The Magic Formula

Research
1

As an exercise, I am trying to use portfolio123 to replicate the “magic formula” rankings in Joel Greenblatt’s new book “The Little Book that Beats the Market”. You can generate his high ranked stocks at www.magicformulainvesting.com. I am finding it is more difficult than I thought to match his results for the following reasons:

  1. GreenBlatt gives a pretty good (but not exact) description of his method, but some of the terminology and fundamental items he uses is somewhat different from the items available in portfolio123.
  2. I only have a basic subscription ($19.95/month) and I cannot access all of the items available. Right now, I’m not using portfolio123 to manage real money, since I’m still working and cannot invest actively at my employer. I plan to use it after I retire next year at which point I will upgrade my port123 service level.

Let me give a brief description of Greenblatt’s method plus my attempted “mapping” to portfolio123 to see if anyone has ideas to more closely match Greenblatt’s results. SInce his book is very popular now (currently #36 on Amazon) it may start affecting how people invest and it would be worthwhile to understand his method and figure out ways to improve upon it.

Greenblatt uses a fairly simple 2-factor model.
Factor 1 is Return on Capital where he uses:
EBIT / (Net Working Capital + Net Fixed assets)
In a footnote, he says that he did not have direct access to EBIT, so he approximated EBIT with (EBITDA - maintenance capital spending)

I wasn’t sure how to precisely match this using portfoliio123. There is an item for EBIT over the last year (EBITA), which may be more accurate than Greenblatt’s approximation.
But I do not see any port123 items for net working capital or net fixed assets. So at this
point I am using tangible book value: EBITA / TanBV$A

Any suggestions on something better would be appreciated.

Greenblatt’s Factor 2 is Earnings Yield where he uses:
EBIT / Enterprise Value
where he defines Enterprise Value as Market value of equity including preferred equity + net interest bearing debt.

I do not see Enterprise Value as an item in portfolio123, so I tried using this approximation for the second factor:
EBITA / (MktCap + DbtLTA - CurAstA)
Again, any suggestions on something better would be appreciated. (I don’t think MktCap includes preferred equity)

When I ran my portfolio123 ranking, I found that some of Greenblatt’s high ranking stocks also ranked high. For example, HRB ranks high in Greenblatt system and also scored over 99 in my port123 ranking. But other stocks like CALL and ELNK scored high in Greenblatt’s system but had mediocre rankings in my portfolio123 rankings. (e.g CALL was only 42.1, ELNK 54.8)

I wonder if anyone else has looked at his system and has any suggestions on better ways to approximate it.

2

I haven’t looked at Greenblatt’s new book, but that’s and idea, thank you. Every new idea is important, because sometimes we can find a diamond in the rough. Sometimes we can come across a valuable idea that can make us money!

The terminology Greenblatt uses is based on fundamentals, but it’s also a terminology that looks different from the terms we use on this site, therefore, chances are, you won’t get a lot of replies in this thread. I suggest you spend a lot of time on this subject, look up definitions in this site. Click Help ==> Factor and Function References ==> Index, keep reading, and slowly build your formula from scratch.

I also suggest you upgrade your P123 membership, take a small sum of your money, get a discount broker, and start experimenting, while you’re still working. After you retire, you won’t have your earnings potential / courage of today. As you know, investing requires courage and sustained risk-taking, and you won’t likely have any more guts after you retire.

3

Hi George,

Net Working Capital (aka Net Current Assets and usually called Working Capital) is Current Assets minus Current Liabilities.

This explanation was taken from the “Dictionary of Finance and Investment Terms” by John Downes, Jordan Elliot Goodman (Paperback - November 2002 and published by Barrons.

This dictionary will allow you able to find and substitue the factors found in P123 for Greenblats other terminology.

Welcome to retirement. You should be able to well in the kind of market we have at the moment. However, learn and faihfully follow good risk management strategy(s).

