WHY DO I LIKE MAGIC FORMULA INVESTING

Because it is Simple (Have a look at my tagline on top of the page). The MAGIC FORMULA screen ranks companies based on only two variables: “cheapness” (which mean low Price to Earnings) and “goodness” (return on capital employed).  Invariably good companies with high ROCE should generate enough cash. If the cash is being used prudently for expansion, the company will grow and so will the EPS.  It is that simple.

Makes sense. Few investors would prefer a bad business to a good one, and few would purposely ignore the price they pay for a stock (How else can you justify price movement of companies that still have to report a penny in profit).  Magic Formula seeks out good companies that are available at good prices. The result is a list of businesses that offer both a high earnings yield and a relatively high probability that capital reinvested in the business will generate high returns. It makes intuitive sense that such stocks should outperform the markets in a broader term. There is one Caveat though – The market sentiment decides the movement of stock prices. If the markets in general are performing well, Magic Formula Stocks tend to do better than the market. But if the markets are heading south, do not expect all Magic Formula stocks to head north. You might still beat the market, in the sense that market might fall by 30% whereas your portfolio of stocks my 20%. You have beaten the market by 10% but you still are in a loss. It is important that you follow the SEnsex/Nifty PE while investing. If the market PE is hovering around mid 20’s a downturn is likely and even magic formula may not save you. You need to be prudent on when you invest.

I invested in Amruthanjan and Liberty Phospate when it first showed up on the magic formula list. I exited Amrunthanjan at 950 odd and am still holding on to Liberty Phosphate. Timing of the market is impossible, but if you enter at high PEs, you are likey to burn your fingers and if you enter at the right time you will be rewarded.

WHY MAGIC FORMULA WILL CONTINUE TO WORK

“Institutional imperative” makes adherence to MAGIC FORMULA difficult. Institutional managers care not only about investment risk but, perhaps more acutely, about career risk. Many managers cannot afford to follow a winning strategy if it involves enduring long stretches of relative underperformance. It is much safer from a career standpoint to be “wrong” when everyone else is losing money than to be “wrong” when everyone is making money. During the 1988-2004 period studied by Greenblatt, MAGIC FORMULA handily outperformed the S&P 500, yet the strategy experienced two non-overlapping three-year periods of underperformance. While most fund managers may be able to endure a quarter or a year of underperformance, they may be left with few investors after a two- or three-year period of sub par results. It is therefore extremely difficult to stick with MAGIC FORMULA when the going gets tough. Fund Managers are under pressure of performance and competition from peers. It is inevitable that they look for short term gains for capital appreciation. Most Mutual funds these days do not have a lock in period, and this adds to the pressure of the fund managers. If the don’t perform in the short run, they perish. We have the liberty to wait for the right time to buy and since it’s our own money and our own target, we are not likely to succumb to such pressures of performance. If you have good money management skills and discipline, you will surely beat the fund managers and the market. If I can with a day job, I guess anyone can.

Investors have a hard time turning off their emotional biases.

Many companies on the magic formula list that I generate are either in out-of-favor industries or have major company-specific issues, such as regulatory scrutiny, accounting problems, executive turnover, or deteriorating operating momentum. While many investors may agree conceptually that buying good companies when they are out of favor is a path to long-term out performance, a much smaller number would actually be willing to follow such a strategy. Easier said than done I guess. Bharti Airtel, Balrampur Chini, Tech Mahindra have all fallen a lot in the last 6 months, it needs conviction, patience and a lot of character to be invested in these companies when the chips are down.

As a quantitative method, the MAGIC FORMULA screen is perfectly sanguine about picking a headhunting firm during a recession or a laser eye surgery provider when the media is calling into question the safety of laser eye surgery. Professional investors legitimately want to use the MAGIC FORMULA list as a starting point from which to do further research and ultimately make a subjective judgment regarding an investment opportunity. Unfortunately, the subjective judgment is frequently tainted by emotional bias. As a result, the investor may dismiss the headhunting firm by thinking, “Of course it’s cheap, we’re in a recession!” Similarly, the investor may dismiss the laser eye surgery company by thinking, “Of course it’s cheap, they might go out of business!” Finolex Cables, Core Projects etc are examples of such companies that have crashed during bad times only to recover in due course of time.

MAGIC FORMULA never runs out of investment candidates. Several value investment strategies have become de facto obsolete over time. For example, whereas Ben Graham successfully searched for so-called “net nets” more than a half-century ago, such companies have become virtually extinct today. If you wait for a company to get to its eight year low before you invest, you may never invest. The few companies whose current assets exceed the sum of their equity market value and total liabilities are typically either depleting those current assets at a rapid pace or there are other reasons why theoretical liquidation values might not be realized. As a result, today’s professional investors cannot build their businesses around “net nets.”

By contrast, MAGIC FORMULA simply ranks public companies relative to each other. There is no absolute cheapness requirement, whether it be “net net” or that book value exceed market value. As a result, MAGIC FORMULA will always provide investors with an investable list of relatively attractive public companies. Again, from my perspective you should be able to time it right. Magic formula list generated and invested in when the market PE is less that average market PE for the last 10 yrs the results will be encouraging.

Investors tend to remain skeptical of winning strategies even after long periods of outperformance. Investors have been taught – you might say “brainwashed” – that markets are efficient and there is no free lunch. As a result, they struggle with the notion that a simple quantitative strategy can systematically outperform the best efforts of large numbers of securities analysts and portfolio managers. For example, stocks that trade at a low multiple of price to book value have outperformed the broader market in a statistically significant way for a long period of time.  If you are interested post a comment and along with the Magic Formula List I can also post list of companies that are trading at less that two thirds of their book value. This was one of the criterias Benjamin Graham recommended, but I am not too sure of its efficacy in Indian Markets and I have personally not tested it. Benjamin Graham used to advocate a holding period of 2 yrs or a gain of 50% whichever comes first. Magic Formula Stocks for me have been giving returns in excess of that and I would not want to change that.

Low P/B stocks have always existed and professional investors do not blindly follow that, even though this is recommended by the ever green guru himself.  Likewise Magic Formula list will never be followed religiously by those who need constant action.

I too do not like sitting idle for a long time and since magic formula stocks did not change for a long time, I ventured into technical trading of fundamentally strong stocks and came up with www.indianswingtrader.blogspot.com. My picks there have been good so far. Probably sheet luck and nothing more. I also wanted to check on how google adsense revenues work and if it is worthwhile to host a domain instead of using free blogging sites. Your feedback on that will be really helpful.

I will be posting the latest magic formula list on my google groups later during the day. One of the stocks listed this time is trading at 50% to its intrinsic value. If you have been reading my posts regularly and heeding by my suggestions, you would know the scrip !

Happy Investing.