This month has been a bit hectic. For one, school is in full swing. While my schedule is not as hectic as other times, I still have my fair share of homework and projects to take care of. I also have to start to prepare for what I am going to do post-graduation. Secondly, I have become a regular contributor at Gurufocus.com.  I have been a regular forum participant for almost 3 years now and I thought their new writers program would allow me to gain some exposure. I’m also using Gurufocus as a place to write about individual stocks. Whether it be here or Value Investing Pro, I have tried to do my best from talking about individual stocks. For one, I like to keep my best ideas for myself.  Secondly, I find value investing to be more about the process of waiting for fat pitches than looking at every stock.

Value Investing Pro

One thing that I have gained from Gurufocus is a tick up in traffic over at Value Investing Pro. With the extra traffic, I also re-gained my motivation for blogging on a regular basis again. I was becoming a  bit unmotivated with my blogs and traffic was seriously starting to tail off.  Anyway, the extra traffic has re-motivated me to get these puppies updated on a regular basis and with that has come a surge in subscribers through RSS and my Youtube Channel. I have big plans for Value Investing Pro, which will probably happen around July of next year. I want traffic to stabilize a bit and I have some smaller projects to launch before I start launching the major fireworks.

Joel Greenblatt Week

Last week was unofficially Joel Greenblatt week. There were two great appearances which are must sees if you follow the magic formula system like I do. Check out both appearances below.

Joel Greenblatt On CNBC

Joel Greenblatt On Bloomberg

Value Investing Stocks: Where are they?

One thing I like about a rising stock market is the % gains. But, I also hate the fact bargains are a bit tougher to find. I have found a couple in the mega caps, but the true fish are in the microcap arena where most mutual funds are simply too big too fish there. While the  market’s run up is nice, I’m becoming very cautious. For one, I’m looking around my neighborhood and I honestly don’t see signs of a recovery. Secondly,  I believe the market has risen too much, too soon. If the market does fall, I’m sitting on some cash, about 25%. Not so much because I’m fearful of a falling market, but I simply haven’t found too many ideas. As a matter of fact, in the past 3 months, i have found 1 bargain that I would seriously put money into.

Warren Buffett U

A while back, and I seriously mean a while back, I started a Warren Buffett site. I simply lost motivation, but now “im feelin it”. I’m restarting things this week. So if you’re interested in Warren Buffett head on over at Warren Buffett U. I  was even going to restart the site’s Youtube Channel but uploading the same thing to two different channels becomes a hassle.  I follow Warren Buffett on a daily basis so I don;t have anything to lose. I have the domain so why not give a try for at least 3 months. If the site gains traction, I will continue updating, if it doesn’t o’well, I can’t say I didn’ t try. That’s pretty much how I got started in this online business, I throw stuff at the wall and I see what sticks.  I still have work to do their, but you get an idea of how the site will look.

Diversification

Before moving on, let me clarify one thing; there is nothing wrong with diversification. I have had a diversified portfolio ( 15+ stocks in my book) for a while now as my time for researching stocks was limited. There are plenty of value investors who diversify and outperform the market by a good margin. Walter Schloss comes to mind.

Some well known concentrators

• Warren Buffett/Charlie Munger – While Berkshire holds a great number of stocks, the majority of the stock portfolio is invested in big bets such as Coca Cola (KO), American Express (AXP), Washington Post (WPO) and prior to that  GEICO just to name a few. It was Buffett’s sidekick Charlie Munger who turned Buffett into a more concentrated portfolio.
• Peter Lynch- The worlds greatest mutual fund manager held hundreds and sometimes thousands of stocks at a time. But as he confesses in his book(s), Peter Lynch had a couple of big bets and a ton of small bets so he could keep up with a company’s “story”
• Eddie Lampert- Once considered the next Warren Buffett as the price of Sears Holdings approached $200, Lampert made the majority of his wealth by betting big on the merger of k-Mart/Sears. I believe his cost basis is $1(I might be wrong on this) as he merged the two companies when K-Mart filed for bankruptcy.
• Joel Greenblatt- Probably never believed in diversification. Reading both of his books, Greenblatt constantly advocates making few but big bets. Before I get bombarded with e-mails about the magic formula strategy and diversification, Greenblatt does make seveal points as to hold 5-8 well researched stocks for greater returns. For those individuals who want to put their portfolio on auto pilot, follow the magic formula as layed out in the book.
• David Dreman- Also advocates a diversified portfolio in his books. But, he made good money by placing big bets in Fannie Mae (prior to its recent  drop he bought below $5) and Altria

Pitfalls of concentration

• A more volatile portfolio.
• A blowup in the portfolio will be a major setback against the market
• You have to be VERY patient

Tools for concentrarion

• Time
• Time
• Time
• Knowledge
• oh yeah, patience

Quotes

I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over. – Warren Buffett

Put all your eggs in the one basket and — WATCH THAT BASKET.
Pudd’nhead Wilson, Pudd’nhead Wilson’s Calendar, Chap. 15

Having a back up is essential to someone who relies on the magic formula as its primary screen. instead of waiting for that day, why not be prepared and have our own screen.

