The Magic Formula Needs An Upgrade

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Includes: AEIS, AGX, AMAG, AMCX, BKE, CJREF, CNCE, EGOV, EGRX, EVC, FTSI, GME, HRB, INVA, MDCA, NTRI, PBI, PDLI, SRNE, SYNT, TPCO, TVTY, UIS
by: Asgeir Strandlie

Summary

The Magic Formula can still be great, but it needs a refinement. An element of historical stock price in relation to present price is added to the value based model.

Combining the two different approaches by adjusting for stock quote development results in a double price discount. This can make the MFI approach more profitable.

How the system can be applied practically and become an efficient tool for ranking stocks. Presenting a new, quantified score as a result.

Examples from my own portfolios that are based on the "Double Discount" approach, and how they perform versus the market.

In this article, I will first go into the basic principle behind the Magic Formula and the Value Investing approach: The Margin of Safety. I will describe in detail why a Margin of Safety is fundamental for becoming a successful investor, supplied with phrases from Benjamin Graham's famous book "The Intelligent Investor".

Furthermore, I will describe how to benefit from price fluctuations by applying the Margin of Safety as a foundation. I will explain how these different principles can be combined and applied efficiently in practical investing in today's markets.

Short background/description of the Magic Formula:

  • "The Magic Formula" was developed by Joel Greenblatt and described in detail in his famous book «The little book that beats the Market».
  • The principles that are utilized in his book and in his stock screener are based on Value Investing principles, first described by Benjamin Graham and furthermore applied by Warren Buffet and other leading, successful investors around the world.
  • I will not go into the explanations of the model here. If you would like a more detailed description of the Magic Formula, it is further described in a previous article that I have written ("Magic Formula Investing Companies Vs. The Most Traded Companies In The U.S. Markets").

Margin of Safety as the Central Concept of Investment

Probably most speculators believe they have the odds in their favor when they take their chances, and therefore they may lay claim to a safety margin in their proceedings. Each one has the feeling that the time is propitious for his purchase, or that his skill is superior to the crowd's, or that his adviser or system is trustworthy. But such claims are unconvincing. They rest on subjective judgment, unsupported by any body of favorable evidence or any conclusive line of reasoning. We greatly doubt whether the man who stakes money on his view that the market is heading up or down can ever be said to be protected by a margin of safety in any useful sense of the phrase.

By contrast, the investor's concept of the margin of safety-- as developed earlier in this chapter-- rests upon simple and definite arithmetical reasoning from statistical data. We believe, also, that it is well supported by practical investment experience. There is no guarantee that this fundamental quantitative approach will continue to show favorable results under the unknown conditions of the future. But, equally, there is no valid reason for pessimism on this score. Thus, in sum, we say that to have a true investment there must be present a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience." (Source: "The Intelligent Investor" by Benjamin Graham, Fourth Revised Edition, Chapter 20, "Margin of Safety as the Central Concept of Investment", page 519-520)

The whole concept of the Magic Formula and Value Investing, in general, is basically built on one key principle: THE MARGIN OF SAFETY. Benjamin Graham (regarded as «The father of Value Investing») explained the importance of using a safety margin as a leading investing principle:

A Margin of Errors

We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck. The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments." (Source: "The Intelligent Investor" by Benjamin Graham, Fourth Revised Edition, Chapter 20, "Margin of Safety as the Central Concept of Investment", page 517-518)

A margin of safety means that there is a margin of errors: When predicting future performance of a company and making estimates, there is always a possibility that future results may differ from present and historical results, either in a positive or negative direction. The future will always be more or less uncertain. But if a company has delivered excellent results and at the same time not been rewarded for it in the pricing of its shares, you've got a safety margin. When established valuation principles indicate or justify a (much) higher stock price, there is a built-in discount. This price discount will work as a buffer when future results for a company become weaker than recent results and/or weaker than expected. Other external, unpredictable factors may also have a negative effect on a company's future performance. But by already having a price discount as a buffer, negative factors will have no or a minimum of effect to the market pricing. In other words, you can say that the Margin of Safety works as a substitute for future estimates, where predictions of company performance will have close to zero importance. This is the core content of Benjamin Graham's famous principle.

