RG crunched some performance numbers on the stocks I obtained from Magic Formula Investing website, which I listed in my January 24, 2006 post.  He then posted his work in the following comment on my post, “Exploring Greenblatt’s Magic Formula“:

I just ran a quick test of the stocks listed in the Jan 24 column. The Magic Formula is down 5.55% from 01/24/06 to 07/24/06. The Russell 2000 is down 6.41% and the S&P500 is down 0.47% during the same time period.

Ticker 1/24/2006 7/24/2006
AEOS 25.39 33.34 31.31%
ANIK 10.5 9.86 -6.10%
HRB 24.9 23 -7.63%
CALL 4.79 3.53 -26.30%
CATT 14.55 9.98 -31.41%
CLCT 15.07 12.38 -17.85%
DLX 28.4 13.57 -52.22%
FORD 10.55 6.05 -42.65%
FTD 10.02 14.86 48.30%
GBEL 11.95 8.6 -28.03%
INSP 23.7 22.02 -7.09%
ISSC 14.01 16 14.20%
IVII 10.99 8.86 -19.38%
JAKK 22.57 17.04 -24.50%
KSWS 31.32 23.55 -24.81%
KG 17.99 17.09 -5.00%
KFY 19.34 18.38 -4.96%
KOSP 45.17 39.27 -13.06%
MGLN 33.85 44.15 30.43%
MTEX 13.84 13.39 -3.25%
MVL 16.5 18.03 9.27%
NOOF 6.49 6.76 4.16%
UNTD 14.48 10.77 -25.62%
EGY 5.77 8.61 49.22%
VTRU 38.22 43.65 14.21%

Average 18.8144 17.7096 -5.55%

S&P 500 1267 1261
-0.47%

Rus 2000 718 672
-6.41%

There is no clear conclusion that can be made from this short performance period, but I thought you would find these numbers to be interesting. I must admit that I have not yet used the Magic Formula to make any investment decisions. 

I have started to become a bit more sceptical of using this formula to automatically build an investment portfolio.  However, I still see it as a decent screening tool to identify potential opportunities.

Phil Town recently commented on The Little Book That Beats the Market and his comments sparked an idea in my head. What if you could combine the MFI list with Phil’s Big Five Numbers from the Rule #1 Book that he uses to test whether companies have wide moats? Well, I decided to do just that.

Using Portfolio123, I screened for companies that for the past five years scored better than 10 percent for each of the Big 5 Numbers. Ideally, I would use 10 year averages, but most screening tools only have 5 years of data. Therefore, I used the following rules:

1. ROI%5YAvg > 10
2. BV5YCGr% > 10
3. EPS5YCGr% > 10
4. Sales5YCGr% > 10
5. (((FCFPSA-FCFPSPY)/ FCFPSPY)+((FCFPSPY-FCFPSPY2)/FCFPSPY2)+((FCFPSPY2-FCFPSPY3)/FCFPSPY3)+((FCFPSPY3-FCFPSPY4)/FCFPSPY4))/4 > 0.1

These five rules produced a list of 165 stocks that I downloaded as an Excel file. I then got the top 100 stocks with a minimum market capitalization of $50 million from Magic Formula Investing. Using Excel, I combined the two lists and using the PivotTable function and then I filtered out a list of stock symbols that appeared two times.

The result was a short list of nine stocks on May 30, 2006. Those stocks are:

• American Eagle Outfitters Inc. (AEOS)
• bebe stores Inc (BEBE)
• Deckers Outdoor Corp (DECK)
• Harvest Natural Resources Inc. (HNR)
• Block (H&R) Inc. (HRB)
• K-Swiss Inc (KSWS)
• Nucor Corp (NUE)
• Patterson-UTI Energy Inc (PTEN)
• USANA Health Sciences Inc (USNA)

I’ll be focusing my research efforts over the next few weeks on this list. With the market providing us with a potential Summer Sale, I might even find some long-term buying opportunities. Please share your thoughts below on this technique and the list of resulting stocks.

