Do what everyone else does and you will just get the same results.
But does the Magic Formula really work?
Well, the backtested data shows awesome results.
Magic Formula Performance 1988-2009
When I first wrote on the Magic Formula, I wanted to verify the strategy with my own backtesting.
This is what I came up with:
Magic Formula OSV Backtested Results
For more recent results, I looked at Joel Greenblatt (Trades, Portfolio)’s Gotham funds. It is not an apples to apples comparison as he does not use the Magic Formula strategy for his funds, but I am going to guess and say there are some similar characteristics.
The performance has not been earth-shattering, but again, it is not an apples to apples comparison.
S&P500 vs Gotham Funds – source: morningstar
The basics of picking Magic Formula stocks
The Magic Formula is surprisingly simple:
- Establish a minimum market capitalization (usually greater than $50 million).
- Exclude utility and financial stocks.
- Exclude foreign companies (American Depositary Receipts).
- Determine company’s earnings yield = EBIT/enterprise value.
- Determine company’s return on capital = EBIT/ (net fixed assets + working capital).
- Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
- Invest in 20 to 30 highest ranked companies, accumulating two or three positions per month over a 12-month period.
- Rebalance portfolio once per year, selling losers one week before the one-year mark and winners one week after the one-year mark.
- Continue over a long-term (three to five years or more) period.
But I think there should be 10 steps – where the 10th is also the most difficult.
Ă‚ 10. Stick to the strategy.
Strategies fail because of the investor’s unwillingness to stick to the process. To find something that works, it takes at least a couple of years of data.
Because money is involved, however, I understand all strategies are on a short leash.
Out of the nine official steps, the two most important are the earnings yield and return on capital.
- Earnings yield = EBIT/enterprise value
- Return on capital = EBIT/(net fixed assets + working capital)
These two are the bread and butter.
I have modified my method slightly to use return on invested capital (ROIC) instead of ROC.
Finding Magic Formula stock ideas criteria
You can always get Magic Formula stock ideas from our free Magic Formula screen list, which is updated weekly.
For Old School Value Insiders, there is a pre-defined Magic Formula screen to get you started. To beef it up, here is how I have set mine up:
Magic Formula Stocks Screen Settings
- Eliminate over-the-counter stocks.
- Eliminate retail, financials and utilities.
- No Chinese companies.
- EV/EBIT between zero and 15.
- Earnings yield between 0% and 50% (Do not want to search too high as it introduces a lot of noise).
- ROIC between 0% and 50%.
These settings yield close to 500 stocks, which is too many.
I want my work to be easier than going through 500 stocks to get a manageable list.
This is where the OSV Action Score comes into play.
I know the A and B-rated stocks outperform, but it is not a guarantee. This year, the Action Score is not performing well because too many retailers are showing up on the list. With retailers dropping like flies, there were about 10 retail stocks in the top 20 at one point this year.
Following the rule of thumb of no more than two companies in the same industry will keep you buffered.
When you zoom out and focus on long-term, year-over-year performance, the results still show focusing your energy on the As and Bs works out.
The chart below illustrates that as the score gets higher, the average return increases.
Action Score Average Return Chart
3 Magic Formula stocks to consider
I started out with 500 stocks. After filtering to only select the A and B-rated Action Score stocks, the final list is down to 76 stocks.
Of the 76, here are three interesting names:
Davita
Davita is Berkshire Hathaway’s (BRK.A, Financial) (BRK.B, Financial) 11th-largest position. It was purchased by Ted Weschler.
Despite its ranking, it is only 1.6% of the entire portfolio.
Weschler and Davita go back a long way. Weschler owned Davita when he worked at Peninsula Capital Advisors. Now at Berkshire, he has been building a position since 2011.
While it has been a great ride, there have been some bumps the past couple of years, which has given the Berkshire portfolio manager more opportunities to add to the position.
As it stands, Berkshire owns just shy of 20% of the company’s outstanding shares.
Since we are talking about Magic Formula stocks, seeing Greenblatt’s name on the list of shareholders is also a good thing.
With Davita and other health care stocks, the common theme is the aging U.S. population and growing health issues people face that cause kidney failure will create more demand for dialysis.
Davita has been touted as a health care play for patient investors.
“Patient” is a good description here. For a $12 billion market cap health care stock with plenty of volume, it does not get much attention.
The Magic Formula numbers show the following:
- EV/EBIT of 10.3.
