Magic Formula Portfolio Achieves Alpha In Q1

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Includes: AAPL, AGX, AMAG, BBSI, BKE, BPT, BRCD, CALM, CPLA, CSCO, DLX, ENTA, FIT, FPRX, GHC, GILD, GME, GPRO, HPQ, IDCC, IQNT, KING, LCI, LIFZF, MSGN, NHTC, NLNK, NSR, OUTR, PDLI, RPXC, SSNI, TIVO, TSRA, UNTD, UTHR, VDSI, VEC, VIAB, WILN
by: Ryan Telford

Summary

Magic Formula >$100M Market Cap Portfolio returned 12.2% this semi-quarter*, compared to S&P Composite 1500 return of 10% over the same period.

10 of the 30 holdings returned more than 20% over the period, while 2 returned over 60%.

Largest “cheap and quality” industries represented are Biotech & Business Services.

(*Note: I refer to the period as first semi-quarter 2016, when in fact stocks are being tracked as of 19 Jan 2016, as this is when I started to track the portfolio. It is not technically a full quarter, and coincidentally avoids the losses to the market in the first half of January (not by intention), however I would like to report performance on this portfolio based on calendar quarters going forward.)

I recently published an article describing Joel Greenblatt's Magic Formula investing method and commented on some potential improvements. To sum up, the screen selects high quality stocks (earning high Return on Capital), but that are also cheap (high earnings yield on an EBIT/EV basis). Each stock in the portfolio is equally weighted by value (say each $1000).

I will be tracking the Magic Formula portfolio in realtime periodically.

Performance Benchmarking

With any investment portfolio, whether through the Magic Formula, another quantitative investing method, or any manually chosen stock portfolio, it is important to track the performance against a comparable benchmark. The S&P500 index (which tracks the largest 500 US firms by market cap), is often times used as a tracking index for portfolios. It should be noted that its performance is only really comparable if the portfolio being compared has similar size holdings.

The Magic Formula universe is unique in that it excludes financials, utilities and real estate holdings. It also does not limit itself to a maximum market cap, only a minimum size. I am screening based on minimum market cap size of $100M.

On 19 Jan 2016, our Magic Formula 30 stock portfolio had average and median market caps of $28B & $800M respectively.

The S&P Composite 1500 tracks equities of large, medium and small market capitalizations. The average and median market caps are $14B and $3B respectively at the end of March. This is a relatively close representation of our Magic Formula portfolio.

Holdings

The 30 stocks that made the Magic Formula screen as of 19 Jan 2016 (> $100M market cap):

Ticker

Company Name

Industry

AAPL

Apple

Electronics

AGX

Argan

Heavy Construction

BBSI

Barrett Business Services Inc

Staffing & Outsourcing

BPT

BP Prudhoe Bay Royalty Trust

Oil & Gas

BRCD

Brocade Communications Systems

Data Storage

CALM

Cal Maine Foods Inc

Food, Major Diversified

CPLA

Capella Education Co

Education & Training

CSCO

Cisco Systems Inc

Network & Communications

DLX

Deluxe Corp

Business Services

ENTA

Enanta Pharmaceuticals

Biotech

GHC

Graham Holdings

Holding Company

GILD

Gilead Sciences

Biotech

GME

Gamestop Corp

Electronic Stores

GPRO

GoPro Inc

Photography

IDCC

InterDigital Inc

Wireless Communications

IQNT

Inteliquent Inc

Wireless Communications

KING

King Digital Entertainment

Gaming

LCI

Lannett Co Inc.

Generic Meds

OTCPK:LIFZF

Lab Iron Ore Royalty Corp

Holding Company

NHTC

Natural Health Trends Corp

Personal Products

NLNK

NewLink Genetics Corp

Biotech

NSR

Neustar Inc

Diversified Communication Services

OUTR

Outerwall Inc

Specialty Retail

PDLI

PDL BioPharma Inc

Biotech

RPXC

RPX Corp

Business Services

TIVO

TiVo Inc

CATV

UNTD

United Online Inc

Internet Service Provider

VDSI

VASCO Data Security Intl

Security Provider

VEC

Vectrus Inc

Business Services

VIAB

Viacom Inc

Entertainment, Diversified

Click to enlarge

Source: Magicformulainvesting.com Screen and Yahoo Finance Industry Classes

Approximately 26% of the portfolio consisted of equal holdings of biotech and business services. Biotech is represented by Enanta Pharmaceuticals, PDL Biopharma, Gilead Sciences, and NewLink Genetics. Business services includes Deluxe Corp, Vectrus Inc, RPX Corp and Barrett Business Services.

The remainder of the holdings were fairly diversified. One will notice that there are not many mining or oil and gas (O&G) firms in this list; to recap the Magic Formula finds companies with high returns on capital selling cheap. While many of the mining and O&G firms are currently selling cheap, they have quite poor returns on capital, which preclude them from making Greenblatt's screen.

Performance over the Period

For the period, the Magic Formula portfolio returned 12.2%, versus a 10% return for the S&P Composite 1500.

See the graphic below for returns on each holding over the period.

Click to enlarge

Significant Gains:

10 holdings achieved gains in excess of 20% in the period. Note the spectacular gains by Natural Health Trends Corp and Lab Iron Ore Royalty Corp .

