Disclaimer: This article is for informational and educational purposes only. Do not interpret anything below as financial advice. Always do your own research & speak to a financial professional before making investment decisions.
Background
My interest in investing developed in March 2020, following the initial outbreak of the global pandemic we are still combatting today. Fresh out of business school and with a year of work experience under my belt, I had started to accumulate some savings and wanted to figure out the best way to put them to work. The pandemic, despite its numerous shortcomings, provided a unique opportunity to begin what would (and has) become an ongoing journey down the road of personal finance and stock market investing. This was accentuated by the harsh restrictions in Spain (where I was living at the time) where for several months during the early stages of the pandemic, trips outside your house were not permitted without a valid excuse such as going to the supermarket.
I soon realised real estate was off the cards, due to the large initial pool of capital required to get started and so decided on investing in the stock market. The ease of accessibility and capital-light characteristics made sense at the time. Over the following months I consumed content by the likes of some of the greatest investors of our time such as Warren Buffett, Charlie Munger, Mohnish Pabrai, Guy Spier and Joel Greenblatt - whose investing framework and methodology outlined out in his bestseller ‘The Little Book That Still Beats The Market’ inspired and laid the foundation of the QuantCompounding newsletter.
Magic Formula
For those who haven’t read the book (or books, there is an earlier edition) I highly recommend doing so. It is a great read for investors of all levels and even those with no investing background (myself at the time) but with an interest in wealth creation. In a nutshell, the book lays out an automated and systematic approach to Warren Buffett’s ‘value’ style investing where Greenblatt suggests screening for stocks with a high earnings yield (‘cheap’ businesses) and high returns on capital (‘good’ businesses) and combining the two metrics to rank all of the companies listed in the S&P 500 index should produce stellar investment returns.
Greenblatt recommends following the below steps*:
Enter two simple security selection criteria and Magic Formula will select top stocks for your investment portfolio. The criteria are number of stocks (30 or 50) and minimum market cap (starting at $50 million). Greenblatt suggests that companies with market capitalisations greater than $50 million or $100 million should be sufficient.
Follow the instructions to obtain a list of top-ranked companies.
Buy five to seven top-ranked companies every two to three months. Invest between 20 and 33 percent of the capital you intend to deploy in your first year.
Repeat Step 4 every two to three months until you have invested all the money you plan to allocate to your Magic Formula Portfolio. This should be after 9 or 10 months and the portfolio size should be between 20 to 30 stocks.
Sell each stock after holding for 1 year and replace with new magic formula selections**.
Repeat the process for many years (minimum of 3 to 5 years to maximise results).
Write to Joel and thank him later.
*I have simplified the steps here.
**In the FAQ section of his website, Greenblatt notes that if the same stock(s) shows up on the screener a year later, you have to make a judgement call if you want to decide if you want to continue to hold the stock(s).
Now, while clearly not a foolproof method of stock picking and with plenty of simplification involved (Greenblatt’s book is certainly not aimed at seasoned investors) I was still very curious to see if the backtested results in the book (30.8% compounded between 1988 and 2004) could you be reproduced in today’s economic climate. So I decided to create my own Magic Formula portfolio and document the results on QuantCompounding*. Every time I make a change to the portfolio (buy, sell or hold) I will explain my thought process and rationale behind each decision. This is a portfolio I plan to run for the long term and I think will make for an interesting use case in the investing space.
*FYI I am already two batches deep into this project already, purchasing my first batch of stocks on 26/11/2021. The decision document this journey came a little later than I would have preferred. In the next section I explain my methodology and stocks I purchased in batches 1 and 2.
Adjustments
While I am attracted to the simplicity and hands-off approach to the original Magic Formula laid out in Greenblatt’s book, I wanted to add a personal ‘twist’ to the approach to add a further level of analysis to the process to whittle down the initial list analytically rather than randomly and potentially yield superior returns over a prolonged period of time.
Below I outline my methodology:
Screen for 30 top stocks on magicformulainvesting.com with a minimum market cap of $50 million
Paste results into a spreadsheet and rank stocks by Filter 1: Free Cash Flow Yield. I decided to use Free Cash Flow Yield as the first filter after reading ‘Investing for Growth’ by Terry Smith (founder of Fundsmith). Smith talks extensively about the metric in his book and describes it as his ‘primary valuation yardstick’, saying that if you can buy companies with a higher Free Cash Flow Yield than the bond yield, you’ve probably created value. I decided to use 10% as my minimum acceptable Free Cash Flow Yield. Any stock with a lower Free Cash Flow Yield would be excluded from the next step.
Rank stocks by Filter 2: Total Debt/Free Cash Flow. Smith mentions that one of the downsides of using Free Cash Flow Yield is that the calculation uses a company’s market value which doesn’t account for debt. I decided that a logical next filter would compare a company’s total debt figure to its trailing 12-month free cash flow figure. I decided to use 3 as my benchmark - all companies with a result less than 3 would proceed to the final filter (i.e. those stocks that could pay off all their debt obligations within 3 years of annual free cash flow). This idea was inspired by Phil Town in his book ‘Rule #1: The Simple Strategy for Successful Investing in Only 15 Minutes a Week!’, coincidentally the first investing book I read.
