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.

Diary: Buffett, Greenblatt

Indecent Haste

Fascinating post on 09-Feb-2010 at Eurosharelab about Buffett's returns. I was vaguely aware of its existence before, and I was keen to get hold of the statistics, but could never seem to find them. Anyway, here they are:

Year             Value of $10,000 invested in             Value of $10,000 invested in   

                     Berkshire Hathaway stock                 the S&P 500 index

1971                       $10,000                                                 $10,000
1974                       $5,708                                                   $7,456
1975                       $5,422                                                   $10,229
1976                       $13,392                                                 $12,643
1991                       $1,361,805                                            $92,940
2008 (17 Nov)          $14,387,737                                          $259,068

Profit and Value Strategy

Sketch notes of article on 21-Jun-2011.

PAV (Profit and Value) Stategry differs from MFI (Magic Formula Investing) in its method of determining value and quality. PAV ises book-to-market for value, and GPM (gross profitability) for quality.

GPM = (revenues - costs of goods sold)/ total assets

PAV turns out to be a slight winner of MFI. Gross profits to assets is explored:

I think it’s interesting that gross profits-to-assets is as predictive as book-to-market. I can’t recall any other fundamental performance measure that is predictive at all, let alone as predictive as book-to-market (EBIT / (NPPE +net working capital) is not. Neither are gross margins, ROE, ROA, or five-year earnings gains).

GPM and PBV produce volatile results. Greenblatt:

it is partially the leverage embedded in low book-to-market that contributes to the outperformance over the long term.

(Side note:  this is very interesting! It could mean that a lot of the outperformance by Greenblatt is simply due to taking on more risk. This could be one of those "it works until it doesn't" strategies).

O'Shanaughnessy is cautious on low PBV:

it’s virtually impossible to buy the stocks that account for the performance advantage of small capitalization strategies.

 A market capitalization of $2 million – the cheapest and best-performed decile – is uninvestable. This leads O’Shaughnessy to make the point that “micro-cap stock returns are an illusion”

Blogger concludes:

I’ve now abandoned book-to-market

Excellent post by Greenbackd.

Diary

Joel Greenblatt lecture

Some notes taked from the scribd article published in Dec 2005.

Buy:

• good: high ROC: EBIT/( net working capital plus net fixed assets)
• cheap: high UEY = EBIT/EV 

EBIT is last 12-month's earnings beffore interest and taxes (maybe use operating profits).

More stocks worked out over one-year rolling periods, rather than two. 17-year annual return was 30.8%; using only the 1000 largest stocks, return was 22.9%.

Greenblatt's personal investment process

Look for value with a catalyst, so nice things happen sooner. Special situations is value investing with a catalyst. Try to figure out what "normalized earnings" will be in 3-4 years time. Ensure stock is cheap based on normalized earnings. 5-8 securities can make up 80% of portfolio. One position would be up to 30%. Concentration works well for "lazy" people. Always consider the downside. Usually spends one month or so to do research. For difficult situations, research could take months. If there is a great opportunity which wont last and they feel they understand it, they sometimes use "Ready, Fire, Aim!" [sic]. Has financials and utilities in the portfolio.

Considers EBITDA - MCX (maintenance capital expenditure) would be a better measure of earnings power, but can be difficult to calculate.

Dislikes shorting, saying that the long-short guys blow up every eight years. He calls it the "I got it! I got it! I ain't got it!" strategy.

Look for a big mess that seems too complicated, not well understood, not well followed, and requires too much work. Look for semi-complicated situations - the key is to identify what cuts to the core.

Prefer numbers over assessments of management. Bad signs are high salaries and insider selling.

Ignore the macro picture. Everything is cyclical. Values can always be found somewhere.

Ignore stock market prices and volatility - it's more important to be able to value companies.

There appears to be a movement towards high ROC comapnies. Low P/B have performed poorly over last decade. He doesn't know if/when the trend will reverse.

Greenblatt's secret to success is identifying situations (mainly corporate changes) which are not interest to the big players, but which offer a high upside potatnital.

Spinoffs

Greenblatt's favourite.

