Magic Formula Stocks YTD and the Top 5


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Jae Jun

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What You Will Learn

  • How to Use the Magic Formula to Find Good Stock Ideas
  • Results of Backtesting the Magic Formula

What are the Magic Formula Stocks YTD and the Top 5

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%
  • Backtest Magic Formula: 17.33%
  • Backtest 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 backtest 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.

(click to enlarge)

Magic Formula Stocks

Magic Formula Stocks

 

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.

(click to enlarge)

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)

#1 PDL BioPharma (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 be 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 barebones. Check it out for yourself.

#2 Bridgepoint Education (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%

#3 InterDigital (IDCC)

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

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 to 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 increased in net income and free cash flow over the past few years.

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

#4 ITT Educational Services (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 their 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%

#5 Kulicke and Soffa Industries (KLIC)

Makes equipment and tools used to assemble semiconductor devices.

About 90% of its sales are from Asia and it 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 the part of the Magic Formula Stocks for this post.

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

Disclosure

Interesting ideas to check out but no positions.

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  • Klarmanite

    Nice post. And I agree that 10 years is decent, but I’m not sure I agree it’s completely adequate. I think backtesting that can really be trusted must be done on data spanning several secular market environments, not just a few business cycles. However, ten years is clearly better than just a few or rules of thumb, market lore etc!

    Also:I think Alpha and Beta should be concepts viewed with skepticism feom a value investing point of view, to put it mildly. The willingness to accept volatility is important if one wants to outperform over time.

    As a smart guy once said, the only thing that should matter to a long term investor is to maximize total after tax profits. Mr Market does the most incredible things and makes the best deals available to us when the proverbial fecal material hits the rotating cooling device. Which, as it turns out, it does from time to time. As value folk, we better be ready.

  • Ben

    One idea that may reduce the volatility of the magic formula and improve performance is to remove stocks that are heavily shorted. If you are using the MF and not researching underlying companies, then it makes sense to not invest in heavily shorted companies. Short sellers generally short because they have serious doubts about a business model. A MF stock that is not heavily shorted will have uncertainty, without high expectations of business failure IMO.

  • Spot on. In the end, it’s all about the absolute return. We like to measure ourselves against something, but having a standard of achieving absolute returns is the best.

    Alpha. I’ve never really looked at it, but for those who are constantly “seeking alpha”, it’s something to look at.

    Stat geeks will love it.

  • interesting idea. On the flip side, the most shorted could also turn out to be the most explosive.

    I’m more interested in seeing how to replicate Greenblatt’s screen. Can’t get the stocks that he has.

  • Ben

    Yes, you give up the short squeeze potential, but you are only investing in stocks where people see too much upside to short, but at the same time too much uncertainty has pushed the stock down. Perhaps Greenblatt’s formula takes company size into consideration? Also, maybe try adjusting the rank weights. Instead of 50% / 50%, perhaps giving more weight to quality (or value) would get closer results to FNSAX

  • Emil

    In The Little Book…, Greenblatt mentions that he “adjusts for excess cash”, but doesn’t go into details how he does this. Do you think that might have anything to do with the different outcomes?

    Thank you for an outstanding blog and site!

    Best,

    / Emil, Sweden

  • I believe that there is more to it than that. Best to go with what he says in the book because I’m sure he wouldn’t flat out lie. Pretty sure he has something up his sleeve. Whether he includes criteria for dividends or something.

  • Good point. I didn’t recall that but now I do remember that Greenblatt uses excess cash.

    The formula for excess cash is not published so that could be it.

  • Pingback: PDL BioPharma Inc. (PDLI), Bridgepoint Education Inc (BPI): Magic Formula Stocks YTD and the Top 5 - Insider Monkey()

  • KS

    Maybe he rebalanced at a different time of year and different stocks were the top picks then

  • John

    In my opinion Standard Deviation is a bad metric.

    Most of that volatility is coming from UPSIDE volatility!

    I invest in both stocks and trade futures on the side for a living, and let me tell you, my metrics on the futures side the volatility is high! Around 20+% yearly… YET my maximum drawdown EVER was 9%. My volatility is high because when I win trades, my equity just spikes up, while when going down it just drifts very slowly until a new spike happens from time to time.

    Semi-standard deviation or something like the Sortino is much much better in my opinion since they only take into account the volatility on the downside.

  • gilesbaker

    If you want to replicate the screen, try his website http://www.magicformulainvesting.com. It has a free screener that runs his algorithm. I’ve used this for the last couple of years, with a $50M market cap minimum (the lowest possible). For 2013 I bought the top 26 stocks, equally weighted. Return was ~60% including commissions. It crossed over the S&P around June. The cool thing about this system is that you apply zero analysis. I have no idea what I own. I buy what it tells me to buy. It takes a total of about 2 hours per year. The small cap stocks can be a bit tricky due to very low volumes (don’t put in market orders!). But so far it seems to be a good system.

  • The thing about the screen is that the ranks have been hidden. The stocks are listed in alphabetical order and not in the order of best to worst.

  • gilesbaker

    That’s true. I just pick the top 30 and buy them all where possible. With the 50M market cap baseline there are sometimes stocks that aren’t easy to get, so it usually ends up at around 28 stocks.

  • nice indeed. Did you rebalance for this year?
    If something goes up a lot, do you sell or do you just hold?

  • Alex

    Great post, which software do you use to backtest and retrieve data from? Thanks

  • Billy

    I am not taking a position on the validity of the formula one way or the other. However, in a 2010 Forbes interview (https://www.youtube.com/watch?v=I7GBHGg3pds – this is part 1, I forget which part exactly) Greenblatt states that the screener will have different stocks everyday given volatility in price. Therefore, if you start on May 1 and I start on April 1, we could/would have different holdings.

  • That is true. It all comes to the price. There won’t be huge changes, but price does play with what the multiples are.

  • Az_kid

    Just finished his book….did you weight your purchases by dollar amount (i.e., $1000 per company), share amount (i.e., 100 shares per company) or some other purchase weight criteria?

  • Az_kid

    Good question! Also when first purchasing do you purchase more of a top thirty stock that has dropped significantly in the recent past relying on the MF ranking to say it is still a great buy?

  • yes equal % weighting.

  • no this post was just based on the screen that I have. At the beginning of the year, 20 stocks are purchased and it is held for 1 year. No rebalancing. This is a custom screen so it doesn’t go by the way of the MF ranking.

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