From what I have gathered through The Little Book That Beats the Market, stocks from the utility and financial sectors are eliminated.  This is primarily due to the unique capital structure of these industries.  In addition, ADRs (foreign stocks) are also filtered out.  My guess is that these stocks are filtered out because of accounting inconsistencies and the unreliability of data regarding foreign stocks in many databases.

I have also set up the screener to eliminate stocks that have less than a $50 million market capitalization.  I’ve done this to come close to the 3,500 highest market capitalization stocks that Joel Greenblatt used when he backtested the Magic Formula. This last step is not a requirement, and in fact, the Magic Formula Investing site let’s you specify the minimum market capitalization of your choice.

I entered the following criteria into the Portfolio123 screener:

1. Universe($ADR) != 1
2. Sector != Utilit & Sector != Financ
3. MktCap > 50

The final screening criteria concerning Rank just returns the stocks with a rank higher than the one I specify.  I adjusted the Rank up and down to get a list of about 100 stocks, so I could compare these 100 stocks with those produced at Magic Formula Investing website.

I ran the screen and I got a list of just over a hundred stocks.  I then visited the official Magic Formula Investing site, and I brought up the 100 stock list of companies over $50 million in market capitalization.  I discovered that 39 out of 100 stocks on the Portfolio123 screen were on the Magic Formula Investing list.  That is not a very good correlation.  I was hoping to get at least a seventy percent overlap between the two lists.  After the initial disappointment, I decided to try a few simple things.

First, I decided to remove the excess cash calculation out of the equations, since I was most uncertain about this calculation.  I replaced my excess cash estimate (cash minus 5 percent of sales) with total cash.  The results were not much better.  I got 40 out of 100 stocks to match the Magic Formula list.

I also decided to try removing the cash calculation all together from the formula.  This results in an equation that assumes that no company has excess cash.  That resulted in only 32 of 100 stocks overlapping with the official Magic Formula Investing results.

Finally, I tried to use Joel Greenblatt’s alternative formula for people who don’t have access to a screening tool that has the data required for the Magic Formula.  The alternative formula simply looks at earnings divided by price per share for earnings yield and return on assets (ROA) for the ROC quality component.  That formula was real easy to set up in Portfolio123.  However, this time I only got 18 out 100 stocks to match up with the official Magic Formula results.

I’m puzzled by my results.  Am I missing something?  I wish I had access to Joel Greenblatt to find out exactly where I am straying from his formula. I’m having a hard time believing that it could just be a difference between the two underlying fundamental datasets being used.  The differences are just too great.

I’m not giving up quite yet.  I’ll be trying a few more things out and sharing them here with you over the next couple of days.  I’ll be looking closely at some of the top ranked stocks on the Portfolio123 screen but not on in the Magic Formula list.  I also plan on backtesting my original Portfolio123 version of the Magic Formula and comparing the results with the backtest numbers published in The Little Book That Beats the Market.

Let me start with return on capital first.  The Joel Greenblatt’s Magic Formula makes several adjust when determining return on capital (ROC).  The basic formula is:

ROC = EBIT / (Net Working Capital + Net Fixed assets)

where EBIT is earnings before interest and taxes.  Going through the Factors and Functions reference for Portfolio123 it is pretty easy to spot that EBITTTM is the variable we should use for EBIT.  By the way, The Little Book that Beats the Market indicates that trailing twelve month numbers from the income statement are used or the latest quarterly numbers for balance sheet figures.

Net Working Capital is a bit more complicated and less direct.  From the Magic Formula Investing website, net working capital is “generally, current assets less excess cash less non-interest bearing payables.”  Current assets are represented by the variable CurAstQ in Portfolio123. 