- Earnings yield of 9.7%.
- ROIC of 9%.
The stock appears to be trading at a reasonable price based on those numbers.
Davita EV/EBIT range | Click to Enlarge
Over a 15-year period, the current price is trading at the bottom of the EV/EBIT multiples range.
Here are other numbers to consider:
- Price-free cash flow is 8.5.
- Price-owner earnings is 7.2.
- ROIC and CROIC have been going up.
- Financially stable on the balance sheet.
Bad aspects of the business:
- Top -line revenue growth has slowed.
- The gross profit margin has dropped from 30% a few years back to 27.8% in the latest fiscal report.
- 55% of revenues are coming from Medicare and Medicaid-assigned plans.
- Affected by government regulations.
What you need to consider is that if Davita is considered a long-term value play for patient investors, how will it do in a one-year holding period of Magic Formula stocks?
Steel Dynamics
Steel Dynamics produces steel and recycles metal.
The Magic Formula numbers are all well within good territory.
- EV/EBIT of 10.6.
- Earnings yield of 9.5%.
- ROIC of 11.1%.
Nucor Corp. (NUE, Financial) is a strong competitor, but Steel Dynamics has been the winner the past few years.
If you company Steel Dynamics to other competitors, it offers better value:
STLD Valuation Comparisons | Click to Enlarge
When it comes to liquidity and efficiency, Steel Dynamics wins two out of six, but comes in a close second for a couple other metrics.
STLD Liquidity & Efficiency Performance
I removed Friedman Industries (FRD, Financial) from the group as it was the worst performer.
The biggest downside to Steel Dynamics is that it is a cyclical and commodity company. Holding a cyclical company for one year can be a losing proposition. Combine that with a commodity and it could be a double whammy in a worst-case scenario.
I owned it last year with Cal-Maine Foods (CALM, Financial), which was rated an A, but due to the cyclical nature of the business, it was sold at a loss at the end of the year for the annual rebalancing.
TSR Inc.
I was hesitant to include TSR with the recent run up.
TSR was one of the A-rated Action Score stocks I bought when rebalancing at the beginning of the year.
With the run-up, it has gone from an A-rated to a B-rated stock as the value score has dropped.
TSRI Value Score
It gets a D value score when ranked alongside other stocks. There are plenty of other stocks with better value score metrics.
On an individual basis, however, I value TSR is higher than a D.
TSR is a tiny microcap with a market cap is $14.7 million. It is small enough to turn off most investors, but the small-cap space is where I have had success in picking Magic Formula stocks and other value strategies. I have followed TSR since 2013 as it has been a net-net until as recently as last year.
TSR is a staffing company providing contractual programming services to clients. There is no moat here. Do not expect a high-quality company.
Insiders own 54% and institutions own 12.6%.
Definitely flying under the radar – just the way I like it.
On May 17, Zeff Capital offered $6.15 per share to buy out the company. Somebody sees value.
Factor in the first one-time special dividend of $1 per share since 2012, and TSR is a shareholder-friendly company that is now confident in its operations.
Magic numbers come out to be:
- EV/EBIT of 11.6.
- Earnings yield of 8.6%.
- ROIC of 4.3%.
TSR may have more room, but with the run-up, the upside may be capped.
I am not using the company's latest free cash flow figure as it looks to be a really good year. If I adjust the free cash flow down to $900 thousand and run a quick discount cash flow calculation with 0% growth and 7% discount rate, the fair value comes out to the $8 range.
If you believe 7% of a discount rate is too low, a 9% discount rate gives a fair value of $7.46, which puts it at today’s prices.
The easy way to find Magic Formula-style stocks
This is just three stocks out of the 76 on the short list.
Frankly, I have not heard of most of the companies on the list.
That is the point though. While other investors are seeking noise and opinions on stocks that are talked about everywhere, this is how I get my ideas for stocks to buy.
I like stocks with high insider ownership.
When I used to ride the train to school, I would get on a slightly earlier train so that I could get a seat before the traffic picked up.
It is the same concept. You can try and ride an overcrowded train, or grab a seat on a cool, air-conditioned train before a throng of people get on board.
Adjusting the Magic Formula will help you pick some new, under-the-radar stocks.
To get started with creating your own short list of Magic Formula stocks or other value stocks, check out the live demo to see how Old School Value works.
Disclosure: Long TSRI.