4

Your EBIT is okay, although I would use EBITTTM, rather than EBITA. EBITTTM gives you the last four quarters regardless of the time of year, while EBITA provides EBIT from the last completed fiscal year. The difference, especially this time of year can be 10-11 months. For example, if the company is a calendar year company EBITA will be from December 2004, while EBITTTM will be the sum of the quarterly EBIT from Sep05, Jun05, Mar05 and Dec04 quarters. Both are 12 months of EBIT, but EBITTTM is far more recent.

Net fixed assets on a traditional balance sheet would be property, plant and equipment. I’m surprised Greenblat doesn’t suggets gross fixed assets, because net fixed assets creates artificially high Return on Capital for companies with older assets (i.e., more of them have been depreciated).

Anyway, there is a way to approximate net fixed assets in P123. Just take Total Assets - Current Assets (which includes cash, accounts receivable and inventory). What is left (Long-term Assets) will be 80-100% net fixed assets. If you wanted to try gross fixed assets as the denominator you would then add back Accumulated Depreciation to the above amounts.

Net working capital is Current Assets - Current Liabilities as explained above. That is the traditional accounting definition.

Your Enterprise Value is close, but traditionally only Cash is deducted, not all current assets. You can get a better Enterprise Value with:

Market Cap + Long-term Debt - (Cash per Share*Shares Outstanding)

(The assumption is that the company, or an acquirer, could use the cash to pay down debt. Not always valid - for example in highly seasonal industries companies cannot pay down debt in slow season because they need cash for inventory or working capital in peak season - but traditionally used nonetheless.)

All of those variables are in P123 (Cash per Share is in the Per Share variables - not sure if it is an entry-level variable)

Hope that helps

5

Thank you all for your suggestions!

Robert: Unfortunately, I can’t follow your advice about opening up an account at a discount broker, because I’m employed in the IT department of an investment bank. We are not allowed to have accounts at outside brokerage firms and need to have a “full service” account at our firm wih many trading restrictions.
It is really only good for very long term “buy and hold forever” investing.
That is one of the reasons I want to retire. I’m not too concerned about losing courage in my investing after retirement, because I am fortunate that my net worth is equivalent to about 40 years salary (50 years including real estate equity). So I really only need to earn about 2.5% annually to match my current salary. (Of course, I’ll be shooting for 20% or more.)

J Paul: Thanks for your suggestion. I guess the best p123 formula to use for net working capital (using the most recent data is): (AstTotQ - LiabTotQ) which are both available to Entry level members like myself. Also, thanks for the tip on the “Dictionary of Finance” book. It’s only about 10 bucks on Amazon, and I ordered a copy.

Gary: Thanks for the tips. I’m quite impressed with your financial accounting knowledge- you must be a CPA , financial analyst, CFO or investment banker!
I’ll definitely use EBITTTM instead of EBITA, and will also try out your other suggestions including use of net fixed assets and gross fixed assets to see how they stack up.
All of the items you list seem to be available for Entry-level members except for depreciation, so that should give me enough to work with:
Current Assets: CurAstQ
Cash per share: CashPSQ
Long term Debt: DbtLTQ
Market Cap: MktCap
Shares Outstanding: ShsOutMR

6

My last post contained some errors in my understanding of Gary’s post. This is what I plan to use (at least for now) in my “magic formula” ranking system. I made it public if anyone wants to play around with it.

return on capital=
EBITTTM / ( (CurAstQ-CurLiabQ)+(AstTotQ-CurAstQ) )

earnings yield=
EBITTTM / ( MktCap + DbtLTQ - (CashPSQ * ShsOutMR) )

7

I’ve run a few preliminary comparisons and the new ranking system matches Greenblatt’s screen very well for many stocks, but is still way off for others. But I think that is happening because Greenblatt is using only annual reports.