Excess cash is a bit of a mystery, since Joel Greenblatt has not answered any questions regarding how this is calculated.  My guess is that excess cash is determined by taking cash and subtracting it from some average ratio of cash over some income sheet metric by industry.  After some google searching, it appears that cash to sales ratio seems to be the most common measurement of “needed” cash.  The ratio seems to vary from 3 percent to 10 percent of sales depending on what industry is involved.  An average of about 5 percent of sales seems to be commonly used over all industries.  My guess is that Greenblatt uses a better measure of excess cash, but for now total cash minus 5 percent of sales appears to be the best metric to use to estimate excess cash.  Only cash per share (CashPSQ) is available in Portfolio123 so I multiple CashPSQ time the number of shares (ShsOutMR) to get total cash (including short term investments that are included in CashPSQ).  I subtract this from sales times 5 percent (SalesTTM * 0.05).  Noting that sometimes a company doesn’t have excess cash, I make sure that the lowest amount that excess cash can be is zero by using a maximize function.  The final equation for excess cash is:

Excess Cash = Max(CashPSQ * ShsOutMR – SalesTTM * 0.05, 0)

The last part of net working capital is non-interest bearing payables.  Portfolio123 does not have a variable for non-interest bearing payables (i.e., accounts payable), but this can be estimated by deduction.  If you take current liabilities and subtract out interest bearing payables (i.e., short-term debt) then the result is or is very close to non-interest bearing payables.  Since Portfolio123 does not have a variable for short-term debt, I had to take total debt (DbtTotQ) and subtract long term debt (DbtLTQ) to get at short term debt.  The final equation for non-interest bearing payables is:

Non-interest bearing payables = CurLiabQ-(DbtTotQ-DbtLTQ)

The final equation for net working capital is:

Net Working Capital = Max(CurAstQ-Max(CashPSQ * ShsOutMR – SalesTTM * 0.05, 0)-CurLiabQ-(DbtTotQ-DbtLTQ),0)

Note that I added another maximization function to this equation and a comma zero at the end.  This is to ensure that net working capital is never below zero, since Joel Greenblatt has hinted that uses zero when net working capital is negative.

The final factor is Net Fixed Assets. Net fixed assets is basically property, plant and equipment after depreciation.  Portfolio123 does not have a property, plant and equipment variable, so I had to estimate one.  I took total assets (AstTotQ) and subtracted current assets (CurAstQ) to get at long term assets where property, plant and equipment resides.  I then remove intangibles and goodwill, as mentioned in the book, by subtracting tangible book value (TanBV$Q) from book value (BV$Q).  The final equation is:

Net Fixed Assets = AstTotQ-CurAstQ-(BV$Q-TanBV$Q)

Taking this all together, I built the following equation to estimate ROC in a very similar manner as Joel Greenblatt.

ROC = EBITTTM/(Max(CurAstQ-Max(CashPSQ * ShsOutMR – SalesTTM * 0.05, 0)-CurLiabQ-(DbtTotQ-DbtLTQ),0)+(AstTotQ-CurAstQ-(BV$Q-TanBV$Q)))

The next factor used in the Magic Formula ranking is Earnings Yield (EY).The equation for earnings yield is:

EY = EBIT/Enterprise Value

I’ve already discussed EBIT, so I will focus on enterprise value.  According to the Magic Formula Investing website, enterprise value takes market capitalization (MktCap), debt, and “subtracts excess cash and includes any preferred stock”.  The new factor here is the preferred stock.  I used total equity (EqTotQ) minus book value (BV$Q) to determine preferred stock.  My final equation for earnings yield is:

EY = EBITTTM/(MktCap + (EqTotQ – BV$Q) + DbtTotQ – Max(CashPSQ * ShsOutMR – SalesTTM * 0.05, 0))

So now you have the two major ranking factors.  I equally weigh the two ranking factors as described in Greenblatt’s book.  In addition to the ranking factors, the Magic Formula also screens out some stocks.  I’ll go over the screen in my next post.  For now, I would love feedback on the ranking system I’ve created that tries to closely match the Magic Formula.  Can it be improved under the Portfolio123 system?  Am I missing anything or have gotten something wrong?  Does anyone know Greenblatt’s secret excess cash formula?