An Element of Price Discount is added to the Margin of Safety

You may have heard about the phrase "Formula-based timing". And it can be used meaning two different things: "Formula-based timing" in the sense of trying to predict the direction of the market is equal to speculation, and should by no means be considered as a true investment. On the other hand, "Formula-based timing" in the sense of present price levels seen in relation to historical quotes definitely has got something to do with the subject of investing. There is a distinct difference between the two. The latter indicates that the investor will be looking for a certain price discount compared to earlier price levels. The levels of pricing will always be of great value for the investor by "buying low and selling high". An attempt to "time" the market by predicting its direction will be like flipping a coin: You can be right or you can be wrong, the probability is 50 % either way. If you are right maybe two or three times in a row, it has nothing to do with a sound and intelligent investment decision, it rather is a result of coincidence. While a careful approach of buying low and selling high will in the end always benefit the true investor. And that is not a result of coincidence. By doing so, the investor makes a decision based on the assumption that present price levels qualify as a discount compared to former price levels. As a result, to him or her the significance of market direction in the short term will then be equal to zero.

It is interesting to notice that Benjamin Graham spent a whole chapter in the revised edition to the subject of market fluctuations:

Market Fluctuations as a Guide to Investment Decisions: Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing..." "...We are convinced that the intelligent investor can derive satisfactory results from pricing of either type. We are equally sure that if he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator's financial results. This distinction may seem rather tenuous to the layman, and it is not commonly accepted on Wall Street." (Source: "The Intelligent Investor" by Benjamin Graham, Fourth Revised Edition, Chapter 8, "The Investor and Market Fluctuations", page 189).

(Please note: The above quotation by Ben Graham cannot be used as an argument for having a margin of safety when applying "Formula-based timing" as in my point above. My argument for having a price discount is the difference between present and former price levels. This idea was not supported by Graham.)

Profiting from Price Fluctuations in individual Stocks applying "Formula-based Timing" (The Price Discount)

Today's markets continuously offer situations where you can apply "Formula-based timing" in a profitable way. Instead of applying it to the overall market and looking only at total market conditions, this approach can be used on individual stocks seen in relation to their historical stock price development. As an example, I apply this in my portfolios using historical prices over the last three years. If the present stock price is close to its three-year high, there is little or no price discount. If the present price is close to its three-year low, the discount increases according to the gap between its three-year high and low, and it gets bigger the closer it is to its lowest levels.

Avoid speculation: Applying this last principle alone, looking only at stock price development isolated from the first principle (the Margin of Safety), is a risky affair though. This is of course because it's not taken into account the fundamentals and the financial performance of the company. And there might be good reasons why a company's shares are trashed and sent to historical lows. Actions based only on this last principle alone are of a speculative character and cannot be regarded as true investments. In other words, "Formula-based timing" can only be regarded as a true value investment when used in combination with the first principle. But: When financial results show that a company's shares are highly undervalued, it cannot be a bad thing that the stock price also is far from its highest levels.

Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies." (Source: "The Intelligent Investor" by Benjamin Graham, Fourth Revised Edition, Chapter 8, "The Investor and Market Fluctuations", page 205).

How can you benefit from combining the Margin of Safety with "Formula-based Timing" (the Price Discount)?

Is there a way to combine the two different approaches in a way that can benefit an investor? Is it possible to make a reasonable system that might be helpful for making better decisions when considering to buy or sell shares in a company? My assertion is, yes it definitely is! I have developed a system that simply adds both "The Safety Margin" and "The Price Discount" of a stock together, giving the stock a quantified total score. The score is based on the following:

  1. One score for financial performance, mainly "Earnings Yield" (EY) and "Return on Invested Capital" (ROIC) added together, eventually adjusted up if Net Working Capital makes up 50 % or more of the company's market cap. This score is basically built on the same principle as "The Magic Formula" ranking system by Joel Greenblatt.
  2. One score for stock price development, where the score gets higher the bigger the price "discount" is: The score is calculated from the percentage difference between present market price and the highest stock price level during the last three years.

