Almost two years ago I read The Little Book That Beats the Market
The Magic Formula is an extremely simple philosophy. You look for companies with a high return on invested capital (ROIC) and a high earnings yield (EY). Note that both of these calculations use pre-tax earnings.
- ROIC = EBIT/(Net Working Capital + Net Fixed Assets)
- EY = EBIT/(Enterprise Value)
The basic theory here is that you want to find companies that earn significant money on their investment in operations and have a cheap stock price compared to their earnings. Mr. Greenblatt set up a website that screens these stocks for you (registration is required).
I picked five stocks from the list every two months. The strategy of the Magic Formula is to hold these five stocks for about a year. As the one year anniversary approaches, you take a look at your stocks. Sell the losing stocks before the year is up so you can take short-term capital losses. Sell the winning stocks after the year so you can avoid short-term capital gains tax.
In the beginning, the Magic Formula was fun. I would look at the list of stocks, pick some, and enter my buy orders. As time wore on I began to lose my enthusiasm for the process for the following reasons:
- This list rarely changes. I would see the same stocks over and over again on the Magic Formula list. This told me a couple of things. First, these stocks were on the list because they make good money on capital and they are cheap. Therefore, they were still cheap month after month. Second, I was relying on a single source for the Magic Formula list of stocks.
- Who are these people? Mr. Greenblatt makes it a point to say you need to know absolutely nothing about investing to use the Magic Formula. You simply pick stocks from the list every couple of months. One day I took a look at my Magic Formula portfolio and realized I knew absolutely nothing about any of the companies I owned.
- This is hard. I found the process of monitoring the anniversary date for my purchases annoying. I missed the anniversary date once due to travel. I also found myself always adding Outlook reminders to sell losers, sell winners, and purchase five more. I started to think the Magic Formula wasn’t so simple.
I decided about six months ago that the magic was gone between me and the Magic Formula. Ever since then I have been selling my Magic stocks on their anniversary dates and I stopped buying new ones. I have friends that swear by the Magic Formula and I am happy for them. If it fits their investing style, then that is great. I even made money with the Magic Formula. For me though, I just prefer to build a perpetual dividend engine instead.
December 15th, 2007 at 10:09 am
You make some good points. I’ve been tempted to try his MF but even he says you need between 5 and 10 years to get the full value from it. That seems like a long time to test a theory, even if he has back tested it, I’m not completely sold on it.
I agree with your point about the same stocks showing up month after month. I see some forums,(gurufocus is one), have MF followings and they all talk about the same companies month after month. How long can you wait for these “undervalued” companies to be recognized? To your point about selling at one year, it seems these stocks don’t mature near fast enough.
Heely’s is one that I don’t think I would ever touch. Who really knows if it’s just a fad or not, yet this seems to be the most popular stock among the MF that I have seen in forums and blogs. I think they are buying on price alone, $6.00 at Friday’s close down from a 52 week high of $40. Sounds like bottom fishing to me.
December 15th, 2007 at 10:37 am
Great point about Heelys. This was a point I meant to make in the original article as well. The problem is that some of these companies are cheap for a reason. PALM was one that was on the list. Take a look at what has happened to them over the last year. They were cheap because their business model was declining.
Thanks for the post.
December 17th, 2007 at 12:17 pm
Hello,
My approach so far to the magic formula is to watch MF stock performance. Each month I download stock results from the website into a spread sheet. I use a market capitalization of 10 million. I now have over one year of data. Using the first 5-7 stocks from every month, the average return is around 27%. That’s pretty good for not having to know anything about stocks.
For me, I’m going to keep downloading MF results and see if I can find a pattern that gets me even higher returns. I’m going to start putting the MF to work shortly as I can now show that it does work.
I like to think of myself as a grinder investor. My goal is to grind out 30+% returns every year. If I can do that, then at some point I will have enough money to retire, but I will also have a methodology that I can repeat over and over again. So not only will I be able to retire, but continue to make enough money to enjoy the sunset years.
December 17th, 2007 at 1:32 pm
Grant, it seems you are doing everything correctly. Those are some ambitious goals for annual returns. You say you choose the first 5-7 MF stocks from every month. How do you sort them to choose the top 5?
December 17th, 2007 at 3:16 pm
I read his book and enjoyed it. How long did you give his strategy? Also what market caps did you try? There’s chart in his book that lists the returns since the 80’s for a variety of market caps.
December 17th, 2007 at 3:40 pm
I have been actively investing in the MF for about a year and a half. I tried different market caps with each purchase. Here are my rough returns so far for each of the different baskets.
31%, -4%, 0%, -26%, 18%
I still have three more rounds of MF stocks to sell over the next six months. I usually purchased every other month. My total return on my sold stocks was 7.5%. This is not bad, but it sure was a great deal of hassle.
December 17th, 2007 at 7:24 pm
Just a year and a half? I’m not defending his strategy but he did say you have to be willing to do it for an extended period of time. Also, you could just invest all at once, like Jan 2nd, then hold them all for a year. But, then I don’t know what you’d do with the cash you’d accumulate during the year.
December 17th, 2007 at 7:52 pm
Jason, I have friends that use it and like it. To each their own, but it wasn’t the returns that bothered me so much as the fact I was relying on his website to pick the companies for me and it seemed to take quite a bit of effort to keep buying and selling. Thanks for taking the time to comment.