Do you have difficulty creating short lists of value stocks when you want to buy something new? Do you look for a reasonably systematic strategy when creating shortlists?
In this article, we use Joel Greenblatt (Trades, Portfolio)’s Magic Formula to provide criteria for value stocks, and use the GuruFocus Magic Formula screener to reduce a universe of stocks into a manageable number.
What is the Magic Formula?
In a previous article, Does Joel Greenblatt’s Magic Formula Have a Solution for Value Investors?, I explored the Magic Formula and assessed its results.
I found the formula interesting and insightful; it involves rating companies on two metrics: Earnings Yield (EY) and Return on Capital (ROC), both of which you can find on the summary page for any company followed by GuruFocus.
There are at least a couple of ways of getting the EY number; in the body of "The Little Book That Still Beats the Market," Greenblatt says we can divide the earnings per share by the price per share. He explains,
“Paying a bargain price when you purchase a share in a business is a good thing. One way to do this is to purchase a business that earns more relative to the price you are paying rather than less. In other words, a higher earnings yield is better than a lower one.” [author’s italics]
Turning to the ROC, Greenblatt says,
“Buying a share of a good business is better than buying a share of a bad business. One way to do this is to purchase a business that can invest its own money at high rates of return rather than purchasing a business that can only invest at lower ones. In other words, businesses that earn a high return on capital are better than businesses that earn a low return on capital.” [author’s italics]
To explain ROC, he uses this example,
“For instance, what if we found out that it cost Jason $400,000 to build each of his gum stores (including inventory, store displays, etc.) and that each of these stores earned him $200,000 last year. That would mean, at least based on last year's results, that a typical store in the Jason's Gum Shops chain earns $200,000 each year from an initial investment of only $400,000. This works out to a 50% yearly return ($200,000 divided by $400,000) on the initial cost of opening a gum store. This result is often referred to as a 50 percent return on capital.” [author’s italics]
These two elements, both important for investors, become even powerful when combined. As Greenblatt says, this leads to “…a disciplined strategy of buying good businesses at bargain prices…“
That’s the theory. In practice, you take a universe of stocks, let’s say small caps, for example, and separately rate each one based on a comparison with all the other stocks in the universe. In working with a universe of 500 stocks, each stock would have a unique rating between 1 and 500, with number 1 having the best EY or best ROC, while number 500 would have the worst.
The final step in executing the Magic Formula is to buy the highest-ranked 20 or 30 stocks on the combined list (lower numbers are better than higher numbers), hold them for at least a year, and then sell them.
Overall, I like the Magic Formula as a tool for developing a short list of good stocks at bargain prices, but I could not find enough evidence in the book or elsewhere to make me want to adopt the whole system. Certainly Joel Greenblatt (Trades, Portfolio) and his Gotham Asset Management LLC have had great past successes, but I don’t know how much, if any, he tweaked the system in his real-life trading. We do know that in recent years, Greenblatt and his investment managers have gone short as well as long on their lists.
Creating a list with the Magic Formula screener
If you buy "The Little Book That Still Beats the Market," you also receive a link to a website created by Greenblatt where you can generate a list for yourself.
If you subscribe to GuruFocus, you can get a list from the Magic Formula (Greenblatt) screener; simply click on "Screener" on the navigation bar at the top of the page and select from the drop-down menu.
But the list that comes out is what we might call a generic list, one made up of all the stocks that GuruFocus follows, and that amounts to thousands.
A custom list
But if we use the screener, we also have a number of filtering options; note the drop-down menu selectors encircled in red:
Let’s review their capabilities:
- All Countries: this is what you get by default; however, by using this filter we can choose one of several other options, including North America, Central America, South America, UK/Ireland, Europe, Africa, Asia and Oceania (Australia and New Zealand).
- All Market Cap: again the default, but again you have a number of choices, including the S&P 500.
- All Sectors: do you want to potentially include all industries? If not, you can use this drop-down menu to select one of 11 different sectors.
- Exclude OTC: this refers to Over-the-Counter stocks, stocks traded through a dealer network rather than a major exchange (such as the NYSE or NASDAQ). Most of us will leave this on "Exclude."
- Predictability: as we know, one of GuruFocus’s strengths is its rating of each company’s earnings consistency, with 1-Star being very poor and 5-Star being excellent. All else being equal, a 5-Star company will be safer than a 1-Star company.
- Market Cap: these two boxes give us the option of setting upper and lower boundaries for market capitalization (number of shares multiplied by the price per share). This covers essentially the same ground as "All Market Cap" noted earlier, but provides for finer tuning. Most of us will simply choose from "All Market Cap."
The choices we make on these filters will determine the composition of the list. If we think of the top stocks in each of these lists as our shortlists, then we can target the kinds of companies that get our attention.
Other features
Below the filters we find another menu, which allows for various displays:
- Default: this display gives us the list of stocks which fit the Magic Formula and the filters set earlier.
- Map: for those who like a visual overview of the stocks and sectors/industries, this filter provides it. Here’s an example:
- Charts: this view gives us smaller charts simultaneously showing several companies share price history, and the Peter Lynch Earnings line. This allows a quick overview of each stock before getting into any one in detail.
- Customized: if you would like to add, delete, or change any of the columns in the Default display, you can make the changes using this tab.
Note as well that each column allows sorting by ascending and descending, by clicking on the column title or on the small arrow adjacent to the name. Of course, if we wanted to find candidates for shorting, we would flip the list so the least attractive stocks appear at the top of the list; this is a strategy Greenblatt mentions briefly in "The Little Book That Still Beats the Market."
Even more customization
If you would like even more customization, you can use the All-In-One screener, which provides literally dozens of different filtering options:
Each of the tabs within the red ellipse allows you to set filters in a different analytical area.
Conclusion
The object of this exercise was to create custom lists of good companies available at bargain prices. The Magic Formula screener provides a default list that includes all stocks/companies followed by GuruFocus.
Most of us, though, will probably want to draw our list, or shortlist, from a more selective perspective, whether that’s country, market cap or another factor. Using the filters allows us to become more selective, and even hyper-selective if we use the All-In-One screener.
As I’ve noted above and elsewhere, I would not use the Magic Formula as my investing strategy, but I think custom screening with either the Magic Formula screener or the All-In-One screener provides another helpful tool for creating short lists of stocks we might want to buy.
Disclosure: I do not own any stocks discussed or displayed in this article, and do not expect to buy any in the foreseeable future.
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