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Number Cruncher

Poof! Magic Formula makes money vanish Add to ...

What are we looking for?

Let’s get an update on our U.S. “magic formula” portfolio, which we created in April. We’ve had good results with the strategy in the past, but in this case the only magic it’s pulled off is making money disappear.

The background

U.S. money manager Joel Greenblatt detailed 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.

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, it’s down 13.6 per cent per in U.S. dollars through Nov. 2. That compares with a drop of 8.1 per cent over the same period for the S&P 500. Both figures exclude dividends.

As you can see from the table, performance was hurt by steep drops in stocks such as teen clothing retailer Aeropostale, specialty vehicle maker Oshkosh and mortgage services provider Lender Processing Services.

Six months isn’t long enough to judge the success of any investment strategy. We'll check back from time to time and update you on the portfolio’s performance. Remember to do your own due diligence before investing in any security. Use screens such as magicformulainvesting.com as a starting point for further research, not as the last word on what stocks to buy.

Follow on Twitter: @johnheinzl


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