Criteria

In “The Little Book That Beats The Market”, Joel Greenblatt gives the reader general screening instructions to find magic formula stocks. The criteria he outlines on page 136 is as follows:

• Use Return on Assets (ROA) as a screening criterioon. Set the minimum ROA at 25%. (This will take the place for return on capital from the magic formula study.)
• From the resulting group of high ROA stocks, screen for those stocks with the lowest Price/Earnings (P/E) ratios. (This will take the place of earnings yield from the magic formula study.)
• Eliminate all utilities and financial stocks (i.e. mutual funds, banks and insurance companies) from the list
• Eliminate all foreign companies from the list. In most cases, these will have the suffix “ADR” (for American Depository Receipt) after the name of the stock.
• If a stock has a very low P/E ratio, say 5 or less, that may indicate that the previous year or the data being used are unusual in some way. You may want to eliminate these stocks from your list. you may also want to eliminate any company that has announced earnings in the last week. (This should help minimize the incidence of incorrect or untimely data.

Our free screen (opens in Internet Explorer)

There are many free stock screens online that can help screen for magic formula stocks. The best one I have found is the MSN Deluxe Stock Screener . Its easy to use and its free. A quick note, make sure to download the deluxe stock screen which requires a download. Your screen should look like this once the Deluxe Stock Screen is opened.

Criteria

Return On Capital

Joel Greenblatt our stock screen does not give the option to search for stocks using  Return On Capital, but the MSN Deluxe Screen has an option for Return On Invested Capital. (Field Name >Investment Return> Return On Invested Capital).

=======> Return On Invested Capital > 25

Earnings Yield

Unfortunately, MSN Deluxe does not have EBIT criteria but the P/E will do fine. (Field Name>P/E Ratio: Current)

=========> P/E Ratio: Current = Display Only

That’s the basic magic formula screen. By default, MSN will return the top 25 matches but that can be changed so it will display the top 200 results.

More Fields I use

Below are some fields I use to help narrow the results and eliminate the financials.

Company Basics> Industry Name> Display Only ( Industry Name=Display Only)

(Field Name >Investment Return> Return On Invested Capital) Return On Invested Capital < 75

This helps  eliminates most trusts and software companies.

P/E Ratio: Current > 5

This coincides with Greenblatt’s suggestion of screen for companies with a P/E ratio greater than 5

Two More Criteria!

Market Capitalization > 2,000,000,000 (2 billion)

The market cap can be changed to one’s individual needs. For example, assume I want to search for companies that have a market cap less than 2 billion but greater than 50 million the input would be :

Market Capitalization < 2,000,000,000 (2 billion)

Market Capitalization > 50,000,000 (50 million)

To eliminate more software companies I will also set the screen so it will exclude companies on the Nasdaq.

(Company Basics > Exchange)

Exchange = NYSE

The results are in!!!!

Here are some interesting names.

Lorillard (LO)- Cigarretts

Accenture (ACN)- has been on the magic formula for a while

Nokia (NOK) – Although an ADR, its still itneresting

Coach (COH)-

Souther Peru Company (PCU)

CF Industry Holdings (CF)

Western Digital Corp (WDC)

Graco (GGG)

Mastercard (MA)

Aeropotale (ARO)

Marvel Enterntainment (MRVL)

Kinitec Concepts (KCI)

I excluded the NYSE criteria and Microsoft (MSFT)  and Research In Motion (RIMM) appear. Microsoft has been appearing on the magic formula website and I am sure it has been climbing the ranks.

