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Number Cruncher

A magic formula that's lost its spell Add to ...

What are we looking for?

Let’s get an update on our U.S. “magic formula” portfolio, which we created in April, 2011.

The background

U.S. money manager Joel Greenblatt outlined his stock-picking strategy in The Little Book That Beats the Market, published in 2006. His formula aims to find companies that are both profitable and cheap by focusing on two measures: return on capital and earnings yield.

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The higher the return on capital – which he defines as pretax operating profit divided by the sum of net working capital and net fixed assets – the more effectively a company is using its capital to generate profit.

The higher the earnings yield – defined as pretax operating profit divided by enterprise value, or the sum of stock and debt – the more attractive the stock is from a valuation standpoint.

We used the stock screener at magicformulainvesting.com to select 20 U.S. companies with a minimum market capitalization of about $2-billion (U.S.). We invested a hypothetical $50,000 in each stock, for a total of $1-million.

The results

Since the portfolio was created on April 26, 2011, it’s down 3.2 per cent in U.S. dollars through March 27. That compares with a gain of 4.8 per cent over the same period for the S&P 500. Both figures exclude dividends.

As you can see from the table, just six of the 20 stocks rose over the period. The portfolio was hurt by steep drops in stocks such as specialty vehicle maker Oshkosh Corp., for-profit college operator Devry Inc. and wireless technology developer InterDigital Inc.

We’ve had good results with the magic formula in the past, but the poor performance of the portfolio highlights the fact that no strategy is bulletproof.

Remember that stock screens are only a starting point for further research, and be sure to do your own due diligence before investing in any security.

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