It’s hard to take something called a “Magic Formula” seriously. But you should. It’s beaten the market by a wide margin over the past two decades and with less volatility.
The Magic Formula — a stock screener designed by hedge fund guru Joel Greenblatt — ranks stocks by two factors:
- Profitability (based on Greenblatt’s chosen metric, Return on Capital)
- Earnings yield (the inverse of the P/E ratio, defined by Greenblatt as EBIT/Enterprise Value)
Buying good, profitable companies at cheap prices is not exactly a revolutionary idea; this is what Warren Buffett has successfully done for decades. But Greenblatt has created a systematic way to do it, and most of the heavily lifting of number crunching is done by the screener.
By Greenblatt’s analysis, the Magic Formula generates annual returns in excess of 30% per year. Independent back tests have generally come up with smaller returns, though the general consensus is that the Magic Formula does indeed beat the market, even after taxes and transactions costs are taken into effect.
For the casual investor, Greenblatt recommends buying a portfolio of 20 to 30 Magic Formula stocks, holding them for one year and then re-running the process annually. And yes, that’s one way to do it.
But I prefer to use Greenblatt’s screener as a starting point for ideas. I like to see which sectors are overweight on the screen. And while I am not a big fan of technical analysis and charting, I do take a quick look at a chart to see what the stock price is doing. It’s usually a bad idea to try to catch the proverbial falling knife; all else equal, I like to see a stock in the early stages of a new uptrend.
So with all of this said, let’s take a peek at which stocks make the Magic Formula cut as of July. I ran a screen of for the top 30 Magic Formula stocks with market caps over $1 billion, and here are the results:
|Booz Allen Hamilton Holding Group||BAH|
|CF Industries Holdings||CF|
|Lender Processing Services||LPS|
|Weight Watchers International||WTW|
A few names jump off the list, such as former market darling Apple (AAPL). It’s a strange world we live in, where the second-largest company in the world by market cap appears in a value stock screen with a strong bias towards small caps. But Apple is cheap enough — and profitable enough — to make the cut.
After spending most of the fourth quarter of last year in free fall, Apple has traded in a range of $400 to $450 for most of this year. Could the stock have further to fall? Absolutely. But it fits the Magic Formula criteria, and the price seems to have a fairly hard floor just below $400.
Apple’s old PC nemesis Microsoft (MSFT) also made the list, as did Cisco Systems (CSCO) — both of which I own in my dividend-focused portfolios. In fact, technology companies make up a full third of the screen. Video game maker Activision Blizzard (ATVI), enterprise IT solutions companies CACI (CACI) and Unisys Corp. (UIS), semiconductor maker Cirrus Logic (CRUS), computer manufacturer Dell (DELL), cyber security firm SAIC (SAI) and hard drive manufacturer Seagate Technologies (STX) all made the cut.
Health and nutritional company Abbot Labs (ABT) – also a Sizemore Capital holding — also is on the list, as is Big Tobacco firm Lorillard (LO) and defense giant Northrop Grumman (NOC).
There are a couple points to note here. First, cheap companies — even those with high returns on capital — can stay cheap for a long time. Microsoft and Lorillard have both been regular fixtures on the Magic Formula screen for several years. (Of course, both have also beaten the S&P by a healthy margin over the past five years).
Second, some companies are not really investable at this point, or at least shouldn’t be. I’ll use Dell as an example. Given that Dell is currently in the midst of heated dispute over whether to take the company private, this is probably a company you should avoid.
I might also add that you don’t have to use my screen. Greenblatt allows you to set a much lower market cap minimum (as low as $50 million) — though you’ll want to be careful when trading in small, illiquid stocks. And you can also expand the list from 30 to 50 stocks to give yourself a larger pool to research.
One final note: the math behind the Magic Formula is explained in Greenblatt’s book, The Little Book that Beats the Market.
Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, Sizemore Capital was long ABT, MSFT and CSCO. Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar but also which stocks will deliver the highest returns. The series starts November 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.