I am convinced of at least two things:

1. If you really want to “beat the market,” most professionals and academics can’t help you, and
2. That leaves only one real alternative: You must do it yourself.

- Joel Greenblatt
The Little Book That Beats the Market

I completely agree with Joel Greenblatt on this point.  I was just rereading his book and I thought I would share with you this little gem.

Location: Barnes & Noble  555 Fifth Avenue (46th & Fifth), New York, NY. All are welcome.

I will not be able to attend this event, but I thought some of you might be interested in it. If you make it to Mr. Greenblatt’s talk, please take notes and share them with us here.

I took a look at the big five numbers, and they were not impressive for FTD Group.  These factors include ROIC, book value growth, earnings per share growth, sales growth, and free cash flow growth over the past five years. FTD Group’s financials on ADVFN kind of look wilted. ROIC is currently negative and it was also negative last year.  Book value per share, however, has been increasing at a good pace over the past year. Until recently, earnings per share had been negative and revenue growth has been rather flat.

As you can probably already tell, I don’t see a wide moat around FTD Group.  They do have a brand name, but I’m not so sure how loyal customers are to their brand. There are several national florist brand names that compete with them, including 1-800-Flowers (FLWS), ProFlowers of Provide Commerce (PRVD), and many others. 

I would be very hesitant to automatically buy FTD Group if I followed the recommended mechanical investing method described in Joel Greenblatt’s The Little Book That Beats the Market.  It’s likely that I’ll be wrong about FTD Group, but it will be interesting to see what happens to FTD over the coming year.

Let’s take a look at the big five numbers.  These factors include ROIC, book value growth, earnings per share growth, sales growth, and free cash flow growth over the past five years. I checked Forward Industries’ financials on ADVFN. ROIC last year was 41.3 percent and it was 27.5 percent on average over the past five years.  Book value per share has grown by an amazing 56% per year from $0.49 in 2001 to $2.92 per share in 2005.  Earning per share however has been a different story.  Earning per share had gone from $-0.33 in 2001 to $1.37 in 2005.  This last quarter however earnings growth has become negative.  Revenue growth has been an average of 28.7 percent over the past five years, but has declined in the recent quarter.  Finally, free cash flow has gone from -$0.7 million in 2001 to $7.0 million in 2005.  All five number seem to indicate a wide moat, but in the last quarter these numbers have weakened.

One thing to note is that OEM customers account for 97 percent of Forward Industries’ sales. I don’t think that OEM customers are likely to be brand loyal.  Forward Industries has approximately 200 active customers.  Five of their customers accounted for approximately 88% of their total net sales in Fiscal 2005. These major customers include Motorola (MOT) and Nokia (NOK) for cell phone products and Abbott Laboratories (ABT), Bayer Healthcare (BAY), and Lifescan for carrying cases for diabetic monitoring kits.

So what is Forward Industries competitive advantage?  I believe that it is associated with the fact that they do not manufacture any of the products that they sell and distribute. Forward Industries’ subsidiary Koszegi Asia’s ability to source quality cases in China on short lead times is probably what has made them so profitable in the past.  

The carry case industry however is very competitive.  Forward Industries estimates that they compete with approximately 1,500 producers and distributors throughout the world.  Forward Industries believes that they can sustain their competitive position through maintenance of an extensive product design capability, rapid response time to customer requests for proposals and product shipment, competitive pricing, reliable product delivery, and product quality. They believe that their ability to compete based on product quality assurance considerations is enhanced by the local presence of their Hong Kong and outsourced Chinese quality control and shipment facilities.  My question is are any of their competitors currently also using Chinese production with a local presence? I would also like to know how costly it would be to create a similar local presence quality control system in China for the carry case industry.