Ticker

Company Name

$ Price

19 Jan

$ Price

01 Apr

$ Change

Return

(excl dividends)

NHTC

Natural Health Trends Corp

18.19

32.68

14.49

79.7%

LIFZF

Lab Iron Ore Royalty Corp

5.62

9.1

3.48

61.9%

BRCD

Brocade Communications Systems

7.85

10.64

2.79

35.5%

IDCC

InterDigital Inc

43.9

55.39

11.49

26.2%

CPLA

Capella Education Co

41.52

52.26

10.74

25.9%

GME

Gamestop Corp

25.5

31.34

5.84

22.9%

DLX

Deluxe Corp

51.19

62.51

11.32

22.1%

AGX

Argan

28.9

35.07

6.17

21.3%

VEC

Vectrus Inc

18.91

22.75

3.84

20.3%

CSCO

Cisco Systems Inc

23.85

28.69

4.84

20.3%

Click to enlarge

The Magic Formula, while a portfolio investing strategy, can also serve to identify undervalued candidates for further study. One who was able to identify NHTC or LIFZF and took more concentrated position(s) would have achieved "quite satisfactory" returns, in Benjamin Graham's words.

Significant Losses:

On the flipside, there were a handful of positions that suffered greater than 20% declines over the period:

Ticker

Company Name

$ Price

19 Jan

$ Price

01 Apr

$

Change

Return

(excl dividends)

BBSI

Barrett Business Services Inc

36.31

28.24

-8.07

-22.2%

NLNK

NewLink Genetics Corp

25.71

18.39

-7.32

-28.5%

BPT

BP Prudhoe Bay Royalty Trust

19.79

13.77

-6.02

-30.4%

LCI

Lannett Co Inc.

33.37

17.61

-15.76

-47.2%

Click to enlarge

Acquisitions:

King Digital was formally acquired by Activision Blizzard on 23 Feb 2016. The deal was announced on 02 Nov 2015 for $18/share.

Ticker

Company Name

$

Price 19 Jan

$

Price 01 Apr

$ Change

Return

KING

King Digital Entertainment

17.87

18

0.13

0.7%

Click to enlarge

There is always the risk of an acquisition deal not closing, however one could argue that KING had limited upside during this period, and could have been replaced with another holding not in the process of being acquired. One of the drawbacks of the Magic Formula is that it does not screen out situations such as this. Perhaps a subject for future article(s) on quantitative investing.

Re-Balancing

The Magic Formula as intended by Joel Greenblatt, is a passive strategy where each stock is held for a period of one year. A variation of the model is to rebalance more often than one year.

More recent research has suggested that re-balancing more often for "cheap" factors (or "value" in the link) provides better results, while re-balancing more frequently for quality factors has little effect.

As highlighted in my previous article, Gray and Carlisle suggest that the quality factor in the Magic Formula may actually detract from overall performance than if one just screened for high earnings yield ("cheap") alone.

On this basis, I will track the Magic Formula portfolio on both annual and quarterly re-balancing periods.

For quarterly re-balancing of our current portfolio, 20 of the 30 holdings still make the screen, while 10 holdings are changed out.

The screen continually ranks the universe for a combination of high earnings yield and high returns on capital. Going into Q2, the following names have been outranked and removed from the screen.

Ticker

Company Name

Return

DLX

Deluxe Corp

22.1%

GHC

Graham Holdings

12.6%

GPRO

GoPro Inc

11.1%

IQNT

Inteliquent Inc

7.5%

KING

King Digital Entertainment

0.7%

LCI

Lannett Co Inc.

-47.2%

LIFZF

Lab Iron Ore Royalty Corp

61.9%

NLNK

NewLink Genetics Corp

-28.5%

TIVO

TiVo Inc

17.3%

UNTD

United Online Inc

13.8%

Click to enlarge

The new portfolio going into Q2 becomes (new holdings in bold):

Ticker

Company Name

Industry

AAPL

Apple

Electronics

AGX

Argan

Heavy Construction

AMAG

AMAG Pharmaceuticals

Diagnostic Substances

BBSI

Barrett Business Services Inc

Staffing & Outsourcing

BKE

Buckle Inc.

Apparel Stores

BPT

BP Prudhoe Bay Royalty Trust

Oil & Gas

BRCD

Brocade Communications Systems

Data Storage

CALM

Cal Maine Foods Inc

Food, Major Diversified

CPLA

Capella Education Co

Education & Training

CSCO

Cisco Systems Inc

Network & Communications

ENTA

Enanta Pharmaceuticals

Biotech

FIT

Fitbit Inc

Scientific & Technical Instruments

FPRX

Five Prime Therapeutics Inc

Biotech

GILD

Gilead Sciences

Biotech

GME

Gamestop Corp

Electronic Stores

HPQ

HP Inc

Diversified Computer Systems

IDCC

InterDigital Inc

Wireless Communications

MSGN

MSG Networks

Media

NHTC

Natural Health Trends Corp

Personal Products

NSR

Neustar Inc

Diversified Communication Services

OUTR

Outerwall Inc

Specialty Retail

PDLI

PDL BioPharma Inc

Biotech

RPXC

RPX Corp

Business Services

SSNI

Silverspring Networks Inc

Computer Based Systems

TSRA

Tessara Technologies Inc

Semiconductor Equipment

UTHR

United Therapeutics Corp

Drug Manufacturers, Other

VDSI

VASCO Data Security Intl

Security Provider

VEC

Vectrus Inc

Business Services

VIAB

Viacom Inc

Entertainment, Diversified

WILN

Wi-LAN

Intellectual Property Licensing, Tech

Click to enlarge

A 12.2% return for the portfolio over the period is encouraging, however this is still a short term period for a long term strategy.

I'm looking forward to providing an update in 3 months.

Disclosure: I am/we are long AGX, GILD, RPXC, WILN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have no affiliation with Joel Greenblatt or the Magic Formula.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.