Shares with the Magic Formula

Turning a blind eye to what happens in the intervening 12 months is likely to be an important factor in successfully following this strategy. That’s because excessive scrutiny of the screen’s performance could make it very hard to apply a vital requirement of the Magic Formula: persistence. 

In his investment classic The Little  Book That Beats The Market, which lays out the method behind the Magic Formula, Mr Greenblatt told readers that they should expect bouts of underperformance from his screen. Viewed at 12 month intervals investors may stand a chance of not being scared off by the bad years. But watching the mechanics of the screen on a day-by-day and stock-by-stock basis could prove more traumatic than most investors are able to take.

A case in point are the five worst-performing stocks from last year’s screen. As can be seen in the table below, the screen managed to highlight some of the market’s very worst-performing shares.

Who let the dogs in?

Source: Thomson Datastream

It is hard to think such catastrophic performances would not trigger a reaction from an investor that was disinterested in stock analysis, but interested in daily stock prices. However, the screen purposely uses loose criteria and a scattergun approach on the basis that its dud picks will be balanced out by big winners. 

That said, last year with the drag of shares such as Staffline and Kier, the successes were unable to offset the failures. While the FTSE All-Share delivered a total return of 11 per cent, the top 10 Magic Formula shares registered a negative 5.1 per cent, the top 20 a positive 1.2 per cent and the top 30 0.1 per cent. The ability of diversity to dampen underperformance, and thereby lessen the psychological strain, underlines Mr Greenblatt’s wisdom in suggesting his Magic Formula is best used to create portfolios of 20 to 30 shares. 

2019 performance

In the nine years I’ve monitored the screen, depending on which version of the screen one looks at (10, 20 or 30 stocks), there have been three to four years when it has underperformed the market. Overall, the bouts of outperformance have been more significant than underperformance. And, importantly, given this screen was devised by Mr Greenblatt as a complete investment package, the outperformance remains after factoring in a notional annual dealing cost of 1.5 per cent.

How the magic formula works

The Magic Formula itself is a very sleek and simple screening method. It considers two factors that are of key importance in making an investment decision: value and quality. For value, the screen uses a slightly modified form of the ubiquitous price/earnings (PE) ratio. Quality is measured using a ratio similar to return on capital employed (ROCE) – return on assets (RoA) is also considered an acceptable alternative. Details can be found below.

Value

Mr Greenblatt uses an earnings yield in his Magic Formula. This is like a PE ratio with the numerator and denominator flipped on their heads and expressed as a percentage. While the PE ratio is the convention used in the UK, the earnings yield has a lot more intuitive appeal as it more clearly expresses the return investors would get based on the price paid if earnings remained static. 

Mr Greenblatt’s earnings yield looks at a whole-company valuation by factoring in the value of a company’s debt as well as the value of its shares; its market capitalisation. To do this the Magic Formula’s earnings yield compares earnings before interest and tax (Ebit) to 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.

Bringing it all together

Stocks are ranked for value and separately ranked for quality. The two rankings are then combined to produce a final ranking. The screen is carried out on all non-financial, main-market and Aim stocks with market capitalisations of more than £50m. Financial companies are excluded from the screen because the nature of their balance sheets means the quality measure used can give dubious results.

Troubled times

The recent poor 12 months from this screen follow a poor performance in the prior year, too. When I assessed the screen last year, I suggested some of the problems it had encountered may be the result of the high valuations being applied to high-quality shares. This makes it more likely that companies that look attractive from both the perspective of quality and value are in fact cheap for a reason, and worse still, could be 'value traps'. The screen is particularly vulnerable due to its focus on earnings, which can often be presented in a rather flattering light. 

Low earnings quality was certainly an issue for a number of last year’s disasters. Take recruitment company Staffline. Having disclosed it was being investigated by the tax man over potential breaches of minimum wage laws, it was forced to go cap in hand to shareholders for £37m to keep it within borrowing terms. Meanwhile, it started 2020 with a warning that profit would be materially below expectations as an internal audit review had found cause for more provisions and write-downs.

Kier has also faced balance sheet strains. Trading was hit by problem contracts while its use of supply chain finance (using lenders to pay contractors on time) also came under scrutiny. Banknote printer De La Rue and Indivior, a developer of treatments for opioid addiction, both face existential crises in the respective forms of the move to cashless transactions and competition from generic drug companies. Meanwhile, investors appear to have given up on Card Factory’s promise of vertically integrated growth in favour of fears of operationally-geared decline. 

Mind the value trap!

The valuation of many of the top 10 stocks selected by the Magic Formula screen this year screams 'value trap'. As a rule of thumb, investors should be on high alert when stocks are valued at less than seven times forecast earnings or yield more than 7 per cent. Still this screen requires a leap of faith. Indeed, the screen’s top-performing pick from last year, UK newspaper group Reach (RCH), fell into – and continues to fall into – this possible-value-trap category. The runners and riders for the next 12 months are listed in the table below along with some fundamental data.

Shares with the magic formula

Source: S&P Capital IQ