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.
Fellow Quant Enthusiasts,
Welcome to a new instalment of my Magic Formula journey. We’re making our way through the second year of this five year experiment. This edition brings the latest buys, sells and holds from Year 2, Batch 3.
Performance since inception: -13.67% vs. -3.11% S&P 500
Performance this financial year: -0.31% vs. 10.49% S&P 500
As ever, my plan for the round was to make the purchasing decisions as simple, systematic and sensible as possible, while maintaining a focus on dividend growing stocks - something I feel I edged ever closer to in the last update.
The steps I followed are summarised below:
Step 1
Mark companies that pay a dividend from initial screen*
Step 2
Mark companies from Step 1 that have increased their dividend over the last 5 years**
Step 3
Rank remaining stocks by EV/EBIT and select 5 top stocks
*In the last selection process, I removed stocks that were not eligible to be sold during the current round (i.e. I hadn’t yet held them for at least a year). I removed this criteria this time round, concluding that if such stocks appeared on the screener, I would simply add to the positions. This scenario indeed played out as the next section explains.
**I used a 10 year dividend growth filter in the last letter. Explanation for the reduction to 5 years is explained in the final section of this letter.
Tweaks
I decided to add to stocks that showed up in the screen that I already owned that matched my buying criteria (growing dividend for last 5 years).
I also figured if there weren’t enough stocks to choose from from the screen, I could choose to hold positions from the batch due for sale consideration (the batch from the corresponding round in the previous year, in this case Year 1, Batch 3) provided these positions matched my current buying criteria.
Year2, Batch 3 Stock Picks
As you may expect, the pool of companies who have grown their dividend consistently over the last 5 years is small.
So much so that out of the screen of 30 companies, only 7 paid a dividend of which 4 had grown it over the last 5 years. Those were: The Buckle, Inc. (BKE), Heidrick & Struggles International, Inc. (HSII), Korn Ferry (KFY) and Medifast, Inc. (MED).
Keen readers of the newsletter will be aware that I already hold BKE, KFY and MED so three easy ‘add’ decisions were made for me immediately. Unfortunately, I was unable to scoop up shares of HSII via my brokerage.
I glazed over the companies I could consider holding for another year from Year 1, Batch 3, only 4 out of 7 stocks matched my buying criteria: BCC, WSM, DKS and KFY. Since I would already be adding to KFY after it appeared in this batch’s screen, I was left to hold on to BCC, WSM and DKS - something I was not unhappy with!
The 3 remaining companies, ITOS, INVA and GPRO, were sold with (not so great) performances of 6.51%, -17.61% and -34.20% respectively.
Since I was unable to purchase shares of HSII, the total number of buyable companies in this selection amounted to 6 (BKE, KFY, MED, BCC, WSM and DKS). Rather than thinking of another filter to find a new company that was available and that matched the criteria I decided against it this time concluding that a bit of portfolio consolidation can’t hurt and as long as I held between 20-30 positions I’d be in line with Greenblatt’s instructions. Below are the final decisions with the each stock’s respective forward dividend yield and current EV/EBIT multiple.
Add
BKE: 4.40% | 4.1x
KFY: 1.24% | 5.0x
MED: 8.04% | 4.2x
Hold
BCC: 0.80% | 2.8x
WSM: 3.17% | 5.1x
DKS: 2.37% | 2.8x
Sold
ITOS: N/A| -2.7x
INVA: N/A | 7.3x
GPRO: N/A | -54.4x
Outlook
In my previous letter I discussed a key difference I’d noticed post-pivot to focus on dividend growth stocks. That difference was reflected in the increased market cap of my previous selections. See, growing a dividend consistently over 10 years indicates a fair amount of overall growth in the business.
I figured that due to the small pool of companies with this characteristic, the higher the chances of me holding/adding to the positions over multiple years without having to succumb to the frequent churn dictated by the original Magic Formula strategy.
My thinking here hasn’t changed much, however, by reducing the dividend growth history to 5 years instead of 10, this opens up a world of small to mid cap companies ruled out by the 10 year filter.
BKE: 1.61B (Small)
KFY: 2.53B (Mid)
MED: 894M (Small)
BCC: 2.99B (Mid)
WSM: 7.3B (Mid)
DKS: 7.86B (Mid)
We ended up with 4 mid caps and 2 small caps this time round, compared with 2 mid caps, 4 large caps and 1 mega cap in the previous round.
Granted, I already owned all of the positions, but it gives you a flavour of how this selection process opens the doors up to a new universe of smaller companies with potentially larger runways for growth.
One thing worth mentioning is that this new selection process means that the portfolio will not necesarily always contain 28 positions as usual. In cases where stocks appear on the screen in consecutive rounds that are held (e.g. BKE, KFY and MED) or stocks are unavailable via my brokerage (e.g. HSII) the number of positions will naturally decrease.
In this round we exited 3 positions (ITOS, INVA and GPRO) and initiated no new positions resulting in a net position decrease of -3 and a new position total of 25.
I’m hopeful the method laid out in this letter will achieve two key objectives over time: 1) gradually concentrate the portfolio to 20-25 solid holdings and 2) reduce the churn experienced in previous rounds.
Hope you enjoyed this one. If you did, I’d appreciate you sharing it with someone who might be interested!
QC
QuantCompounder Koyfin Discount
I’m not one to promote products I don’t personally use. Koyfin is a brilliant tool built by investors that provides access live market data and powerful analytical tools so you can analyse companies and see the data you want to see, how you want to see it.
By using this link you can enjoy a 10% discount to Koyfin’s Plus and Pro plans if you’re interested. It also helps support this publication’s growth.
