What are we looking for?
Yesterday, we said farewell to our portfolio of U.S. “Magic Formula” stocks. We were sad to say goodbye, because our portfolio left the S&P 500 in the dust, gaining 41.4 per cent over roughly a 16-month period compared with a 20-per-cent advance for the S&P 500.
Today, we’ll create a new batch of U.S. Magic Formula stocks and see whether they can achieve similar success. We’ll check in with them every few months and provide updates in future Number Cruncher columns.
(In March, we also created a Canadian version of the Magic Formula portfolio. We’ll be updating you on that portfolio in future columns as well.)
The Magic Formula aims to find companies that are both highly profitable and cheap. The formula’s inventor, U.S. hedge fund manager Joel Greenblatt, detailed his stock-picking methodology in The Little Book that Beats the Market, published in 2006.
Mr. Greenblatt focuses on 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 – 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.
Mr. Greenblatt provided back-tested data indicating that the strategy produced returns more than double those of the S&P 500 from 1988 through 2004.
“I believe that if you are able to stick with the magic formula strategy through good periods and bad, you will handily beat the market averages over time,” he wrote.
Our new U.S. portfolio
We used the stock screener at magicformulainvesting.com to select U.S. companies with a minimum market capitalization of about $2-billion (U.S.). We invested a hypothetical $50,000 (U.S.) in each stock, for a total of $1-million.
Our previous magic formula will be a hard act to follow, and we’re just as curious as anyone about how the new stocks will fare.