI from Dan Myers. His comments are all still relevant and the video goes through the financials, debt, the drop in revenues, valuation and the risks in the industry.

Check out his other video analysis on his youtube channel too.

  • Earnings Yield = 30.8%
  • Return on Capital = 59.4%

No. 5 Kulicke and Soffa Industries (NASDAQ:KLIC)

Makes equipment and tools used to assemble semiconductor devices.

About 90% of its sales are from Asia and after a tough recession, the company has been performing strongly since 2009.

Gross margins are at its peak at 46.4%. From 2003 to 2009, gross margin was slowly ticking up to 40% until the recession hit so a 6% increase in a few years is a great achievement.

  • Earnings Yield = 45.1%
  • Return on Capital = 25%

Compare with Formula Investing Fund (FNSAX)

Although investors are able to pick and buy the stocks themselves, there is an official magic formula fund managed by Greenblatt.

It started in November 2011 so it still needs more time to prove itself commercially.

Interestingly, none of the official top 5 match my top 5, which does prove that Greenblatt has a special algorithm for ranking the stocks.

He spelled out that stocks are ranked based on:

  • Earnings Yield = EBIT / Enterprise Value
  • Return on Capital = EBIT / (Net Fixed Assets + Working Capital)

That’s as easy as it gets, but seeing how PDLI is the only stock listed in his official holdings, it is clear that Greenblatt has another metric or ranking criteria only available to himself.

Disclosure: No positions.

Source: Magic Formula Stocks Year To Date And The Top 5