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A Tweaked Magic Formula Screen That Looks Very Promising

February 04, 2014 | About:
Patientbioinvest

Patientbioinvest

3 followers

I’ve recently decided to go back and re-read a few classics on performing valuations and what value-based systematic strategies have  worked over the years.  One of the most impressive findings in the financial literature of the past 10 years is the now-famous book by Joel Greenblatt (Trades, Portfolio): "The Little Book That Beats the Market."

This is based on the simple realization that ranking companies based on specific measures of return on capital and earnings yield and choosing the best ranked ones to construct a portfolio would have outperformed the S&P over any three-year period since the mid-1960s.

While I was a bit skeptical initially as to the merits of  a single formula to outperform the market, the back-testing provided was compelling, and I decided to take a closer look at how I could implement the formula while using the GuruFocus tools.

While it is not possible to rank the stocks based on any metric, the All-in-One screener allows us to screen for companies based on both ROC and earnings yield. I chose a slightly more restrictive approach to the Magic Formula by imposing stringent lower limits:

  • An ROC of at least 25%.
  • Earnings yield higher than 14%. These two conditions are very similar to the ones used in the Magic Formula.
  • Since I am a big believer in watching insiders' ownership, I also chose to focus on companies with insider ownsership of 1% or higher.
  • Also, I decided to exclude companies with declining mid-term growth rates, so a condition was added of  positive five-year EBITDA growth to weed out rapidly falling angels.
  • Finally, to take full advantage of the Gurufocus website functionality, I added a condition saying we would screen out for companies with at least one guru buying over the past 6 months. 
  • I should also mention that I focused on non-financial companies as the high ROC measure breaks down as a value proxy for financials.

Even with very stringent criteria like these, I was surprised to have a list of about 18 companies that meet all criteria: incredible returns on capital, high earnings yield, insider ownership and growing EBITDA and liked by at least one guru.

You can find the list here.

My only wish would have been to be able to calculate ROC and earnings yield as a five or 10-year average (hint hint, GuruFocus developers!).

The first thing that struck me looking down that list is that most companies are small- to mid-cap. I was glad to discover that, since I also believe this is the most fertile ground to bargain hunt.

 The other thing that I was happy about is the diversity of industries, which probably means there is no inherent bias in the methodology, as we are able to find bargains across sectors from oil and gas to education and training.

The other thing that drew my attention is that Joel Greenblatt (Trades, Portfolio), the “inventor” of the Magic Formula, has been adding to quite a few of the positions the screen identified. Clearly, this indicates the screen might have some overlap with what Mr. Greenblatt has been advocating, and I’m looking forward to doing more fundamental research on these companies to identify the ones with a durable moat. 


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