Magic Formula Investing
Magic Formula Investing 101
Like many individuals, after reading Joel Greenblatt’s The Little Book That Beats The Market I was a bit confused on what to do next. The Magic Formula site provides a screen but does not rank the stocks as stated in the book.They are simply put in alphabetical order. I am not going to invest my hard earned money in a company blindly and had to develop a system for selecting the magic formula stocks. I hope this post will provide useful information in selecting magic formula stocks as the process that I detail has produced great results in my personal portfolio.
Lets get straight to the point and rank the stocks as described in the book. Visit this page to rank the magic formula stocks, the site will rank the magic formula stocks and cut down the fat on which companies to invest in. I have to thank “streetcapitalist” from valueinvestingnews.com for providing this link. Now the due diligence begins. It is up to the investor to decide how deep in security analysis they want to get into. Now that we have the rankings, it is time to separate the good from the ugly.
The first thing I do is weed out the companies I understand. This is easy as either you get it or you do not. The action for this is as follows. Head over to Yahoo Finance, type in the stock symbol and click on profile. For Heely’s (HLYS), the profile looks like this.
In the case of Heely’s, it is understandable so it might be a candidate. The problem with the magic formula is it contains a lot of beaten down businesses. For example, biotechs whose products were not approved by the FDA or their main product is going to lose its patent. Another example might be the business whose earnings peak as the economy peaks. To weed out the good from the ugly head over to morningstar.com
Again, at this stage we are simply sorting the good from the ugly. Type in the ticker symbol, on the left side click “Key Ratios”. The screen should look something like this: (click on pic to enlarge)
As the picture illustrates, NVTL ’s (currently ranked 16th) numbers are all over the place. Everything from profitability and ROE% are inconsistent and does not merit any more time. What you want are consistent numbers like ARO ( a former magic formula stock).
Now time to get into some security analysis. I start with the S&P 500 reports provided by my broker and read as much as possible about the company through their SEC filings, and news (going back 2 years) . Everyone has their methods so I really cannot dwell onto this. Next, time for some valuation.
As far as I can tell, most magic formula stocks will carry a low P/E with them. Depending if I have time, one half of my buy decision will come from this. The other half will come whether or not the stock is trading at a 52 week or all time lows. This alone is dangerous but has worked well for me so far. Finally, if you are a fan of discounted cash flow models (I am not), Joel Greenblatt does hint on them in the book (pages 40-47).
The first thing we need is some analysts estimates on how much are earnings are expected to grow for the next 5, 10, 15, 20+ years. Not too many people can predict earnings that far and that is why I do not like DCF models. Again, head over to Yahoo Finance and click on “Analyst Estimates”. Scroll down until “Growth Estimates” appears. We are looking for “Next 5 years Per Annum”. (picture below)
Five years is a short enough period where the numbers are semi accurate. In the above picture, Heely’s is expected to grow 5% for the next 5 years. How accurate is that depends on your analysis of the company. As everyone knows, Heelys is a one product company and that itself might be a optimistic estimate. To be cautious, I highly recommend cutting back on growth estimates for any company. For example, if a company is expected to grow 15%, assume 10% growth. Now time for some valuation. I am going to assume you have a growth rate, discount rate and earnings per share for the past twelve months. Next, go to moneychimp.com’s discounted cash flow calculator and insert numbers. This will give you an estimated intrinsic value. Next, cross your fingers the stock is selling at a discount and buy or move on.
Aeropostale (ARO) is a recent example of a magic formula stock that I bought and sold. When I bought the stock, I found it on the magicformula website and on the 52 week low list. I knew the business as it is one of my favorite place to shop. All the numbers and story seemed fine and I bought it on a low P/E & 52 week low basis. If I had done the process detailed above, it would have been a good illustration. Analysts expect the company to grow 17% for the next 5 years. I could assume 12% for the next five years discounted at 10%. I would also assume either a 1% growth rate after 5 years or no growth at all. The 1% is a discount to U.S GDP growth (2-4%?) . No growth because the business has no moat and competition is plentiful (AEO, ANF, etc).Also, retilaers have a shady record. The 12% growth for the next five years and a 10% discount rate would give me an intrinsic value of $28.00. Aeropstale’s 52 week low is $18.xx, providing a 34% margin of safety. Again, that was assuming reduced growth rates and no growth after 5 years. Joel Greenblatt recently sold between $28 and $31.
Finally, this by no means is a tell all article on which magic formula stocks to invest in. This is simply what works for me. Feedback welcome. How do you select magic formula stocks?
Disclaimer: I own not stocks mentioned above; as stated I once owned ARO
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14 comments for “Magic Formula Investing 101”
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how do i select magic formula stocks? i read good blogs and copycat them!
