"In theory there is no difference between theory and practice. In practice there is."
— Yogi Berra
On a theoretical basis, the Magic Formula is difficult to challenge. The philosophy involves identifying companies with high pretax earnings yields which reinvest their earnings at a high rate of return (ROIC). There is nothing very magical about that concept, if I own a highly profitable hamburger stand and I employ the majority of my profits producing other highly profitable hamburger stands; I am going to become rich in a relatively short period of time. Unfortunately, Ray Kroc beat me to the punch on that brain storm.
Of course relatively few publicly-traded companies possess the aforementioned attributes at any particular point in time. Generally, stocks which fit the formula are either recognized by the market as values and soon rise in price, or suffer substantial forward declines in earnings and/or returns on capital which justify their depressed price (value traps). In other words, very few stocks remain on the "bargain list" year after year; although holders of King Pharmaceutics (KG) prior to being bought out by Pfizer (NYSE:PFE) last fall, might dispute that claim. Either the market is correct or the formula is correct and the dispute is generally settled in a relatively short period of time. It seems that more often the formula is correct; there in lies the beauty of the system.
The Magic Formula possesses several other favorable attributes. It factors out tax rates by comparing companies on a pretax basis, and it incorporates the value of cash versus the liability of debt by using enterprise value, instead of market capitalization.
The formula also recognizes that depreciation is a true business cost, therefore it relies upon Earnings Before Interest and Taxes (EBIT) rather than Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) as the numerator in its earnings yield multiple.
Problems with the Magic Formula: Accrual Earnings vs. Cash Earnings
Robert Olstein has pointed out on numerous occasions; "earnings are opinions, cash is fact." Mr. Olstein is quite accurate in pointing out that various corporations display a wide variation in the "quality” of their earnings.
Olstein, originally borrowed that notion from his former partner Thornton O'Glove. O'Glove is well known for writing the investment classic "Quality of Earnings, The Investor's Guide to How Much Money a Company Is Really Making,” in the mid 1980s. It remains one of best books on the market pertaining to a comprehensive evaluation of accrual earnings. In future articles I intend to cover the specifics of the classic in greater detail.
O'Glove was among the first to point out that analyst projections are generally garbage, auditor accreditations are not always synonymous with proper accounting and veracity, in addition to revealing specific accounting tricks that companies use to enhance their earnings. In other words, certain companies embellish earnings sufficiently enough that the actual cash which is available for business reinvestment, dividends or stock buybacks is not nearly as great as the accrual earnings would suggest.
It would seem that the objections of Olstein and O'Glove strike at the heart of Magic Formula theory. The old adage "garbage in garbage out" would apply to at least some of the "value stocks" which the formula identifies. Since the Magic Formula relies on EBIT and ROIC (accrual not cash figures) to evaluate whether a company qualifies as a buy; it becomes imperative that accrual figures accurately reflect the true profitability of a company. The accurate rate of profitability will also directly determine the "real" rate of return for the business.
Let's say Company A has a pretax earnings yield of 20% and a pretax ROIC of 40%. Not only does the company appear inexpensive on a price to earnings basis, it also seems to be doing an excellent job of redeploying its earnings to grow the business. The business appears to a worthy of an investment, correct — in the immortal words of Lee Corso — "not so fast.”
What if the company is only yielding pretax cash returns amounting to 50% of its EBIT? Not only does that affect the "real" earnings yield of the business but it also belies the ROIC since the calculation of that figure is based upon EBIT. In other words, any method of calculating a return on investment relies upon some type of earnings figure as the numerator in the fraction. If the earnings figure is inaccurate then the rate of return is inaccurate as well.
It is exactly such problems that drove the likes of Walter Schloss towards investments based upon the value of the assets that a business holds rather than the value of their future cash flows.
Problems with the Magic Formula: Cyclical Adjustment of Earnings
A second major problem with the Magic Formula is the cyclicality of earnings for some of the companies which it tends to identify. Home building stocks frequently turned up on the list of Magic Formula stocks prior to the credit crisis along with other highly cyclical businesses, such as energy, energy-related companies as well numerous stocks. Had the formula used an average EBIT dating back 5 to 10 years then many of these highly cyclical businesses would have been exposed.
It has occurred to me since the inception of Magic Formula that numerous cyclical businesses would turn up as buy candidates, exactly at the peak of their earnings cycle. Indeed that is when their trailing EBIT and ROIC is at its highest point.
