The Magic Formula Investing Strategy

“The secret to successful investing is to figure out the value of something and then-pay a lot less”

Joel Greenblatt

The Little Book That Beats The Market

In his The Little Book that Beats the Market, Joel Greenblatt, a top-performing hedge fund manager since the 1980s,  describes a Magic Formula to beat the market. The secret of his magic formula is actually no magic to it at all. It is basically “a long-term investment strategy designed to buy a group of above-average companies (High return of capital) when they are available at below-average prices (low EV/Ebit)”. How intuitive it is!

The concept is simple, the explanation is simple, but most important of all, the execution for investors is simple enough to do on their own. For more detail explanation of the Magic Formula of Greenblatt, refer to the link below:

http://en.wikipedia.org/wiki/Magic_formula_investing

The key driving formulas used by Greenblatt for his Magic Formula are:

• Earnings Yield = EBIT / Enterprise Value
• Return on Capital = EBIT / (Fixed Assets + Net Working Capital)
  • Enterprise value = Market capitalization + total debts + MI – excess cash
  • Fixed assets generally is the property, plant and equpment
  • Net working capital = Receivables + Inventories – Payable
  • Ebit is earnings before interest and tax, or operating profit
  • MI is minority interest if any
  •  

Performance of the Magic Formula in US

So how well the Magic Formula worked in the matured market of the United States? The table below shows that the Magic Formula outperformed the S&P500 by a wide margin for the 22 years from 1988 to 2009.

The Magic formula outperformed S&P 17 out of the 22 years and achieved a compounded annual growth of 23.8%  as compared to the 9.6% of S&P. $10000 invested 22 years ago in 1988 has grown to 1.09m by the end of 2009, even after the US sublime crisis in 2008-2009. This is by no means a small feat.

Why does the Magic formula investing works?

In an efficient market like that of the US market, how come investors have the chance of buying good companies at low price and hence profit from the strategy? Below could be some of the reasons:

1. Most investors tend to avoid buying many of the biggest winners.

The market prices certain businesses cheaply for reasons that are usually very well-known. Whether you read the newspaper or follow the news in some other way, you’ll usually know what’s “wrong” with most stocks that appear at the top of the magic formula list. That’s part of the reason they’re available cheap in the first place! Most likely, the near future for a company might not look quite as bright as the recent past or there’s a great deal of uncertainty about the company for one reason or another. Buying stocks that appear cheap relative to trailing measures of cash flow or other measures (even if they’re still “good” businesses that earn high returns on capital), usually means you’re buying companies that are out of favour. These types of companies are systematically avoided by both individuals and institutional investors. Most people and especially professional managers want to make money now. A company that may face short-term issues isn’t where most investors look for near term profits. But many of these companies turn out to be the biggest future winners.

2. Investors tend to sell their good stocks after they underperform for some time.

Many investors dislike holding underperforming good stocks for a period of time and simply sell them, held more cash, and/or buy other more “exciting” stocks. It’s hard to stick to a seemingly good stock that’s not working for a little while.

 3. Many Investors sell their good stocks after the market and their portfolio declined.

This is a similar story to #2 above. Investors don’t like to lose money. Beating the market by losing less than the market isn’t that comforting.

Since the Magic Formula worked in the more efficient market in the US, it should logically work better in a less efficient market as that of Bursa for the reasons below.

1. There are less institutional investors here and hence less follower of this Magic formula.
2. The fewer institutional investors often have no mandated to buy those stocks which meet the Magic Formula, which most of them are probably small and mid capitalized stocks.
3. Retail investors here are generally not that savvy in fundamental investing. The percentage of them who know how to determine a good company or a good price is relatively low.
4. In fact few retail investors are interested in fundamental investing. Many are relying on reports from investment bankers who have their own self interest, listening to rumours and hearsays.
5. The psychology of fear and greed also have greater influence on the retail investors here.

Use of the principles in Magic Formula investing in Bursa

So why don’t we use the Magic Formula’s principles to invest in Bursa? I seriously think we should if we wish to earn extra-ordinary return from Bursa. In fact we can make improvements to this proven strategy to enhance our winning chances with the following:

1. Give emphasis to quality of earnings by looking at its cash flows
   1. Cash flows from operations close to or above net profit
   2. Free cash flow positive most of the years, preferably above 10% of invested capital, 5% of revenue.
2. A healthy balance sheet with little and manageable debts and hence lower risk.
3. What about some growth?

My investing experience in Bursa

I have been using the principles of The Magic Formula picking stocks for a couple of portfolios of stocks in Bursa with the modifications above. The first portfolio was set up on 21^st January 2013 as shown in link below:

http://klse.i3investor.com/servlets/pfs/13147.jsp

Note that the returns of the stocks and portfolio as published in the website have not taken into account of dividends for all the stocks and bonus issues of 1:1 for Pintaras Jaya, prestariang and Jobstreet. The total return is shown in appendix.

The followings are the salient points about the performance of the portfolio as at 7^th May 2014.

1. portfolio of stocks returned an average of 79% for a holding period of 14 months, outperform the return of the broad market of about 17% by a very wide margin.
2. There is not a single stock which had a negative return, indicating the strategy is of low risk.
3. There are three stocks having three-digit returns; Prestariang (242%), Pintaras Jaya (157%) and Jobstreet (107%), indicating this strategy could yield fantastic result in a up market.
4. Only one stock underperformed the market, SKP Resources at 8.8%, but it is still positive.

At the beginning of August 2013, another portfolio was set up, basically also using the modified Magic Formula. The portfolio only consists of two old stocks, Kumpulan Fima and Pintaras Jaya,  and nine new stocks. The returns of the stocks and the portfolio is as shown in the link here.

http://klse.i3investor.com/servlets/pfs/21089.jsp

The followings are the salient points about the performance of the portfolio after 9 months as at 7t may 2014.

1. The portfolio return a total gain of 65.6% for a holding period of 9 months as shown, outperformed the broad market of 5% also by an almost similar wide margin.
2. Again, there is not a single stock with a negative return, indicating the strategy is of low risk.
3. There was a multi-baggers in Datasonic with a return of 384%.
4. There are only two stocks underperforming the market; Tien Wah at +2.6%, and Haio at +0.2%. The rest of the stocks are all double-digit returns.

I have to admit that the holding periods may be too short to claim victory for my investment strategy in Bursa. I also acknowledge the role of luck could play an important part in the good return. However, it is hard for us to dismiss the probability that the extra-ordinary outperformance could also be due to the viability of the strategy of the Magic Formula.

So what do you think? Let’s  do it with the Magic Formula!

Please contact me if you like to know more about the Magic Formula at

ckc13invest@gmail.com

KC Chong (7/5/14)

Table: Returns of Stocks and Portfolio set up on 21/1/2013