Here is the URL to the screen:

http://moneycentral.msn.com/investor/invsub/finder/finderx.asp?Query=SV1QF168Z04L25ZF140Z00S1F227Z00F168Z05L75ZF140Z04L5ZF234Z04L2000000000Z&Name=Custom%20Magic%20Formula%20Screen&Tickers=25

The fact that Bruce Greenwald is a professor at the Robert Heilbrunn Professorship of Finance and Asset Management at Columbia Business School is a must read. I stumbled across this book about four years ago when I was buying everything that was related to value investing. Even though I re-sold most of the value investing books, I kept the must reads like The Intelligent Investor, All of the David Dreman books, Joel Greenblatt’s Little Book, and a few others. I kept this book because it has its own little niche in the value investing arena, its truly a modern approach to Ben Graham and Warren Buffett. Bruce Greenwald’s 3-Step approach to valuing a company is one that a) makes sense and b) does not put too much emphasis on future growth. For those individuals that have not had a chance to read the book, Greenwald advocates a 3 step approach to valuing a company.

1. Value the assets
2. Find the company’s Earnings Power Value (EPV = Adjusted Earnings x 1/R, where R is the current cost of capital or rate of return
3. Only when the company displays a franchise can we incorporate growth into the equation

Especially during the dot-com boom, #1 (Assets) was highly ignored. Companies that had little to no assets were valued greater than a stalwart like Proctor and Gamble (PG). The beauty about investing in companies with hard assets is, if the company disappoints on in the earnings front, one can sleep conferable at night knowing the assets are there (like a safety net). Dot-com companies never had this safety net and the stock price experienced catastrophic declines when earnings disappointed. #2 can be applied to just about any company but I highly suggest looking at companies who have a history of consistency. Third on the list is factoring growth where a franchise is in place. Greenwald defines a franchise as when the firms EPV exceed the company’s Asset Value (43). Another way to think about this is what Warren Buffett calls a moat. Companies with a moat tend not to require additional investment, but can still increase its earnings (think See’s Candies, Burlington Northern). Now, Greenwald and Co. do a tremendous job in walking the reader on how to analyze a company and valuing the company using his 3 step approach ( he values WD-40 Co (WDFC) and Intel (INTC)) but the second half of the book is devoted to value investors and some of the techniques they employ.

The second half of the book profiles value investors that have outperformed the market. Greenwald devotes the most attention to Warren Buffett 9bug surprise there right?) and highlights some of Warren Buffett’s shareholder letters. Below are the value investors highlighted and the chapter title

• Warren Buffett :Investing Is Allocating Capital
• Mario Gabelli : Discovering and Unlocking the Private Market Value
• Glenn Greenberg : Investigate, Concentrate and -Watch that Basket
• Robert H. Heilbrunn : Investing In Investors
• Seth Klarman: Distressed Sellers, Absent Buyers
• Michael Price: Discipline, Patience, Focus, and Power
• Walter and Edwin Schloss: Keep It Simple, and Cheap
• Paul D. Sonkin: Small Is Beautiful, Especially When It’s Ugly

I have read this book twice, and each time I re-read the book I pick up a nugget or two. I have taken this book out of my library and have set it aside to re-read. Finally, the book is selling for 8.99 on Amazon.com and I highly reccommend it. As stated above, its definately not the easiest read, but its definately not the hardest either.

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

So far the results have been bad. Just about every blog/site testing the magic formula has underperformed the market. For example, check out this magic formula investing blog, the blog is filled with posts about the under performance of the magic formula. Although the blog is a great read, it’s unfortunate the fella is losing money.Now, Joel Greenblatt does mention in his book and in interviews that the Magic Formula will go through periods of time in which it will under perform the market, but at what point does the public draw the line and say it simply does not work.

In my opinion, the magic formula does work. The idea of buying companies with high pre-tax earnings and high return on capital is what value investing is all about. Take Burlington-Northern (BNI) as an example. Even after its run to $91, the stock still trades with a pretax earnings yield of 12.17%. I think Warren Buffett was buying BNI when it had a pretax earnings yield of 15%. A stock that Warren Buffett and others have been loading up on is Kraft (KFT). Kraft currently trades with a pretax earnings yield of 8%, which does not justify the whales loading up on it. But, considering Kraft has 3.57 billion of operating cash flow alone, Kraft’s management has a lot of flexibility on what it can due to enhance shareholder value.

Finally, it has been 2 1/2 years since the book was written and the results have not been pretty. Joel Greenblatt does advocate a holding period of 3-5 years so one can at least replicate the results in his book. The magic formula continues to be one of few strategies that offer a clear sell strategy (sell after 1 yr and 1 day) and a clear buying strategy and it is times like these that truly test investors.

What are your thoughts on the magic formula and its performance so far?