Diary: Magic Formula Investing

I follow the Yahoo Group magicformulainvesting. Here's a snippet from an interesting post:

I understand there is a general lack of enthusiasm for the Magic Formula in this group.  But I'm wondering if this is just some short term blues. Isn't the whole point of the system to stick with it even through some years of underperformance? Maybe it works better in a bull market than it does a bear market but long term it will do right, no?

--- In magicformulainvesting@yahoogroups.com, "marsh_gerda" wrote:
>
> Clearly MFI has been struggling for the past 18 months.  I have
> identified 4 clear groups that have gotten crushed:
>
>
>    1. Chinese RTOs
>    2. Education
>    3. Nursing Homes
>    4. Solar-Related Stocks
>
> That raises the question, should an MFI investor be thinking hard about
> being diversfied and not having too many eggs in the basket of any
> single industry/sector?

Another  poster said:

>Arbitrage trading platforms and high frequency trading algorithms by the big firms are dominating the scene (especially in the last 6 to 9 months) AND with the addition of ETFs (now representing over $1 trillion in U.S. dollars (not to mention the ability for hedging, and trading leveraged products in IRAs and other retirement type accounts (short and ultra short ETFs included)) which used to be unheard of, it is my opinion, that fundamentals have a low level of influence on modern markets.

>
>
>This is making investment grade stocks from a value perspective very hard to find (but not impossible).


In the first paragraph, you seem to be saying that the ETFs, short-termism and suchlike are causing erratic stock movements and a disconnect between price and value. Surely that should make value stocks easier to find, not harder.

That last paragraph was my own response .

My own feeling is that MFI is the right idea, but it has a tendency to pick up junk. A lot of junk. I take Greenblatt's point that there's usually going to be something nasty-looking at the stock and there's a chance to earn asymetric returns. But it was ever thus on contrarian stocks - and we get back to the usual argument that just because something is cheap, doesn't mean it's cheaper than it should be.

It seems that the whole idea of broad diversification isn't working out too well on these stocks. It should be remembered that diversification diversifies away unsystematic risk, not systematic risk. Indeed, it appears that the MFI has been concentrating that systematic risk, because it a poster has noticed its propensity for homing in on Chinese RTOs, and the like.

I'm not sure that there's an easy solution. Stay away from any Chinese RTO would probably be a good start. Sector diversification is also likely to be beneficial, even if the company ranking doesn't look as good. I also think 30 shares is likely to be over-diversified. I'd just choose one share per sector; you don't need a whole bunch of them in the same sector.

Here is good old Blighty, I notice that there were a lot of companies floated around about the year 2006. I'm seeing suspensions, serious trading difficulties and fraud accusations galore in these kinds of stocks. In fact, now that I think at it, I'm seeing a heavy clustering of problems in stocks that have been listed for less than a decade. Simply by avoiding these unseasoned stocks, I think investors are saving themselves from a lot of headaches.

I've got a couple of other pointers that I think would be helpful.

Firstly - and this applies mainly to smaller cap companies - check the level of insider ownership, and the growth of the number of shares in issue. If insider ownership is low, and the number of shares outstanding keeps ratcheting up through continual fundraising (you don't need to worry about share splits, for example, there's nothing wrong with those), then be on high alert!

Secondly, compare net cash flows to net profits. The former should be consistently higher than the latter, because the latter will usually include non-cash charges like exceptionals and depreciation. Take a look at GNG (Geong International), for example, a company that is drawing debate on the boards over the legitimacy of its accounts. During that last 5 years, it's net profit has totalled £7.2m, yet it's net cash flow has only been £0.1m. The company is not generating nearly as much cash as its profit and loss account would seem to imply. Buyer beware!

I'm actually beginning to think it is highly instructive to study companies that go wrong. I've got at least one such company in mind. That's for another post.

Have a happy and prosperous new year, folks.