Highly cyclical stocks tend to act contrary to normal stocks, meaning they are usually acquired by savvy investors when they appear expensive in terms of price to earnings and sold when they still appear to be inexpensive.
Identifying and investing in highly cyclical entities when they are at or approaching their peak earnings, is a recipe for disaster. Of course some of the peril is diminished by the fact that "formula" investors diversify into 30 different stocks and they rebalance on an annual basis. However, I still believe that factoring out highly cyclical companies which are "approaching a cliff" would significantly magnify the overall results for "formula" investors.
Suggestions for Creating a Better Formula
I believe the Magic Formula could be improved by two relatively simple steps:
1) Using a pretax 5-year cyclically adjusted cash formula rather than EBIT as the earnings yield.
2) Using a pretax 5-year Cash Return on Invested Capital (CROIC) rather than ROIC to measure the rate of return.
The earnings yield would be calculated as follows: EY = Cash Flow From Operations (CFFO) + Income Tax (IT) - Depreciation and Amortization Expense (D&A) divided by Enterprise Value (EV).
One would use the five year average of CFFO+IT-D&A/EV as the earnings yield.
The return on capital rate would be calculated as follows: CROIC = CFFO+IT-D&A divided by Shareholder Equity (E) + Total Liabilities (TL) - Current Liabilities (CL)
One would use the five year average of CFFO+IT-D&A/E+TL-CL as the CROIC
Additional Thoughts on the Magic Formula
The Magic Formula can be an excellent lead generating source; although I question its utility as a systematic investment strategy. Despite its back testing which seems to have established that it has been successful in outperforming the overall market over a significant period, I suspect that it will eventually revert to producing a yield similar to the overall market averages.
The fact that it has become popular as an investment tool dooms the system to eventually revert to the mean. Whenever a statistically significant sample of investors pile into a limited group of stocks, the ultimate result is a decline on the return on investment for that specific group of stocks. Simply stated, the investors drive up the price of the chosen group and eliminate any hint of value.
I turn to the world of thoroughbred horse racing for just such an example. Many readers are probably familiar with Andrew Beyer and his handicapping innovation, "adjusted speed figures,” which are now universally referred to as "Beyers" in racetrack patois. Without going into the specifics of how the figures are calculated, the intention is to establish a "real" clocking of how fast a horse covered a certain distance of ground with regard to variables such as wind, track speed, etc. The angle is to establish "real" race times to compare between horses which ran on different days or on different race courses. The comparison is accomplished by producing a track variant which is added or subtracted from the final time with the goal of standardizing the performance of the animal. Thus a universal figure is assigned to every horse in every race, with the objective of establishing exactly how fast the animal ran. The figures are now calculated and published by the Daily Racing Form for every legitimate race track in the US and Canada.
Back in the 1970s before Beyer published his book on "speed figures,” he made a considerable amount of money by betting on horses which actually ran faster than their race time indicated. He was successful in betting on horses which appeared to be overmatched by their competition. At that time relatively few handicappers were privy to "speed figures" and the result was high odds on these seemingly overmatched animals.
All that changed quickly after Beyer published his popular book which explained in detail how to calculate the figures. The book was published well over a decade before the figures were listed on the past performances of the Daily Racing Form. Almost immediately after Beyer's book was released, the odds on horses jumping in class with competitive "adjusted speed figures" began to steadily plummet. The reason was simple, the betting community was now privy to a new source of information and they quickly adjusted the market price (paramutual odds) accordingly.
1) The improved formula utilizes the best ideas of the Magic Formula; specifically pretax comparisons, cash vs. debt considerations, and the assumption that depreciation represents an ongoing cost in any business.
2) The improved formula is superior in minimizing the effect of ambitious accounting and diminishing the effects of cyclicality on economically-sensitive businesses. By calculating five year averages, the temporary nature of earnings cycles in particular businesses, is factored into the formula.
3) It is likely that using cash rather than accrual means to establish the value of a Magical Formula stock has not yet been "priced" into the equities; therefore it is more likely to produce a higher investment return.
4) Any Magic Formula computation should be used merely as a lead source since virtually all investment systems are flawed and ultimately destined for failure, in the event they become popular with investors.
"In theory there is no difference between theory and practice. In practice there is."