The intial price after the spinoff is usually unreasonably depressed, due to people jettisoning them. In corporate changes, determine where the interests of the insiders lie. A large stake in a spinoff implies high level of commitment. The credentials of the parent company are also important.

The spun-off company is generally some kind of drag on the parent company's valuation, and the spinoff usually even exciting, and may not even be that good.

Merged Securities

He warns against merger risk arbitrages (too many uncertainties, chance of being burned are high). Contrariwise, merged securities are more interesting. Often, the acquirer pays using bonds, preferred stock, warrants or rights. Insitutions typically shun these securities, and indivuals often quickly dispose of them. This drives down price.

Bankruptcies

The bonds, bank debt and trade claims of companies that are emerging from bankruptcies might offer opportunities. Care needs to be taken.

Restructurings

Invest after restructuring has been announced or when a company is ripe for restructuring. Analysts tend to drop coverage of these companies. Be sure you understand what's really going on, though.

Recapitalizations

Buybacks (aka recaps) [but he doesn't mention the scale of the buyback] create opportunities: it increases the leverage of the balance sheet, and the tax saving. "there is almost no other area of stock market where research and careful analysis can be rewarded as quickly and generously".

Diary: mfi, look, ardn, hvn

LOOK: Lookers - General Retailers - 54.1p/£208m

LOOK, the car retailers, has been getting a bit of interest from the value investing blogs. Valuhunteruk wrote about it yesterday, but I can't find offhand who else is interested in it. He cautioned about the lease situation, and I haven't factored that into my calcs. I calculate a ROC of 19.8% and a UEY of 19.4%, based on EBIT of 45m, TEV of 227.8m, EV of 232.4m (terms defined below). Pretty good - but remember my calcs are quick-and-dirty.


What the cat dragged in

Scanning down the list of heavy fallers on 03-Nov-2011, the following couple of companies caught my attention.

ARDN (Arden Partners) was down 17% on that day (ouch), but is interesting because it's now a net-net: market cap £8.9m against NCAV £11.5m. The Company's business consists of corporate finance, equity research, equity sales and market making activities. Arden Partners plc specializes in advising and provides corporate financing and corporate broking services medium and small sized companies across a range of industry sectors. The cause of the fall was a trading update: "the Company was meaningfully profitable after charging share based payments and restructuring costs although, it will be materially less than market guidance."

HVN (Harvey Nash Group) was down 11% on that day. No real news, except that it did speak out in an article in What Investment Trader: "The chief executive of Harvey Nash, the recruitment and outsourcing consultancy, has leapt to the defence of FTSE 100 directors as criticisms mount following a report that showed their earnings had increased 50 per cent in the last year." So there we go, apparently a 50% pay rise is quite reasonable. It caught my attention because it has an UEY = 17.0% (unleveraged earnings yield) and ROC = 57.5% (return on capital), which might be interesting to magic formula folk. I calculated EBIT = 7.3m, EV = 43m, TEV = 12.7m

Diary: HSV, MCO, Magic Formula

HSV: Homeserve - Support Services - 337.9p/£1.5bn
Business: provides 5 million customers with cover against home emergencies such as broken boilers and burst pipes. An independent investigation by Deloitte found that their sales processes were sub-standard (which seems to be code for "mis-selling"). HSV immediately suspended all telephone sales and marketing activity until around 500 staff had undergone "retraining". The FSA (Financial Services Authority) could fin the company if it has breached sales regulation. Link. One commentor said "Homeserve is a non-stop menace".

The share price is down a savage 30.4% today on the news. Ouchies. What is instructive, though, is to see some of the comments from the pundits on HSV. It is instructive in the sense that "nobody knows". Anyway, here's what's been said about it:

30-Sep-2011 The Times said that it was attractive on growth, the shares are pricey at 17X, but was justified; buy on weakness.

08-Sep-2011 The Independent says it is a "rare British business", and the growth profile deserves a premium rating. It says that the price looks stretched, and advised taking profits (at around 482.2p). In some sense it was kinda right, but it never emphasised that rippy-offy nature of the business.