This results in a total score which will give you a quick impression of how big the double discount is. The score will also be helpful when comparing the "strength" of stocks in different industries, or if you need to compare one company to its competitors. Combining the two different approaches by applying the score in your investment decisions will give you a very powerful tool.

The Market Adjusted Total Score: The quantified version of "The Magic Formula Refined"

I have chosen to name the model "The Market Adjusted Total Score" (MATS) since the score is not only a product of the fundamentals of a company but also adjusts for and takes into account the changes in a company's market pricing over the last three years. And this is The Magic Formula Refined!

I am not going into the details of how the model ranks stocks and how the scores are calculated here, but there is a detailed description of the model available on my website where you can read more about how "The Market Adjusted Total Score" is calculated and the principles it is built on.

Examples of how The double Discount can be applied practically by using "The Market Adjusted Total Score"

Since January this year, I have applied the model every month and made a portfolio every quarter (established in the beginning of January, April, and July) with a ranking of companies with the highest scores in US stock markets. Every portfolio is an exact result of the model explained above, and all stocks are generated from the Top Bargains Watch List presented on my website every month since January. The number of stocks in the portfolios may vary because only stocks that receive an above average score in the model's calculations will be included. Remember that the highest scores simply mean the same as highest total price discounts. Below you will find both a list of companies included in the portfolios and the performance of the portfolios year-to-date. Please note that this article in no way is an attempt to convince anyone that the MATS model is superior to other systems, or that the model will outperform the market. It neither is an attempt to predict future performance of the system. The lists of companies and the performance of the portfolios are only included to give you as a reader specific examples of how the two different price discounts explained above easily can be applied practically and used in real investments. You will find further and detailed explanations of the portfolios and how the stocks are picked here. Here you will also find more information about how the portfolios are managed.

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(Source: All images and graphics from stockbargains.net. Data from stockbargains.net and Yahoo Finance)

As you can see from the charts, the portfolios from Q1 and Q2 have performed quite well so far this year. No stocks are replaced during the period (one year) and no stocks are added. The column in the table named "Risk Adjusted Performance" shows the performance of every stock when keep-gain and stop-loss principles are included: A stock is "sold" when it has a loss exceeding 25 %. A winner is "sold" and taken out of the portfolio when it has reached a gain of minimum 50%, but not before it has turned down again and "lost" ¼ of its total gain (this is to allow the stock price to develop and not sell it while it is still rising, in other words, to avoid selling before the full price potential is most likely reached).

Below is the third quarter portfolio, established at the first trading day of July (using closing prices from June 29th). The development of this portfolio during its first couple of months is more typical for this approach than how the other two portfolios have developed from the start (the two portfolios from the first and second quarter started with gains from the start, which is quite surprising).

(Source: Images and graphics from StockBargains.net. Data from StockBargains.net and Yahoo Finance)

Make sure you follow me here at Seeking Alpha, so you won't miss out on my next articles. In a later article, I will go into the advantages and disadvantages by applying a system like the one described above. Then, I will also focus on the challenges, but also the rewards, an investor will face when applying a true value investing approach.

Please engage and join the discussion relating to this article. I appreciate your views and comments!

No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what Graham called the "margin of safety"-never overpaying, no matter how exciting an investment seems to be-can you minimize your odds of error."
(Source: "The Intelligent Investor" by Benjamin Graham, Fourth Revised Edition, "A note about Benjamin Graham, by Jason Zweig")

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The Market Adjusted Total Score (MATS), The Top Bargains Watch List and my portfolios are only a result of my own calculations, and must not be interpreted as “buying or selling signals” in any way. I am not an investment advisor. Even though I do my best to avoid mistakes, wrong calculations may occur.

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.