Background On The Magic Formula
The Magic Formula was first conceptualized by famed investor Joel Greenblatt in his 2005 book "The Little Book that Beats the Market." The Magic Formula's basic premise is that buying good companies at bargain prices makes sense and delivers market beating investment returns. Using a quantitative screen, good companies are identified by their high profitability in terms of ROC, ROIC or ROA; while bargain prices refers to stocks trading at either low EV/EBIT or low P/E ratios (equivalent to high earnings yields). In his book, Joel claims that back testing the Magic Formula returned 30.8% per annum from 1988 to 2004, compared with a market average and S&P500 return of 12.3% and 12.4% respectively. While some have contested his claims to varying degrees, but alternative studies confirm the presence of significant alpha, albeit to a lesser extent.
Modifications To The Magic Formula
I make two key modifications to Joel Greenblatt's The Magic Formula.
Firstly, I use operating income (revenue minus operating expenses, calculated from the top of the profit & loss statement), instead of EBIT, in my calculation of earnings yield (operating income/enterprise value). This is inspired by Tobias Carlisle who blogs at Greenbackd.com, is the founder and managing director of Eyquem Investment Management LLC, and is the author of "Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations." Tobias explains on his website, The Acquirer's Multiple, that "calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items-earnings that a company does not expect to recur in future years-ensures that these earnings are related only to operations." EBIT, when it is calculated from the bottom of the profit & loss statement by adding back interest and taxes to net profit, is more likely to be "noisy" and obscured by one-offs.
Secondly, I consider all companies with return on capital (NYSE:ROC) greater than 100% to be equally ranked on ROC. In John Mihaljevic's book "The Manual of Ideas: The Proven Framework for Finding the Best Value," John makes several suggestions on improving The Magic Formula. One of these was introducing "an arbitrary hurdle, above which we would consider all companies tied from the perspective of returns on capital," as he wondered "whether it was meaningful to rank a company with a 5,100 percent return on capital employed ahead of a company with a 5,000 percent or, for that matter, 1,000 percent return on capital." Companies with such high returns on capital are typically asset-light companies like consulting firms that do not utilize tangible assets on their balance sheet to generate income. As a result, it is not meaningful to rank one capital-light firm over another one based on returns on tangible assets.
There are other suggested modifications to The Magic Formula that i have come across, which I do not agree with. One example is the use of forward earnings in the calculation of earnings yield and ROC for The Magic Formula. One negative is that forward earnings are based on analysts' estimates, which are subjected to various biased. Another negative is that using forward earnings for The Magic Formula will exclude a significant number of stocks not covered by sell-side analysts (hence the absence of forward earnings).
List Of Hong Kong Magic Formula Stocks
Among more than 1,700 stocks listed on the Hong Kong Stock Exchange, approximately 900 of them have positive operating income, invested capital and enterprise value, which I ranked them based on EV/operating income and ROC. I calculate ROC as trailing twelve months operating income divided by the sum of net working capital and net property, plant & equipment.
The list of the top 30 Hong Kong listed stocks as ranked by The Magic Formula are as follows (Subscribers to my Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service get access to the list of the top 100 Hong Kong Magic Formula stocks):
|Symbol||Company||Market Capitalization (HK$ million)||Earnings Yield||ROIC|
|HKG:8100||GET Holdings Ltd||301||141.0%||216.5%|
|HKG:635||Playmates Holdings Limited (OTCPK:PYHOF)||1,992||74.4%||836.0%|
|HKG:869||Playmates Toys Limited (OTCPK:PMTYF)||1,685||72.1%||329.1%|
|HKG:878||Soundwill Holdings Limited (OTCPK:SDWHF)||3,031||42.6%||182.4%|
|HKG:703||Future Bright Holdings Ltd (OTC:FTRHF)||653||41.5%||152.4%|
|HKG:2229||Changgang Dunxin Enterprise Co Ltd||524||897.0%||69.6%|
|HKG:153||China Saite Group Co Ltd||1,646||46.3%||77.3%|
|HKG:623||SinoMedia Holding Ltd.||1,365||36.3%||114.6%|
|HKG:221||PNG Resources Holdings Ltd||543||124.2%||67.1%|
|HKG:176||United Pacific Industries Limited||766||34.8%||710.4%|
|HKG:2341||EcoGreen International Group Ltd||833||41.0%||76.1%|
|HKG:687||Tysan Holdings Limited||2,991||37.0%||81.4%|
|HKG:70||Neptune Group Ltd (OTC:NPGPF)||411||34.2%||86.9%|
|HKG:2399||China Fordoo Holdings Ltd||1,274||37.0%||75.7%|
|HKG:864||Wing Lee Property Investments Ltd||417||29.5%||102.3%|
|HKG:1443||Fulum Group Holdings Ltd||1,443||26.9%||293.7%|
|HKG:1263||PC Partner Group Ltd||288||26.8%||112.8%|
|HKG:410||SOHO China Ltd (OTCPK:SOHOF)||15,980||26.1%||108.4%|
|HKG:336||Huabao International Holdings (OTCPK:HUIHY)||9,413||34.9%||72.0%|
|HKG:896||Hanison Construction Holdings Ltd.||1,143||31.9%||75.5%|
|HKG:884||CIFI Holdings (Group) Co Ltd||7,861||25.6%||113.6%|
|HKG:2300||AMVIG Holdings Limited (OTCPK:AMVGF)||3,010||23.9%||126.1%|
|HKG:273||Mason Financial Holdings Ltd||3,319||32.8%||65.4%|
|HKG:2010||Real Nutriceutical Group Ltd||2,004||69.4%||51.5%|
|HKG:2228||CECEP COSTIN New Materials Group Ltd||2,514||23.6%||86.5%|
|HKG:1181||Tang Palace (China) Holdings Ltd||549||25.4%||73.2%|
|HKG:382||Welling Holding Limited (OTC:WLLHY)||3,694||44.5%||51.5%|
|HKG:1235||Travel Expert (Asia) Enterprises Ltd||452||20.0%||107.0%|
|HKG:1678||China Creative Home Group Ltd||1,827||39.2%||49.5%|
|HKG:752||Pico Far East Holdings Limited||2,684||19.7%||162.0%|
I have also written about Magic Formula stock, Dynam Japan Holdings Co. Ltd. (OTC:DJPHF) (HKG:6889), a Hong Kong-listed, Japanese pachinko hall operator, on Seeking Alpha here. Dynam Japan is currently ranked 223 on the list of Hong Kong Magic Formula. It used to be ranked higher at the point of my article, but its ROC declined (and its Magic Formula ranking suffered) following the release of its interim results.
Note: Subscribers to my Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service get full access to the 9 potential Asian wide moat investment ideas and 8 potential Asian wide moat value traps, which include "Magic Formula" stocks, wide moat compounders, hidden champions and high quality businesses, that I have profiled in the past months.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.