29-Jul-2011 Brewin Dolphin upgraded from buy to add, raising the price target from 566p to 600p. The PER of 16.9X was reckoned to be too low for the business which has "proven resilience and growth potential".

14-Jun-2011 The Scotsman rated it a buy, despite noting that the shares looked a little expensive at 19X (share price was about 524.5p).

Everyone was talking about growth, but no-one was talking about the legitimacy of the business. The company does have enormous returns on capital, no debt problems, but the company still isn't cheap even after the share price drop. So it isn't a buy. What is interesting is the severity of the decline. The share price opened at 240p - a decline of a little over 50% on the previous close. It's interesting because it's perhaps one of the most brutal savagings on a share price in a long while, and it's no minnow stock. At £1.6bn, it's heading towards Footsie territory (the smallest Footsie company has a market cap of £2.1bn).

There's a moral here, but first Moodys ...

MCO (Moody's Corp) is an American company, and provides credit ratings and economic research; although I'm sure you all knew that. Buffett has also been long-associated with Moody's, who likes a coke and a credity rating. On 13-Nov-2006, Emil Lee at Motley Fool waxed lyrical on the company. He didn't actually say "buy", but instead offered the more sensible advice: "All it takes is a single opportunity to buy shares of Moody's at a discount to reap the benefits of a decade worth of superior returns."

... or does it?  The article came out at almost the exact top of for MCO. If you had bought at the beginning of 2006, your shares would have declined 42%, compared with an increase in the DJIA of 13%. To be fair, Emil didn't actually recommend a "buy"; but he did think it was a great company. That reputation was tarnished during the credit crunch. That is not to say that no investment in MCO was a bad idea. If you had bought at the beginning of 2009, you'd be up 61%, compared to the DJIA of up 34%. All of that outperformace was attributable to its performance since about 2011. It is a very volatile stock, BTW.

This just in ... I see in my broker recommendation roundup, times at 12:27, both Panmure Gordon and Peel Hunt have downgraded HSV to "sell".One has to ask, rhetorically of course, "what's the point?".

And I think the point is this ... no-one really knows the future, and they tend to look at the wrong thing, or ommit important details that are more obvious in hindsight. I suspect that credit rating agencies didn't suddenly become rogue in 2006. Frank Partnoy wrote the book F.I.A.S.CO. (the title alone says it all!) in 1997, criticising rating agencies heavily. No doubt Buffett was aware of some of the dubiousness of the credit ratings business, but it didn't stop him investing.

All this is leading me to think that maybe Joel Greenblatt has it right all the time: look for beaten down companies where all the hideous news is out, but have good returns on capital. Worth thinking about.

MFI shorting doesn't work

Just saw this note from jthe MFI Yahoo Group:

In the appendix of the last edition of the Little Book, Greenblatt briefly reported the results of backtesting a portfolio in which there were both long positions of stocks taken from the first 50 in the MFI list, and short positions of those stocks being at the very last positions of the same list.
According to him, the results were completely negative and this approach would have lost the entire invested capital.

PIC.L - Pace - crazy price

Perennial investor disappointer Pace saw its share price fall a further 1.48% today, although the Footsie itself was down a little over 2%. PIC qualifies as a "Magic Formula" company.



According to Google Finance:

Pace plc, formerly Pace Micro Technology plc, is a United Kingdom-based developer of digital television technologies for the pay television industry. The Company's principal activities are the development, design and distribution of digital receivers and receiver decoders for the reception of digital television and the reception/transmission of interactive services, telephony and high-speed data.

Analysts expect mid-double digit EPS growth over the next two years. In a report on 8 March for y/e 31 Dec, directors reported adjusted EPS up 24%, improved return on sales, revenues up by 17%, and the completion of three strategically import acquisitions. The board expects similar levels of revenue growth in 2011, and improved returns on sales. "Overall, the Board is confident that Pace has created an excellent platform for growth as its customers continue to lead the global evolution of managed digital services into and around the home."