If the answer to these two questions indicates that Forward Industries doesn’t face a direct threat to their current competitive edge, I would label this company a wide moat company. A recent comment by Forward Chief Executive Officer Jerome E. Ball indicated sales and profit were adversely affected by unit pricing pressure in the past quarter.  That doesn’t sound positive, but it is also only one quarter.

Given that Forward Industries only has a market cap of $66 million, I would probably cut them some slack in determining whether the have a wide moat.  I would be very interested in hearing your comments on this company.  As you can tell, I’m kind of sitting on the fence on this one.

CallWave is in a phase of rapid change where they are moving from direct channel to indirect channel customers. Their new business focuses in on convergence of fixed, mobile phone and the Internet VoIP. CallWave is offering some mobile services for free to help study consumer adoption patterns.  It might be worth trying this service out if you are interested in this company.

Let’s take a look at the big five numbers.  These factors include ROIC, book value growth, earnings per share growth, sales growth, and free cash flow growth over the past five years. I checked CallWave’s financials at ADVFN. ROIC in the previous quarter was 14 percent and in the previous year it was 18 percent.  However, over the past five years CALL did not produce a ROIC.  Book value has also only become positive recently.  Earnings per share has decreased dramatically recently. Revenue has been at a 37 percent growth rate.  However, revenue has been declining recently.  Free cash flow has decreased from 2004 to 2005 and is likely to continue to decline given the companies investment activities.  These numbers do not really indicate that CallWave has a wide moat at this time.

CallWave competes with traditional telecom suppliers that have longer development lead times.  CallWave believes they provide a hosted solution in the convergence application market that can evolve quickly by capturing market intelligence in real time.  CallWave’s service and applications allow end users to obtain a call on any device.  CallWave’s service allows one phone number to be sent to fixed land lines at high quality, wireless services, and carrier branded computer VoIP software. When a customer signs up for CallWave’s convergence services with their telecom company, CallWave will start to bill the telecom for the service monthly at a wholesale rate.

CallWave has been selected by several carriers to provide convergence telecommunication services recently.  This could be a toll booth with potential switching costs, but the depth of the moat and its sustainability is not clear to me at this time.  They are at the early stages of potentially developing a moat.  Their partners right now include Earthlink and Hawaiian Telecom.  They are targeting regional access carriers like Hawaiian Telecom for future growth.  This could be a limited market.

CallWave is now focusing on developing and providing software and services. They won’t be replacing churn in their direct customer base. The hope to encouraging regular active use of their services. 

On yesterday’s conference call, CallWave indicated that they do not expected to be profitable over the next four quarters.  In fact, they estimate that they could loose $10 million in that time period.  They are in an investment mode to develop their new indirect channel business.

CallWave does not look like a Fat Pitch investment at this time.  The company does not have a wide moat at this time.  However, they have the potential to develop a moat in the future.  Their major challenge is competing with the R&D departments of major telecommunication companies and the potential that their regional telecom customer base could decrease even further if there are more telecom mergers.  I’ll be passing on this stock for now.

H&R Block is a diversified company with subsidiaries delivering tax, investment, mortgage and business services and products.  The company’s key products include:

• Tax preparation in the United States, Canada, Australia, and the United Kingdom with the Peace of Mind guarantee
• Refund anticipation loans
• Refund Anticipation Checks
• Easy Pay Loans
• Express IRAs
• Tax Return Preparation Courses
• TaxCut tax preparation software
• H&R Block DeductionPro
• Kiplinger’s Home and Business Attorney
• Kiplinger’s WILLPower
• Online tax preparation
• Franchises
• Mortgage services
• RSM McGladrey business accounting and tax services for the middle-market
• Financial planning
• College savings products
• Brokerage accounts
• Insurance annuity products

H&R Block is basically the McDonald’s of financial services. Just taking a quick glance at their offerings and associated branding, it appears that H&R Block has a moat.  Warren Buffett has even owned this stock.