Nice article. Regarding buying and selling, I noticed that Greenblatt suggests picking up 6 or so companies every 2 months for 10 months to establish the portfolio. Do you implement this strategy? Or, rather, do you select companies throughout the year as they move onto the screens which meet your criteria? Also, do you hold for the suggested 1 year holding period then sell? Or do you sell when it hits your estimate of fair value?
John, be patient. use the screen as your guide and select companies that meet your criteria. The beauty of the stock market is that you get to chose your spots. You will find that passing on what seemed like a bargain, will result in finding a better bargain at a later time. Very few stocks move fast enough for me to sell in less than one year. If I sell in less than a year, its usually because I made a mistake in my analysis, something has changed in the company that might result in permanent loss of capital or I find a better investment opportunity’s.
Thanks for the advice, that makes a lot of sense. You mentioned that you don’t like DCF analysis to determine fair value. If you don’t mind me asking, which methods do you use? I noticed that Mr. Greenblatt mentions calculating normalized earnings in a few articles which have been written about him. Do you have any suggestions about books or other sources that detail this methodology? I have tried searching amazon.com and a Google and have not been able to find much.
Thanks.
I sometimes use the formula described in Professor Greenwalds Book ” Value Investing: From Graham to Buffett and Beyond ” But sometimes will rely on a low P/e approach. it has worked for me in the past and chances are it will work for me in the future. The funny thing about Wall St. is, it is full of idiots who will tell you AIG will go to $30 “because the options say so”. Or my favorite bearish argument for AIG, ” I am a retired floor specialist”.
Maybe Greenblatt considers EBITDA as normalized earnings?
Professor Greenwalds book goes into detail about normalized earnings.
Terrific, thanks for the information. I will check it out.
Alexg
I am curious to hear how the ad you ran on my blog went and how many click throughs you got from my blog
Thanks
John Bougearel
Successfultradingtips.com
Nice article…I have a question tho’. I tried the discounted cash flows calculator and am having problems. I used your example ARO. From Yahoo finance I took the last four quarters of EPS Actual which were .17, .18, .48 and .93. I added them together and divided by 4 to come up with .42 EPS for the last year. I plugged that in the Earning per share (last 12 months) section of the calc. Next I looked up Growth est for next 5 years. 17.5 - 5 = 12.5%. I plugged that in the calc next. for the next 5 years. I put leveling off at 0% like you recommended. I left 10% at the discount rate. Pressed calculate which gave me a result of 6.95 Stock Value per share. This is where I’m confused………you stated “The 12% growth for the next five years and a 10% discount rate would give me an intrinsic value of $28.00. Aeropstale’s 52 week low is $18.xx, providing a 34% margin of safety. How does the $6.95 stock value correlate to the intrensic value of $28? And waht do you mean by “intrensic value”? Looking forward to your response…..go easy on me…..I’m scandinavian…lol.
” From Yahoo finance I took the last four quarters of EPS Actual which were .17, .18, .48 and .93. I added them together and divided by 4 to come up with .42 EPS for the last year”
No need to divide. Adding them together would give you EPS for the trailing twelve months.
In the calculator insert 1.76 in Earnings Per Share last 12 months with your estimted growth rate (12.5, and 10% discount” and you should get $29.xx
Ahhhhh….told ya I was scandinavian. Thanks for the correction. I’m starting to track the top 50 (Market Cap 100mil) as of today. I’ll keep ya posted. By the way, how is the portion of your portfolio using this strategy working for you?
Great. You will encounter volatility though, so have patience.
Great article and links. Can you please advise how often you update your ranking screen that is provided.(last was June 14 I believe). what are your thoughts about cashing out portion of the earnings after one year if there any if the stock is still on the buying screens recommendations. thanks
Joseph,
its not my ranking screen. Someone over at Value Investing News provided the link while I was preparing the article. There is a post coming up on selling a stock so stay tuned
March 24th, 2008 at 4:03 pm
I sometimes use the formula described in Professor Greenwalds Book ” Value Investing: From Graham to Buffett and Beyond ” But sometimes will rely on a low P/e approach. it has worked for me in the past and chances are it will work for me in the future. The funny thing about Wall St. is, it is full of idiots who will tell you AIG will go to $30 “because the options say so”. Or my favorite bearish argument for AIG, ” I am a retired floor specialist”.
Maybe Greenblatt considers EBITDA as normalized earnings?
Professor Greenwalds book goes into detail about normalized earnings.
might want to use the true graham model next time.. aig hit $30 today. eventually magic math by traders/anals comes to reality. you can not mix a buffy and graham model,, graham buys value and waits until it doubles or more and sells it to buffy who buys it on leverage the same as the re+banks clowns have been doing all the way down.
might want to shift your investing focus to ‘growth’ ,, especially anything growing DESPITE the economy.