Sounds pretty good, right? So why is PIC trading on a PER of only 6? Well, the company delivered two bombshells that caused the share price to plummet after it issued its report. The first thing the market didn't like was a one-off exceptional cost of £19m from "transaction related expenses, acquisition integration costs and restructuring to implement post-acquisition operating structure". Consensus seems to be that the board landed that one as a bit of a surprise. The second one, which isn't in the report, but was mentioned during the presentation, was that a customer decided to forgo plans to upgrade, in favour of switching to Pace's next-generation technology in 2012. It appears that this will not affect analyst forecasts.

PIC is a growth company, but it does operate in a competitive business. So, whilst growth is expected, there is clearly some risk with this company. At a PER of 6, it appears that the market is way over-pricing the risk involved. News flow through this and the last year has actually been quite positive, with new deals in India in the offing, which could be huge, new deals in Brazil, and a favourable court ruling on the tax status of its set-top boxes. All the favourable points have been completely overshadowed by the events I have mentioned above.

Potential investors will have to take a view on this one: weighing up the quite positive growth prospects against the risks. Maybe Pace will be out-competed, but that doesn't seem to be the main problem here. If you believe that the company has been unfairly hammered by negative sentiment, then now is a golden opportunity to load up. Not a company to bet the farm on, but the upside seems very favourable compared to the risks and the share price.

BLT.L - BHP BILLITON - a Magic Formula Company

Magic Formula Investing Filter explained

In his book, "The Little Book That Beats The market", Joel Greenblatt laid out an investment formula for selecting a portfolio of shares that should beat the market over the long term. His formula contains a few grey areas. Sharelock Holmes has a screen for Greenblatt; although it is unlikely to be an exact replication of the formula. It is proably "good enough", though. As part of my filter, I select companies with a market capitalisation of at least £300m. Investment Trusts are excluded, not least because the database doesn't hold their details. They are unlikely to be suitable candidates in any event. As at March 2011, this yields a universe approaching 400 companies, which is a goodly selection to choose from. I then focus on the top 40 stocks within that universe. The purpose of the MFI (Magic Formula Investing) filter is to find stocks that are "good and cheap". "Good" is measured by ROC (Return On Capital), calculated as EBIT (Earnings Before Interest and Taxes) to "tangible capital employed". "Cheap" is measured by EY (Earnings Yield), being EBIT/EV (Enterprise Value). Greenblatt uses a slightly modified version of EV. He also excludes financials from his screen, although I include them for simplicity's sake.

Elevator Pitch

BLT.L - BHP Billiton - Mining - 2587p/£56bn
BLT is a blue chip mining company with good prospects and a solid balance sheet. It qualifies as an MFI company, having high returns on captital available at an attractive price. It deserves a place in a diversified portfolio, despite some uncertainty about the direction of commodities.

Discussion

I could describe this company as a commodity play, but I wont. I have heard so many bullish and bearish arguments about commodities that it is impossible for me to decide who to believe. My feeling is this: mining is an important sector, so unless you have a strong bearish conviction about the sector, BLT deserves a place in a balanced diversified portfolio. If commodities tank, then BLT will likely tank, too. That's the risk you take. In a different post, I remained sanguine about the outlook.

There are other interesting miners/oil/gas companies in the MFI that are also likely to be worthy of attention, although I haven't looked at them myself: CNE, DGO, KENZ, RIO. I was mainly attracted to BLT when I was searching for MFI stocks around christmas time. I noticed a hefty director purchase of £1m, and share buybacks, so it was a stock that particularly piqued my interest. (Link)

The balance sheet of BLT is excellent from all angles. It is on a z-score of 3.5 - a very comfortable score. It has a gearing of 0%; and net cash of £125m, compared with net profit at the latest interim stage of £6.6m (for 6 months).

BLT has enjoyed consistently good ROEs throughout the last decade, and analysts predict robust growth in future earnings. It trades on a rolling PER of 11.4, and a PBV of 1.6. That is a shade higher than that recommended by Ben Graham for enterprising investors, but I am not going to quibble. Although it marginally fails to meet that test, it does pass his test that PE * PBV < 22.5. No doubt they'll be chuckles at the quaintness of my respect for Graham's work.

BLT is yielding 2.3%, which is a little under the median for the Footsie, which stands at 2.7%. I don't consider that a factor worth much attention though, unless you are an income investor.