Let’s take a quick look at the 5 primary factors that I use to help indicate whether a company has a wide moat.  These factors include ROIC, book value growth, earnings per share growth, sales growth, and free cash flow growth over the past five years.

According to ADVFN, H&R Block currently has a ROIC of 21.9 and a five year average of 21.7.  Looks good to me.

Book value per share has gone from from $3.20 in 2001 to $5.97 in 2005 according to the numbers on ADVFN. That’s an average growth rate of 16.9 percent over the past five years.

Over the same time period, EPS has gone from $0.76 to $1.92.  That is about a 26 percent average annual growth rate over the past 5 years.  EPS was down slightly over this past year however.

Revenues have grown at 10.5 percent over the past five years.  For the current trailing twelve months versus the previous 12 month period, revenues have grown by 26 percent.

Free cash flow has bounced around quite a bit over the past five years.  Overall, it was about a 13 percent growth rate per year in free cash flow.  However, give how free cash flow has bounced around dramatically, I wouldn’t put too much faith in this number.

There is substantial competition in each of H&R Block’s businesses.  However, H&R Block has a significant brand name and it’s massive seasonal retail network dramatically widens its moat. 

This moat has been under siege by tax preparation software products and online tax filing.  H&R Block has addressed these issues by creating their own software product and online tax services.  The main weakness that H&R Block has is that it has become reliant on taking advantage of unsavvy financial service consumers with their high cost tax refund advances and other financial products.  Their mortgage business also exposes them to the potential risk of a housing crash. 

Even given a few of these weaknesses, I believe that H&R Block still has a sustainable competitive advantage.  This Magic Formula stock looks like it might be the real deal with a wide moat and worth further investigation.

I discovered that Anika Therapeutics develops, manufactures and commercializes therapeutic products and devices to promote the protection and healing of bone, cartilage and soft tissue. Their products are based on hyaluronic acid (HA), a naturally occurring, biocompatible polymer found throughout the body.  A useful FAQ on Anika Therapeutics‘ website indicates that it currently has 61 employees and was founded in 1983.

I quickly reviewed the 5 primary factors that I use to help indicate whether a company has a wide moat.  These factors include ROIC, equity growth, earnings per share growth, sales growth, and free cash flow growth over the past five years.

According to the ADVFN‘s financials for Anika Therapeutics, current ROIC is 36.9 percent.  However, average ROIC over the past five years is only 2.1 percent.

Looking at the equity numbers for ANIK, at the end of 2000 total equity was $26.7 million.  By the end of 2005, that number has grown to $30.4 million.  I estimate growth in equity has averaged about 3 percent over the past five years.  Both ROIC and equity growth are both below 10 percent over the past five years.

Earnings, sales and free cash flow recently spiked.  However, over the past five years these factors have not grown by an average of 10 percent.

Strickly looking at the numbers over the past five years, it does not look like Anika Therapeutics has a sustainable competitive advantage.  However, it is also important to look ahead.

The FDA approval of Anika Therapeutics cosmetic tissue augmentation product has had a major impact on its current financials.  Anika appears to have unique capabilities in researching and developing hyaluronic acid based products.  According to their 10-K, their patents expire between 2009 and 2022.  I’m not clear on exactly what these patents are and it appear that some of their technology is licensed from Tufts.  The 10-K also notes:

We are aware of several companies that are developing and/or marketing products utilizing HA for a variety of human applications. In some cases, competitors have already obtained product approvals, submitted applications for approval or have commenced human clinical studies, either in the U.S. or in certain foreign countries. There exists major competing products for the use of HA in ophthalmic surgery. In addition, certain HA products for the treatment of osteoarthritis in the knee have received FDA approval and have been marketed in the U.S. since 1997, as well as select markets in Canada, Europe and other countries. In December 2003, the FDA approved an HA product for the treatment of facial wrinkles which has been marketed internationally since 1996.