Rank stocks by Filter 3: Insider Ownership. As ‘value’ investors, we like to consider stocks as real businesses rather than pieces of paper. This mindset was developed by Benjamin Graham, the father of value investing. That being the case, in theory we want companies with owners who have ‘skin in the game’ i.e. companies with high insider ownership. The thinking behind this filter is as follows: the higher the insider ownership, the higher the interest the company’s owners have in its long-term success and therefore the higher reliability there is that the company is well-positioned to deliver long-term value to shareholders. This filter is definitely not foolproof or not black and white, however, it certainly fills me with greater confidence investing in companies with higher insider ownership alongside the owners than those companies without this characteristic.
Buy the 7 companies that rank the highest after applying the previous three filters. Invest 25 percent of the capital I intend to deploy in my first year. Fortunately, the brokerage platform I am using offers fractional shares, meaning I can invest equal amounts into every batch of stocks that I purchase.
Repeat Step 5 every three months until I have invested all the money I plan to allocate to my Magic Formula Portfolio. This should take 12 months in total (7 stocks each batch) and should result in a portfolio size of 28 stocks. I decided to extend the investing period over a whole year instead of 9 to 10 months like Greenblatt suggests, primarily to be able to continue to provide equally distributed updates each batch and also to capture the fluctuations of the market during the full course of a year rather than 9 or 10 months of it.
Sell each stock after holding for 1 year and replace with new Magic Formula selections.
Repeat the process for many years. I plan to document this journey for many years to come to see if the Magic Formula approach still works in today’s economic climate.
Portfolio update
As mentioned in the note above, I started this process on 26th November 2021, so I am already two batches deep into the strategy. Below I list the stocks purchased in the first two batches using the above criteria to get you up to speed.
Batch 1 Stock Selections - 26/11/2021
Atea Pharmaceuticals Inc - AVIR
Fulgent Genetics Inc - FLGT
Nautilus, Inc. - NLS
HP Inc - HPQ
Brilliant Earth Group Inc - BRLT
Academy Sports and Outdoors Inc - ASO
Immersion Corporation - IMMR
Batch 2 Stock Selections - 28/02/2022
Buckle Inc - BKE
Ovid Therapeutics Inc - OVID
Zedge Inc - ZDGE
Surface Oncology Inc - SURF
Sleep Number Corp - SNBR
Quidel Corporation - QDEL
Crocs, Inc. - CROX
Final thoughts & observations
Before wrapping up, I want to provide some final thoughts on this approach and what you can expect from future write ups.
Pharmaceutical stocks
As mentioned in the earlier ‘Magic Formula’ section, this strategy is not foolproof and after purchasing two batches of stocks already it is clear why. As a result of the global pandemic, it is clear that pharma stocks are increasingly visible on the Magic Formula screener, as a result of high returns on capital in the past year, possibly due to new drug releases. This is something I definitely want to take into consideration moving forward so as to avoid building a portfolio of pharma-heavy companies and becoming overly concentrated in one sector.
Stock avoidance
Occasionally, stocks that would have made it into the portfolio don’t because they are unavailable on the brokerage platform I am using. When this is the case, I will simply select the next best stock following the criteria outlined above. The same applies for stocks I consider to be ‘immoral’ or ones that do not align with my personal values.
Holding period
In Step 7 of my adjusted criteria I suggest holding the stocks for 1 year before buying, selling or holding. This is what Greenblatt suggests in the original strategy, however, I believe this is largely for tax purposes since in the United States, investors that hold stocks for longer than a year are subject to a lower capital gains tax rate. I am still open to holding my stock picks for up to 2 years to give them the time they need to revert to the mean and realise their true value. Mohnish Pabrai suggests 2 years is an adequate minimum holding period for stocks to realise most of their value in his book ‘The Dhandho Investor: The Low–Risk Value Method to High Returns’. I have no problem with this. In fact, I feel that 1 year is not a very long holding period in the grand scheme of things.
Metrics
For the time being, I am happy with the three metrics I have chosen. I do not want to over complicate things by adding more filters so I intend to stick with three moving forward. After all, this approach is intended to be largely passive by nature. That said, I am open to trying new filters as time goes on. I am considering swapping my final filter (Insider Ownership) to Median 10 year ROIC at some point in the future. The reason for this is because I believe relying on a trailing twelve month ROIC figure can lead to anomalies like in the case of the pharma stocks mentioned above that can skew future performance. A 10 year median ROIC of above 15% for example would not only prevent this from happening, it would also provide greater insight into businesses who have a long history of creating high returns on capital for shareholders that are likely to continue to do so for years to come.
Expectations & goals
I am hoping to beat the S&P 500 index over the long-term with this approach i.e. achieve greater than 8% returns over a 5+ year timeframe. I will be using Sharesight to track my returns, which I intend to share annually with subscribers.
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