Shares with the Magic Formula

It’s been 10 years since I started monitoring a screen based on the Magic Formula set out by hedge fund star Joel Greenblatt in his best selling book, The Little Book That Beats The Market. The 10-year stretch has finished with a flourish. Performance seems to have benefited substantially from the rally in value stocks late last year. 

Greenblatt’s Magic Formula really gets to the nub of what fundamental analysis of shares is all about: finding a favourable mix between quality and valuation. It is designed to be very straightforward, too. Greenblatt envisaged the screen as a tool for investors that were fairly disinterested but engaged enough to run the numbers and reshuffle their portfolios once a year. 

Disinterest would certainly have benefited anyone following this approach over the past 12 months. The stocks selected by the screen last February served up whipsaw returns. First they tanked during the March crash before storming ahead during the recovery. One of the reasons – but not the only one – that I try to emphasise that the results from the screens run in this column are best seen as ideas for further research rather than off-the-shelf portfolios is that it is incredibly hard to stick with a no-brains system at times of stress. Suddenly what seemed so smart and assured when performance was good, looks irresponsible and flawed when a portfolio is in free fall. 

However, the Magic Formula screen is different to most of the other screens I monitor. It was actually specifically designed by Greenblatt to provide its users with a no-brains 20 to 30 stock portfolio. 

It would have been especially hard to stick with the strategy during its March plunge because this calamity (or so it seemed at the time) followed two years of marked underperformance. Indeed, at its low point the screen had racked up losses of about 50 per cent from its 2018 peak (the so-called maximum drawdown). That is a level of loss that most people can only stomach if they avoid looking at their portfolio’s value. The length of the losing streak may have something to do with the fact that part of the stock-picking approach is based on 'value', and 'value' has been very out of favour over recent years.

Whatever the reasons for recent underperformance, though, the comeback from the 2020 corona-crash was stunning. The top-10 selection that I monitor had a particularly storming run, with the shares of two miners providing a particular boost to the overall result. 

2020 PERFORMANCE

Source: Thomson Datastream

The strong turn for 2020 means the Magic Formula screen’s scorecard looks good for its first 10 years under scrutiny by the Investors’ Chronicle. I monitor several versions of the screen, ranging from the officially prescribed 20 and 30 stock versions, as well as white-knuckle-ride 15 and 10 stock versions. The cumulative performance of all these screen variations can be seen on the accompanying graph as well as in the accompanying table. 

The table also provides performance figures adjusted for a notional 1.5 per cent charge to represent dealing costs. It's worth looking at the difference in performance of the screen with and without costs to see what an impact such a seemingly modest charge has on long-term returns. It should also make anyone who invests in funds thankful that we live during a time of declining management fees and charges.

Source: Thomson Datastream

Looking at the variations of the screen in the table, while the benefit of only selecting the top 10 shares would appear to be clear from the performance numbers, this does not tell the whole story. Going back to my earlier comments, the psychological damage done by the yo-yo performance of the top 10 would be a lot to take. The relative difference between the out- and under-performance each year of the 10 stocks and the 30 stocks can be seen in the accompanying graphs. With a different quantum of return has come a different quantum of turbulence. 

But back to the Magic Formula itself. It works by simply ranking stocks for value and, separately, for quality. These two rankings are then combined to give a final ranking and the stocks for the coming year are selected from that. Hey presto! 

The measures used for value and quality are as follows:

VALUE

Greenblatt uses an earnings yield in his Magic Formula. This is like a price/earnings (PE) ratio with the numerator and denominator flipped on their heads and expressed as a percentage. Greenblatt’s earnings yield looks at a whole-company valuation by factoring in the value of a company’s net debt or cash as well as the value of its shares; its market capitalisation. The formula's earnings yield compares earnings before interest and tax (Ebit) with enterprise value (EV). In its simple form, EV subtracts a company’s cash and adds its borrowings onto its market capitalisation.

QUALITY

To measure quality, Mr Greenblatt looks at how much Ebit is generated relative to a company’s 'tangible assets'. Tangible assets consist of net working capital added to net fixed assets. The idea is that tangible assets represent the assets that are actually being used in a company's operations to generate profits. This is similar to the popular return on capital employed (ROCE) ratio.

Here are the top 30 ranked Magic Formula stocks for the next 12 months. 

Source: FactSet