"Magic Formula" Investing - What Resources Are Available For UK Investors?

28th Mar '11 by Mark Carter

4 comments 12072 reads

In his book, "The Little Book That Beats The market", Joel Greenblatt laid out an investment formula for selecting a portfolio of shares that should beat the market over the long term. In this piece, I assume some familiarity with his book and formula. His formula contains a few grey areas. Sharelock Holmes has a screen for Greenblatt; although it is unlikely to be an exact replication of the formula.

Greenblatt does, apparently, use the formula for selecting stocks for his hedge fund, Gotham Capital. Greenblatt likes to run a concentrated portfolio, but he advises readers to diversify into about 30 stocks. Having seen some of the companies produced by Sharelock Holmes, I readily concur. Specifically, HLO (Healthcare Locums) and RCG (RCG Holdings) spring to mind, and if memory serves, HMV (LON:HMV) were given high rankings by the filter. All three have had their problems: HLO was suspended for accounting irregularities, RCG has been highly dilutive of shareholder equity and has engaged in a "rash" of "confusing" acquisitions, to put it politely. It will likely delist in April. HMV is highly indebted, and may soon breach its banking covenants. Greenblatt's formula tries to find cheap and good companies. The three companies that I mentioned are certainly cheap, but are far from likely to be considered "good". In my opinion, there is a high probability of permanent impairment of capital with these companies.

Presented below is a list of resources that I have assembled on MFI (Magic Formula Investing), that readers may find interesting; albeit that they are focussed on US stocks. There is the official site by Joel Greenblatt, although it is not particularly useful as a resource. None of the sites listed below are officially affiliated with Greenblatt.

Magic Formula Pro - a blog by an unknown author. The blog also tracks Ackman, Berkowitz, Buffett, Einhorn, Li, Klarman and Schloss. One page on the site spells out the author's own calculation of earnings yield.
MFI Diary - commentary and tracking of a portfolio of stocks using the MFI approach by Marsh Gerda
Magic Formula Investing Yahoo Group - this group discusses the MFI approach, and is open to public participation. The main page provides links to other blogs, and an Excel add-in.

On the MFI diary site, Marsh spells out his calculation of earnings yield…

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Edward Croft

28th Mar '11

Mark - of course HMV, HLO and RCG seem priced to oblivion already. Some of these companies get priced so cheaply that the market prices in a near certainty of bankruptcy - if only one of these companies turns their fortunes around significantly, it may pay for one of the others going bust several times over.

The point that Greenblatt makes is that you have to trust the quant implicitly. You have to trust that on average, a list of 30 stocks within his criteria will outperform the market significantly in spite of the ones going bust.

Some of the stocks on a Greenblatt list will require a deep breath before purchasing and may go completely against all your instincts (such as in those 3 quoted above). Greenblatt's previous book was all about buying distressed assets and his hedge fund returned 50% per year for almost a decade (Gotham Capital) - so there's a lot of value in turnarounds. I'd be extremely interested to know what proportion of Magic Formula returns came from deep turnaround stocks that were in a perilous situation - it would probably be a lot. After all those are the 'cheapest' stocks from an earnings yield perspective so MF lists will be full of them.

PS - welcome to Stockopedia!

Mark Carter

29th Mar '11

Also check out Magic Diligence.

Tim_sp

4th Apr '11

@ Edward, interesting question on the contribution of turnarounds. You are right, as Joel has mentioned in numerous interviews, you sometimes have to hold your nose and buy.

A good magic formula screener for the USA, UK and Europe can also be found here:
www.value-investing.eu
(Disclosure: I write a newsletter for them so indirectly I have a vested interest)

I use the screener extensively for my own portfolio.

Take a look at their back tested studies here:
http://www.value-investing.eu/papers.aspx

The back tested results show the magic formula can be enhanced by combining it with the Piotroski F-Score.

@Tim. I have read your paper before, and I like it very much. As I recall, there was a distinctive small-cap effect on the results; although from memory of a screen I did some time ago, that is where some of the hairier companies are too. Some of the "best looking" companies quantitatively also turn out to be the worst, as the market sometimes sees the flaws in the companies correctly. Richard Beddard also wrote an interesting article recently called Formula not so magic in UK. It might be interesting to run an "accept" and "reject" portfolio (i.e. an up-front hand-chosen subset), to see whether one can personally add value over a purely quantitative portfolio.

"Magic Formula" Investing - what resources are available for UK investors?

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Mark Carter

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