For those that are keen on oil companies (it seems that the boys on Stockopedia talk about nothing else!), I notice that 14% of their FY09 revenues were in petroleum, with the underlying EBIT of 22%. It's interesting to see a disproportionate amount of their profits comes from a relatively small part of their turnover.


Good company. Good price.

Magic Formula Retailers

Oh dear, retailers haven't been fairing so well lately, have they? CPR.L (Carpetright) recently issued a profit warning, as reported on Stockopedia. DXNS.L (Dixons) recent trading statement also reported deteriorating conditions. The stock market pros have been shuffling their holdings in Dixons throughout last week. Nearly all of them are lightening up their holdings on Dixons, according to the RNS filings, with only Skagen reporting an increase in their stake. It should be noted that in this article I am only concentrating on "general" retailers, and specifically excluding food and drug retailers, for whom I have a much different perception.

Overdone share price drops, or more yet to come? More on that later, but first some statistics. Here are a complete list of retailers that pass on my Magic Formula screen, together with some stats:

EPIC   Z  CASH PROFIT YLD NAME

DEB  1.1  -517     97 3.1 DEBENHAMS

SMWH 5.2    56     69 4.8 WH SMITH

NXT  6.0  -530    400 3.9 NEXT

JD.  5.4    60     43 2.3 JD. SPORTS FASHION

DXNS 2.7  -220     60 0.0 DIXONS

HOME 3.5   364    209 7.2 HOME RETAIL

LEGEND:
EPIC - company code
Z - z-score - above 3 is acceptable, below 3 is much more marginal
CASH - net cash in £m. Negatives imply net debt
PROFIT - profit £m for latest financial year
YLD - dividend yield %
NAME - name of the company

Note that the cash and profit figures for JD., DXNS and HOME are the latest available year-end figures, which are over 6 months old. Be warned. Figures are taken from Sharelock Holmes. The first take-away from the table is that some companies are sitting on cash, and some are saddled with debt. Applying a strict z-score filter of at least 3 would lead us to rule out DEB and DXNS immediately. A measure of debt on a cash to profit basis doesn't make them look too bad for them at first flush, though. Still, if you're going to choose a magic formula stock, then why not favour the ones with a lot of money to spend?

So. Retailers. Are they a buy?

With the likes of Dixons trading on PERs of 7, and retailers having taken a beating, is it time to now back up the truck?

THE BULL CASE: In his article Dixons in the dock, Kevin Murphy, of Schroders, argued that there was a window of opportunity for value investors. He notes that at 12p, DXNS trades very near its 2008 all-time low. Its bonds yield 12%, compared to early 2009, when they yielded 20%. He further comments that at a yield of 12%, the bondholders obviously do not consider the company risk-free, but that there is reason to suppose that it is putting its house in order.

THE BEAR CASE: Simply put, things are getting visibly worse: VAT hikes, government cutbacks, rising input costs, employment insecurity and low wage inflation don't bode well. About the only good news is that the Bank of England are unlikely to put up interest rates any time soon - although one could posit a bear case even for the current state of interest rates. Now, you could argue that with so much bad news reflected in share prices, the companies are a steal. I would urge caution on that front, as I fear that potential investors may be walking into a classic value trap. IF profits take further significant beatings (and I have no sagely insight as to what will really happen, other than that things aren't looking too good at the moment), then
those low multiples will probably offer no downside protection to the investor. In the dire words of Peter Lynch: buying cyclicals on low PEs is a proven way to lose money. The lesson of HMV.L looms large in my mind. Now there's one sick puppy that kept sliding, sliding, sliding, and then sliding some more. Just make sure that if you buy, you're not buying into another HMV.

I actually hold JD.

I haven't really thought much about all the retailing stocks in the magic formula list, but I would rule out DEB and DXNS, given that there are better alternatives. When I went into DEB last, it seemed to have more shop staff than customers. The JD. shop I went in was small, and whilst not bustling with trade, at least the (paying!) customer to staff ratio was greater than 1. I'm not sure about HOME. My dad doesn't like them, I know that. I think NXT and SMWH might be reasonable buys, with a preference given to SMWH on account of its cash position. Besides, everyone still needs stationery, right?