For example, MIVA is one of Greenblatt’s current picks that scores very low in the port123 rankings. I looked at the earnings and balance sheet data on Yahoo Finance. MIVA’s last annual earnings report for 2004 was quite good- $27 million in EBIT. But MIVA’s last two quarterly reports show losses. My guess is that Greenblatt is only using the annual reports, so his information can be very stale. Any who uses his screens needs to be careful to check the more recent data.

http://biz.yahoo.com/ap/051107/earns_miva.html?.v=2

8

Mr. Greenblatt was a guest on the Motley Fool radio show this past weekend. It was funny listening to the hosts. He professed to earning 40% annually over the past 20 years or so, and they did everything they could to knock him down. I don’t even know why they had him on the show, because they sounded like they were very skeptical, and even annoyed at times.

Mr. Greenblatt said his normal holding period is 1 year. He actually likes to sell losers after 364 days, and winners after 366 days. He buys 5 or 6 stocks at the beginning of each month until he has a total portfolio of about 20-25 stocks.

I ran a few sims with only 2 buy parameters - AvgVol(20)>40000 and Rank>99.5. I held them (20 positions) for 1 year, and used a 30% stop loss. With the following ranking systems, I got annual returns between 45 and 52%:

IReturn09
TopPort123 Factors&Formulas
TFCombo-1
BJS Small Cap GARP DHP
BJS Mo Value

Brian

9

mozart325 thank you for attempting to recreate the magic formula using Portfolio123. I’m playing around with your ranking system, but I noticed many of the stocks that it produces are different than those on magicformulainesting.com. It looks like you noticed that same thing. Have you been able to create a ranking system that more closely matches those of the Magic Formula website?

I did note that Greenblatt’s book says that the formula doesn’t work for financial or utility stocks. Maybe, the ranking system or screener needs to filter out those industries. Anyone know how to do that? I’m new to the tools on Portfolio123 and any help would be appreciated.

10

Mozart, I’m sorry, I had no idea about the unusual restrictions your employer had imposed on you. With the restrictions of your employer, and the kind of net worth you probably have, I, too, would keep thinking about retirement. In the unlikely event you’ve got a very small salary, your net worth appears to be large enough to enable you to immediately unlock and throw away your shackles. Consider ridding yourself of your shackles, and consider retiring now, right now, while you’re still able to enjoy life! Consider making room for those who are both younger and less wealthy than you are! However, if you still want to fight traffic to get into the office every morning, and if you still want to be chained to your desk every day, there’s another plan you might want to investigate. It’s a well known plan… a plan known as the “dogs of the dow” that requires investors to buy and hold for one full year a few carefully selected stocks of the 30 stocks that make up the Dow Jones Industrial Average. While past results do not guarantee future results, historically the dogs of the dow do make around 20% per year, the kind of money you want to shoot for. For more info, see the http://dogsofthedow.com web site, which is completely free. Additionally, while I haven’t seen it here, on this (p123) site, it’d be pretty easy to back test the dogs of the dow, right here, on this (p123) site.

I hope this helps.

11

Robert,

Can you please talk me into retiring, too? :^)

12

George,

To eliminate utilities and financial stocks use the folowing Buy Rule in your Sims:

Sector != Utilit & Sector != Financ

To add it to the Ranking System is a little more dificult since you have to add 2 new functions and give them each a high weighting so that their weight dominates the total rank value. If you want to evaluate the effect of eliminating those sectors with the Ranking Performance you will have to add the functions to the Ranking System.

If you only need to evaluate the effect in Sims, use the above Buy Rule.

Denny :sunglasses:

13

Brian,

You’re not kidding, are you? Tell me about all the bad things about your work situation, and I’ll be happy to talk you into retiring.

Robert

14

Denny,
Thank you for the help. I also added Universe($ADR) != 1 as a buy rule since I read that Greenblatt doesn’t include ADRs in the Magic Formula analysis.

Feel free to look at my sim and make any additional recommendations on how to make it better match Joel Greenblatt’s Magic Formula. I called the sim, Magic Formula Sim.

I think Joel also filtered out companies with missing financial information and stale filings. Is there any way to do that with a Simulation?