What are we looking for?
At the end of 2009, we created a portfolio of U.S. stocks using the “Magic Formula.” Let’s check in with our stocks one last time before we create a new portfolio using the strategy.
The Magic Formula aims to give investors the best of both worlds – stocks that are both profitable and cheap. The formula’s inventor, U.S. hedge fund manager Joel Greenblatt, outlined his strategy in The Little Book that Beats the Market, published in 2006.
Mr. Greenblatt focuses on two measures in particular: return on capital and earnings yield.
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 – which he defines 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 U.S. companies with a minimum market capitalization of about $2-billion (U.S.). The screener lets you choose portfolios of 30 or 50 stocks; we only wanted 20, so we created a 30-stock portfolio and took the first 20 in ascending order of market capitalization.
We invested a hypothetical $50,000 in each stock, for a total of $1-million.
From Dec. 31, 2009, through Apr. 21, 2011, our Magic Formula portfolio gained 41.4 per cent in U.S. dollars (excluding dividends). That more than double the S&P 500, which gained about 20 per cent over the same period.