So, why do I hold JD.? Well, it is a magic formula stock, and trades at a PER of 7.8. That doesn't stop it from being a value trap, of course. The yield isn't great, but I'm not going to overfuss on that. In January of this year, the company reported increased like-for-like sales during the christmas period, and maintained its gross profit margins. That's in stark constrast to some other retailers, who really felt some pain over christmas. It appears that the snow that affected the weak retailers somehow didn't present much of an obstacle for JD.. Peculiar that, isn't it? JD. did note, however, that it expects tough trading conditions this year. JD. will make a preliminary 2010  earnings statement on the 13 Apr, so I think we'll get to see if I was woefully wrong, or not. Some encouraging news is that JD. has a strong balance sheet, likes to operate in niche areas, and has been buying up some of the competition that has fallen by the wayside. Even if we see declining like-for-likes, we could well see increased revenues and profits. "Yes, but the like-for-likes are declining", I hear you object. My counter-argument would be yes, fair enough, the company is facing tough conditions, but it is buying up the weaklings on the cheap. If and when conditions do improve (and it's by no means certain that like-for-like will drop), I think JD. will have shown itself to have made some shrewd purchases. I am also encouraged to see that JD. has withdrawn from the bidding of JJB Sport. It gives me some confidence that the directors are being selective in their purchases, and are not just buying any thing at any price. Admittedly, there are risks of share price deterioration.


My Magic Formula Screen
In his book, "The Little Book That Beats The market", Joel Greenblatt laid out an investment formula for selecting a portfolio of shares that should beat the market over the long term. His formula contains a few grey areas. Sharelock Holmes has a screen for Greenblatt; although it is unlikely to be an exact replication of the formula. It is proably "good enough", though. As part of my filter, I select companies with a market capitalisation of at least £300m. Investment Trusts are excluded, not least because the database doesn't hold their details. They are unlikely to be suitable candidates in any evernt. As at March 2011, this yields a universe approaching 400 companies, which is a goodly selection to choose from. I then focus on the top 40 stocks within that universe.

DPLM.L - Diploma - Qualifies as a Magic Formula company

£DPLM (website) operates in the following areas:

• life sciences - supplying a range of consumables, instrumentation and related services to the health care and environmental industries
• seals - supplying hydraulic seals, gaskets, cylinders, components and kits used in heavy machinery
• controls - supplying specialised wiring, connectors, fasteners and control devices

 At a price of 328p (£372m market cap), it trades at a PER of 15.2, a yield of 3.0%, and a PBV of 2.7. It has a very solid balance sheet, with a z-score of 6.4, non-current liabilities at only half last year's net profit, and a gearing of -22% (negative gearing). Analysts estimate an EPS growth of 24% for 2011, and further growth of 10% for 2012. Median ROE for the last decade was 15%, which co-incides with the current ROE for the latest reported full figures. All good signs, in my opinion.

In a recent trading statement, the directors noted a strong increase in revenues and profitability in the first quarter of trading, which has continued into a second quarter, and expect that the adjusted profit before tax for the year ending September 2011 will be materially ahead of the market consensus of £36m.

Directors have been making purchases to the tune of £69k in March, and £90k in February.

£DPLM is also appearing high on my Magic Formula screen. I use Sharelock Holmes to produce a "Greenblatt Ranking" (which is Sharelock's calculation of the Magic Formula score) for companies with a market cap of over £300m. Investment Trusts are excluded. This returns a list just short of 400 companies. A company in the top 40 is worthy of further investigation, in my opinion. £DPLM meets such a test, possessing a high return on capital, and an "earnings yield" (actually more like EBIT/EV) of 10%. It is difficult to know, for sure, how closely the Sharelock Holmes results would match the actual rankings if they were produced by Greenblatt, but judging by the glossary on the Sharelock websites, it would seem that the results are likely to be "close enough". £DPLM thus qualifies as a "cheap and good" company.

For those that like a little bit of momentum behind the share price, £DPLM has a relative 6-month strength of 7% (i.e. it outperformed the market by 7% over 6 months), and a relative strength of 56% over a 12-month period.

