Buy cheap, sell high – when Joel Greenblatt first developed his technique for selecting good, cheap companies to invest in, he kept the process simple. For the founder of successful New York hedge fund Gotham Capital, the Magic Formula Investing screen remains a key tool in his armoury, even forming the basis of his latest Formula Investing US Value mutual funds, and its apparent simplicity has won it many followers in the investment community.
At its heart, the Magic Formula involves selecting a basket of between 20 and 30 stocks – some of which may have the potential to make a prospective investor blanch. Unloved, misunderstood, occasionally debt laden or with broken business models, Greenblatt’s selection is not a magic bullet and the large basket reflects the likelihood that some of these companies may well struggle to become investment successes. However, these are profitable businesses and by putting trust in the ‘quant’, the theory is that it won’t take too many success stories for the screen to pay off.
Greenblatt’s formula looks to two metrics in a given stock: a high return on capital and a high earnings yield – or, to put that another way, it has to be ‘good’ and ’cheap’. The return on capital measures how effective the company is at making a profit from its assets – this is used as a proxy for how ‘good’ the company is. The earnings yield takes a company’s operating profit and divides it by its enterprise value – the higher the earnings yield the more ‘cheap’ the stock. By ranking the market from high to low for each indicator and adding the two ranks an investor can come up with a ‘Magic Formula’ score for all the eligible companies in the market.
The advantage of this screen is that there will always be companies that are trading at a discount for any number of reasons, and the Magic Formula picks them out. While Greenblatt detailed his techniques in the popular “The Little Book That Still Beats The Market”, his US focus has deprived UK investors from easily applying the screen on this side of the pond (his own website readily produces the results for US stocks). That’s frustrating for those who have been eyeing with interest the impressive returns cited in his book – according to Greenblatt at least, the Magic Formula approach has averaged a 17-year annual return of 30.8% and beats the S&P 500 96% of the time.
Thankfully, using Stockopedia PRO we have now crunched the numbers based on last year’s annual results across all Main Market, AIM and PLUS market stocks– and ironed out some of the potentially tricky definitions that are used to arrive at Greenblatt’s equations. On that point, Greenblatt’s formula for working out return on capital is EBIT/(net working capital + net fixed assets) and there has been some debate about how precisely to do this. Essentially, quantifying return on capital requires a careful calculation of net working capital. Fortunately, our data-set allows us to exclude short-term debt from current liabilities, so we have been able to properly address the non-interest bearing payables calculation.
To spice up the Magic Formula, some investment commentators have pointed out that if you overlay the basket with Joseph Piotroski’s nine-point value technique, the screen delivers even better and less volatile results. With that in mind, we start by highlighting the two companies in our 30-strong Magic Formula list that also score a Piotroski 9. The first of them is PLUS-quoted Quercus Publishing (PLUS:QUPP), which saw its profits leap last year from £0.9 million to £7.5 million as a result of surging sales of Stieg Larsson’s Millennium Trilogy. While economic conditions and the growing popularity of digital books have asked some tough questions of the traditional publishing world, Quercus has stressed its willingness to adapt to changing consumer behaviour. The company has been focusing on expanding its geographic coverage and sales of its e-books grew last year by 1,650% and now account for 3.0% of group revenues With an earnings yield of 44.3% and a return on capital of 106.5%, Quercus has the 8th best Magic Formula rank across the UK stock universe (in line with Greenblatt, we disregard all stocks with a low market capitalisation below £15m for liquidity reasons).
Also boasting a Piotroski 9 is Impellam (LON:IPEL), which is one of three recruitment consultancies in the Magic Formula basket (the others are Morson (LON:MRN) and Staffline Recruitment (LON:STAF) ). Impellam was created from the 2008 merger of The Corporate Services Group and Carlisle Group and is now one of the largest UK quoted staffing businesses. A subsequent streamlining of the group and a strong focus on its cash and debt position contributed to a doubling of profits last year to £21.1 million. Despite that, shares in the company have fallen from 330p to 270p during the last month. With an earnings yield of 22.6% and a return on capital of 101.7%, Impellam is the number 12 contender on our Magic Formula list.
Meanwhile, Shipbrokers are a notable presence on the Greenblatt screen, with ACM Shipping (LON:ACMG) scoring the highest of all of them based on last year’s results. However, given that the company issued a profits warning for the first half of 2011, let’s turn to the next highest ranking stock, and the largest of the three, Clarkson (LON:CKN) (the third stock is Braemar Shipping Services (LON:BMS) ). As a bellwether for global trade, analysts tend to pay close attention to the performance of shipbrokers and last year Clarkson exceeded expectations despite volatile freight rates. While global economics are strained, Asian demand for commodities has kept the shipping market afloat but macro concerns still dominate – and Clarkson’s share price reflects that, down 250p to 1052 since the beginning of August. Nevertheless, with an earnings yield of 35% and a return on capital of 147.4%, the company scores a Magic Formula rank of 5th.
Another industry notable by the number of companies on the list is Media & Marketing and the top ranking among them is Motivcom (LON:MCM). Last year the company exceeded market expectations, with pre-tax profits up 43% to £4.4 million as its clients spent more and new contracts were signed. Since then, Motivcom has gone on to make two acquisitions, the half-year figures were weaker, market conditions have worsened and it is now set to miss expectations this year. As a result the shares have dived from 140p to 69p since the summer. Despite that, the company insists the new purchases will pay off in the medium term. With an earnings yield of 32.8% and a return on capital of 85.5%, the company achieves a Magic Formula rank of 13th.
Easily the largest stock on the list is drugs giant Astrazeneca (LON:AZN), where a couple of recent disappointing news stories have only helped to polarise analyst opinion even further on whether AstraZeneca is a decent bet. Of late, its TC-5214 antidepressant failed a clinical trial and there were mixed results from trials of Crestor, its heart disease candidate. Meanwhile industry-wide pricing pressures have added to the uncertainty. Market conditions dented the stock over the summer and a despite a rally in October, the shares remain pinned below 3000p. With an earnings yield of 18.5% and a return on capital of 128.2%, AstraZeneca achieves a Magic Formula rank on our list of 16th.
If anything, Joel Greenblatt’s Magic Formula Investing screen provides an intriguing insight into the types of stocks and sectors that are currently feeling the cold shoulder of the market. Based on the fact that these companies are profitable (and being valued at a cheap price by the market) the screen offers a useful starting point for value investors – and applying additional screens such as the Piotroski F-Score builds in an extra dimension.
Of course, Greenblatt emphasises the importance of a diversified basket of the top 20-30 stocks, rather than just one or two, and so you can see the full list of stocks here on PRO. In addition, we’ve also added a handy visual meter on all stock reports so you can check how a given stock stacks up according to the Magic Formula.
It is worth stressing that careful consideration is needed of the calculations involved as well as the macro and micro pressures that can and do throw companies off course. So investors should be wary and do their own research. Nevertheless, Greenblatt does have excellent form and apparently still uses the screen today – as do many of his followers.