A Magic Formula for a New Year

As we stare down the end of 2020 and welcome 2021, you may be looking for some magic formula to use in your investing. If you are, you are in luck, at least in name only and possibly more. This is a simple fundamental formula for investing developed by Joel Greenblatt in his 2006 book, “The Little Book That Beats the Market.”

The historical returns for this approach have proven fruitful, but like all systems, a lot comes down to application. Having learned this approach several years ago, this system incorporates two important facets of fundamental stock evaluation: valuation and profitability. If you are someone that incorporates equity investments in your portfolio, these are two evergreen points of analysis.

Magic Formula Metrics

Many fundamental systems incorporate a litany of criteria that is quite limiting, but not the Magic Formula. The great thing about simple, is that it provides a lot of latitude for top-down oriented analysis. This may not have been the intent, but it is an outcome. Let’s take a look at the two fundamental criteria:

1. Earnings Yield
2. Return on Capital

Earnings Yield

If you’re familiar with earnings yield, you’ll need to relearn what it is for this formula. Rather than taking the inverse of P/E, this calculation replaces EPS with EBIT and market capitalization with enterprise value (EV).

This is a rather clever approach in that it takes away some of the effects of capital structure for a business and the takeover value of the company. I’ve been a fan of EV/EBITDA as a valuation measure for a long time, and so learning about this approach to earnings yield made a lot of sense to me.

By taking the inverse of a valuation metric like EV/EBIT, you now gain perspective of the return on the business while maintaining a valuation perspective. Also, there isn’t a minimum value for this metric, it’s all relative. That makes it great for letting the cream rise to the top.

Return on Capital (ROC)

What defines a profitable business? Cash flow has to top that list, but what about the return to debt and equity holders? This is where ROC is so significant. Every company has capital that is invested, and the return that management is generating on that capital provides a strong basis of comparison. If you consider cost of the capital invested (interest, etc.), a company needs to generate a return in excess of the weighted average cost of capital (WACC).

Adding ROC to the mix opens up an understanding of the effectiveness of management of generating a return on the capital that they have been entrusted with. In the case of ROC and the Magic Formula, there isn’t a minimum value, it’s again used to rank companies.

The Magic Formula

Here is a list of the criteria in the Magic Formula:

1. Include stocks with $100 million market cap or higher
2. Exclude stocks in the Financials and Utilities sectors, foreign companies and ADRs
3. Calculate ROC & Earnings Yield
4. Rank each company by ROC
5. Rank each company by Earnings Yield
6. Add the two ranks together and order smallest to largest
7. Buy 2-3 stocks from the top 30 each month
8. Hold each position for one year

As you begin to execute this process, you can start with some beginning values for earnings yield and ROC. Using a baseline of 5% earnings yield and a 15% ROC is a good starting point to reduce the pool to a more manageable number.

Building the Portfolio

As you consider which 2-3 stocks that you are going to buy each month, this can be left open to what industries you think will perform the best. This may be freeing for some investors and deal-breaker for others who don’t trust themselves.

Exit Criteria

The final criteria incorporate timing of the exit to maximize after-tax gains. Selling losers just before the one-year mark and selling winners just after the one-year threshold can help with reducing capital gains taxes. Selling losers before a year is a tax-loss harvesting technique.

Magic Formula List

The following is are the top 10 stocks that meet the above criteria, but with a twist. The twist is that I have incorporated companies with lower debt, high interest coverage and reasonable cash-to-debt levels.

The next consideration for this list is the liquidity of the stocks and diversifying across different industries. For example, three of the 10 would be biotechnology companies if there weren’t any considerations for diversification.

1. VirnetX Holding Corp (NYSE: VHC)
2. Mesabi Trust (NYSE: MSB)
3. Catalyst Pharmaceuticals Inc (NASDAQ: CPRX)
4. Co-Diagnostics Inc (NASDAQ: CODX)
5. Medifast Inc (NYSE: MED)
6. PetMed Express Inc (NASDAQ: PETS)
7. Texas Pacific Land Trust (NYSE: TPL)
8. National Beverage Corp (NASDAQ: FIZZ)
9. FutureFuel Corp (NYSE: FF)
10. Turtle Beach Corp (NASDAQ: HEAR)

Conclusion

For those that are beginning to consider fundamentals for their equity investments, the Magic Formula may be a good starting point. The fact it incorporates both valuation and profitability is a great mixture. You may decide to modify it as I did in the above example or take it straight. Either way, there is a procedure or formula that may help guide you on your journey.

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