On the downside, Interactive Investor blogger Richard Beddard recently estimated a fair value for £DPLM of 200p using a residual income model with 5-year projections. The web page contains a detailed explanation of the methodology used, and was praised by Steven Baines, a professional investment analyst. Richard produced a revised valuation of 480p yesterday (no, it wasn't an April Fool's joke), but the model was based on 10-year projections instead of 5. The RIM he used calculates quite conservative carrying values, so extending the forecasting horizon has the effect of upping the intrinsic value.

Conclusion: £DPLM is a magic formula company with a solid balance sheet, good returns on capital, and is available at a reasonable price. You even get a divvie out of it. The outlook for the company is good, and recent director purchases bolster this bullishness.

Disclosure: I own shares in £DPLM (I never take short positions).

Magic Formula Investing - some notes

In his book, "The Little Book That Beats The market", Joel Greenblatt laid out an investment formula for selecting a portfolio of shares that should beat the market over the long term. In this post, I assume some familiarity with his book and formula. His formula contains a few grey areas. Sharelock Holmes has a screen for Greenblatt; although it is unlikely to be an exact replication of the formula.

Greenblatt does, apparently, use the formula for selecting stocks for his hedge fund, Gotham Capital. Greenblatt likes to run a concentrated portfolio, but he advises readers to diversify into about 30 stocks. Having seen some of the companies produced by Sharelock Holmes, I readily concur. Specifically, HLO (Healthcare Locums) and RCG (RCG Holdings) spring to mind, and if memory serves, HMV (HMV) were given high rankings by the filter. All three have had their problems: HLO was suspended for accounting irregularities, RCG has been highly dilutive of shareholder equity and has engaged in a "rash" of  "confusing" acquisitions, to put it politely. It will likely delist in April. HMV is highly indebted, and may soon breach its banking covenants. Greenblatt's formula tries to find cheap and good companies. The three companies that I mentioned are certainly cheap, but are far from likely to be considered "good". In my opinion, there is a high probability of permanent impairment of capital with these companies.

Presented below is a list of resources that I have assembled on MFI (Magic Formula Investing), that readers may find interesting; albeit that they are focussed on US stocks. This site is the official site by Joel Greenblatt, although it is not particularly useful as a resource. None of the sites listed below are officially affiliated with Greenblatt.

• Magic Formula Pro - a blog by an unknown author. The blog also tracks Ackman, Berkowitz, Buffett, Einhorn, Li, Klarman and Schloss. This page spells out the author's own calculation of earnings yield.
• MFI Diary - commentary and tracking of a portfolio of stocks using the MFI approach by Marsh Gerda
• Yahoo Group - this group discusses the MFI approach, and is open to public participation. The main page provides links to other blogs, and an Excel add-in.

On this page, Marsh spells out his calculation of earnings yield and return on capital. I cannot vouch as to just how accurately it reflects Greenblatt's own computations, but it certainly helps clear up some of the grey pronouncements in Greenblatt's book:

• Working Cash = Max(0,[(AP + Current Liabilities Other) - (AR + Inventories + Other Current Assets)] 
• Excess Cash = Cash & ST Investments - Working Cash

AP is Accounts Payable, and AR is Accounts Receivable.

Update 29-Mar-2011: Magic Diligence is also a good site that I had located before, but it dropped through my net. In this post, the author reports a very interesting point from his analysis of Warren Buffet's 2011 letter:

Farther in the letter, I thought it was interesting that Buffett actually comments on the earnings on un-leveraged net tangible assets that some of his businesses have. This is almost exactly what Joel Greenblatt's Magic Formula Investing strategy measures for its return on capital number. Buffett even gives ranges: "terrific" 25-100%, "good" 12-20%. This jives very well with what I've seen in MFI. Very few companies with sub-30% return on tangible capital ever get screened, unless they are absurdly cheap.

The author has an other very interesting recent posts:

• Be wary of Magic Formula stocks that grow through acquisitions, and suggests a way to counteract that is to restrict your search to companies where goodwill and intangibles represent less than 10% of total assets.
• Should price momentum be important to value investors?