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?