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Number Cruncher

'Magic formula' losing its touch on latest stocks batch Add to ...

What are we looking for?

In March, we created a portfolio of Canadian stocks using the "magic formula" strategy of U.S. hedge fund manager Joel Greenblatt. Because Mr. Greenblatt's stock screen at magicformulainvesting.com covers only U.S. equities, we used a Canadian screen developed by Validea Canada.

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Today, we'll get an update on the portfolio.

The background

Mr. Greenblatt looks for companies that are both profitable and cheap. He focuses on just two measures: 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 - 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.

By focusing on those two measures, the "magic formula" aims to get the best of both worlds. According to Mr. Greenblatt's book, his formula produced back-tested returns that handily beat the S&P 500 from 1988 through 2004.

"[Mr.]Greenblatt's research shows that while beating the market is hard, it doesn't have to be complicated," says Validea, which has no affiliation with Mr. Greenblatt.

"The hard part comes not in developing a complex strategy, but instead in finding a proven approach and sticking with it through good times and bad. [Mr. Greenblatt]stresses discipline as much as any of the gurus we follow."

The results

Over the years, Number Cruncher has had excellent results using the strategy. But the magic appears to have worn off for the latest batch of stocks, which are down 16.8 per cent for the period from March 2 to June 20, compared with a drop of 7.8 per cent for the S&P/TSX composite index.

The worst performer was Research in Motion, which plunged 60.3 per cent amid growing competition in the smart phone sector and concerns that RIM is losing its edge. Other big losers included tour operator Transat A.T., which has been hit by rising fuel prices and increased price competition, and Yellow Media, whose bread-and-butter business of publishing print directories is in decline.

All of this goes to show that, while the magic formula may be good at identifying profitable stocks that look cheap, it has trouble weeding out companies facing fundamental threats to their business. These companies are cheap for a reason.

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