Cash Magic trounces the market again

2014 Cash Magic Performance

Source: Thomson Datastream

There are two clear inspirations for this screen: a reader request for a screen using the cash-return-on-capital-invested (CROCI) metric, and the screening methodology used by US hedge fund manager Joel Greenblatt. The Greenblatt methodology is very well suited to creating a screen that is highly focused on a given fundamental, such as CROCI. That's because his screening method provides a wonderfully succinct way of getting to the nub of fundamental analysis - identifying shares that can be bought for a price that undervalues the quality of the underlying business.

To make a comparison between value and quality, Mr Greenblatt employs a ranking system. Each stock is ranked based on the 'value' on offer and then is separately ranked based on the underlying business 'quality'. The rankings are then added together to create a combined ranking and those stocks with the best combined rankings are the ones to buy. The real beauty of this ranking system is that it allows for shares in high-quality companies with good but not excessively cheap valuations to rank alongside very low-priced stocks in businesses that are of not such high quality. By doing this, it blends the twin investor concerns of value and quality very neatly.

In the case of Mr Greenblatt's famous Magic Formula, expounded in his highly readable book, The Little Book That Beats The Market, his focus is on an earnings-based measure of value and a measure of a company's efficiency at producing those earnings from its asset base. CROCI, which is the metric used in my Cash Magic screen in response to a reader request, is a measure of a company's efficiency at producing cash from its asset base rather than earnings. Specifically, the ratio looks at cash profits - known in investment jargon as earnings before interest tax depreciation and amortisation (Ebitda) - as a percentage of a company's capital employed. Capital employed is a company's total assets less its current liabilities, which is a shorthand way of measuring the capital a company needs to conduct its day-to-day activities.

Given that CROCI measures the underlying quality of a company's operations based on its ability to produce cash, I use a valuation measure based on free cash flow as a gauge to how cheap or expensive the company's shares are. The valuation metric I use in the Cash Magic screen is much like a free-cash-flow yield, although turned on its head. Free cash flow (FCF) can be considered to be the amount of cash left over to reinvest in the business or return to shareholders following all the cash demands made on the company in the course of a year.

As such, FCF can be thought of as the cash-flow-statement equivalent to post-tax profit (the E in EPS) in the income statement. A key difference between the valuation measure I use for the Cash Magic screen and a traditional FCF yield is that rather than comparing FCF with a company's market capitalisation, I compare it with a company's enterprise value (EV). EV takes account of a company's debt and cash position by subtracting net debt from market capitalisation. This means companies with high debt look less attractive on this valuation ratio, while those with net cash look more attractive. The formula is simply: EV/FCF.

When I originally conducted the Cash Magic screen I back-tested the idea and the results of this suggested a portfolio of 30 shares was likely to produce the best results from this screen. This neatly fits with Mr Greenblatt's recommendations for the Magic Formula screen, although he suggests a 20-stock portfolio could give adequate diversity, too.

As well as the core portfolio of 30 shares I have been testing a portfolio that also takes into account shares' three-month momentum. This has been less successful than the core 30-share portfolio, although it has still outperformed the market, producing a 7.3 per cent return over the past year compared with 5.9 per cent from the FTSE All-Share and a cumulative two-year return of 35.6 per cent compared with 15.6 per cent.

2014 momentum 20% performance

Source: Thomson Datastream

The selection criteria for the momentum shares is that they need to be among the top fifth of the Cash Magic rankings and boast momentum that is superior to the market over the past three months. Given that two years is a short period over which to judge a screen I am running the momentum version of the portfolio again to see if its performance peps up, but the 30 top-ranking Cash Magic shares portfolio currently looks a significantly superior strategy.

Here are this year's Cash Magic Stocks ordered from highest to lowest ranking shares.

Cash Magic

Source: S&P Capital IQ

Momentum 20%

Source: S&P Capital IQ