New Magic Formula Picks

Investing is often made to seem complicated. It doesn’t have to be. The screen I’m running this week exemplifies how a very uncomplicated but intelligent approach to investing can prove extremely effective. The screen is based on the 'Magic Formula' developed by hedge fund star Joel Greenblatt and it has produced excellent returns in the seven years I’ve run it, with the top 10 stocks boasting a cumulative total return of 254 per cent compared with 68 per cent from the FTSE All-Share over the same period.

 

It is easy for would-be investors to be put off the stock market by the reams of jargon the investment industry invents to package even the simplest of ideas – a cynic may wonder if the chief reason for the deluge of investo-waffle is to confuse and intimidate clients that may otherwise be asking why their fees are so high. Meanwhile, an intricate knowledge of company accounts and searing analytical skill may help prevent some bad investment mistakes, but basic portfolio diversification can also be a very effective guard against the danger of individual stocks blowing up. And while charting tools and market-timing strategies may be invaluable for some day traders, for those with longer-term time horizons, these techniques can simply prove a complex nuisance. But with so many investment approaches competing for attention, it is all too easy to lose sight of the wood for the trees.

However, boil everything down, and aside from luck, there are essentially two basic determinates of stock market success: the quality of stocks bought (higher the better) and prices paid (lower the better). Mr Greenblatt outlined a screening method as simple and succinct as this basic concept in his 2005 best-seller The Little Book That Beats The Market. Indeed, when Mr Greenblatt wrote the highly-readable book, the reader he had in mind was a disinterested investor who wanted to generate strong returns but didn’t want to spend time pawing through company accounts and watching the market.  

The screen itself was designed to produce outperformance over the long term, but in any single year it is liable to underperform. That means the advice to anyone following the Magic Formula system is to stick with it come good times or bad, in fact, especially come bad. Over the seven years I’ve monitored a screen based on the Magic Formula approach, this advice has certainly been valuable. Indeed, following two years of relatively weak performance up to February 2016, the screen has taken off again in the last 24 months. The table below shows how the screen has performed in each of the seven years I’ve run it. Mr Greenblatt suggested his formula should be used to construct a portfolio of 20 to 30 stocks, but I’ve also monitored the performance of more concentrated portfolios of 10 and 15 stocks, which have produced stronger returns to date but have also been more erratic.

Year-by-year performance table

Source: Thomson Datastream

Over the last 12 months it has been the screen’s top picks that have really delivered. But while very big gains by some of the top 10 stocks powered the overall performance, there were also some truly grizzly returns from lower ranking stocks. Fortunately, though, the diversity of the 20 and 30 stock portfolios helped limit the impact of the really bad performing picks. It is worth noting that several of last year’s big disappointments crop up again on this year’s list of Greenblatt stocks, such as troubled outsourcer Capita (CPI) and struggling newspaper group Trinity Mirror (TNI).

2017 performance

Source: Thomson Datastream

As the time over which I have monitored this screen gets longer, the significance of the cumulative nature of returns (building this year’s performance on last year’s) becomes more pronounced. This also means the importance of considering the cumulative burden of costs also becomes more important. The table below shows how a notional 1.5 per cent annual cost for reshuffling portfolios would have affected returns. The impact of charges is becoming quite pronounced with the total return from the most concentrated portfolio of 10 shares dropping from 254 per cent to 218 per cent once charges are included. As well as the table showing returns with and without charges, the bar-graph attempts to illustrate their significance. Charges are not factored into the total return graph, though.

IMPACT OF NOTIONAL 1.5 PER CENT CHARGE

The Magic Formula screen works by looking at a slightly modified form of a price-to-earnings ratio to assess 'value' (the price paid) and a modified version of a return on capital ratio to assess 'quality'. Details can be found below. All stocks are then ranked for value and separately ranked for quality. The two rankings are then added together and a final ranking is produced. 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.

Value

Mr Greenblatt uses the earnings ratio in his magic formula (this is simply like a PE ratio with the numerator and denominator flipped on their heads) calculated using enterprise value (EV) and earnings before interest and tax (Ebit). EV adjusts a company’s market capitalisation for cash and debts (debts can include pension deficits and long-term lease liabilities in some versions of EV, but not the one used by this screen).

Quality

To measure quality, Mr Greenblatt looks at Ebit generated from 'tangible assets'. Tangible assets consist of net working capital added to net fixed assets, which reflects assets that are actually being used in a company's operations to generate profits.

By simplifying the investment process to the degree the Magic Formula does, a lot of the nuances factored into a typical investment decision are eschewed. While this certainly saves time and effort, and can result in bold and profitable investments, it comes with risks. Anyone familiar with the stocks that make up the top 10 Greenblatt picks this year will probably be able to see those risk writ large. Indeed, the low valuations many of the stocks boast reflects chronic concerns about their businesses. What’s more, major issues with several of these companies may mean the purported quality of their operations is set to deteriorate. This, for example, is likely to be the case with companies such as Capita and Interserve (IRV), which have been forced to write down the value of their assets in response to poor trading. What’s more, Capita has been forced into a rescue writes issue. That said, for investors willing to hold their nose and dive in, there is a strong contrarian angle to many of these situations and the track record of this screen certainly provides grounds for encouragement even if it means kissing a few frogs along the way.

2018 Greenblatt picks

Source: S&P Capital IQ