That doesn’t sound like a wide moat to me.  I think I will be passing on this stock for now.  In time, it could become clearer whether or not Anika Therapeutics has a wide moat. Continued development of their products could result in some positive developments in the future and may expand their moat.  For now, the best that could be said is that Anika Therapeutics could be developing and emerging moat.

After reviewing the notes, I don’t think I see any direct responses to the questions we submitted to Shai:

1. What do you think of going private transactions in this post Sarbanes Oxley Act environment that didn’t exist when you wrote “You Can Be A Stock Market Genius”?  Do you think it is profitable for small investors to participate in these risk arbitrage opportunities associated with the reverse split/fractional shareholder cash outs used for some going private transactions?  How should investors be evaluating which of these opportunities are good and which ones are bad?
2. The Magic Formula produces an interesting list of companies.  Some of the profitable companies on this list however don’t appear to have sustainable competitive advantages and their high profits may be temporary.  When you personally use the results of the Magic Formula do you try to sort out which companies have sustainable competitive advantages versus the ones that don’t?  What other criteria do you use to select which companies to invest in from the result of the Magic Formula? 

Greenblatt did touch on the issue of special situations.  Shai notes indicate Greenblatt said, “Special situations are just value investing with a catalyst.”  He also notes, “Finding complicated situations that no one else wants to do the work to figure out is a way to gain an advantage.” That’s where my advantage regarding going private transactions comes into play.  That advantage can also be your advantage if you gain access to Contributor’s Corner.

I found the following Joel Greenblatt’s comment regarding his Magic Formula reassuring. ”The Little Book is for people who cannot value companies. If you can value a company, you can start with the MF list. Then estimate normalized earnings, normalized free cash flow, and expected growth rates.” Joel acknowledges that digging deeper into the Magic Formula list is productive if you understand how to value a company, which somewhat addresses some earlier comments that I received.

“International investing may offer the best opportunity, at least in terms of cheapness,” notes Greenblatt. I plan on preparing myself better in regards to international investing.  It is not something easy to do, and it can be expensive.  However, like everything else, a little homework and preparation can help you achieve success.

I encourage you to visit Shai Dardashti’s site for the complete story.

What is this Magic Formula?

The Magic Formula seeks to identify “good” businesses selling at “bargain” prices.  It uses two factors to rank stocks so that you can identify the best businesses selling at bargain prices. 

The first factor identifies a good business as one that produces a high return on capital (ROC).  Return on capital is calculated by dividing earnings before interest and taxes (EBIT) by the sum of net working capital and net fixed assets.

ROC = EBIT / (Net Working Capital + Net Fixed assets)

The second factor identifies businesses selling at bargain prices by examining earnings yield, which is basically the in inverse of the price earnings ratio (P/E).  More specifically, earnings yield is defined as earnings before interest and taxes divided by enterprise value.

EY = EBIT/EV

Shai Dardashti has done a great job discussing Joel Greenblatt and The Little Book that Beats the Market, and he has compiled all his work in a recent post to prepare for a meeting with Joel Greenblatt.  In fact, Shai will be publishing his transcript of that meeting shortly.

Looking under the hood

I’ve decided to take a closer look at how the Magic Formula works in the real world.  I just went over to the Magic Formula Investing site and registered for free.  With the login information in hand, I decided to run the Magic Formula screen. 

The first step required me to select the minimum market capitalization that I would allow.  I entered 50 for $50 million market cap minimum, since I heard that is what Joel Greenblatt used in when he developed the formula.  Step two requires you to select the number of top ranked stocks that you wish to choose from.  I selected 25, and then I did step three, which was to hit go.  Here’s the list of stocks that it returned today:

• American Eagle Outfitters Inc (AEOS)
• Anika Therapeutics Inc (ANIK)
• Block H & R Inc (HRB)
• Callwave Inc (CALL)
• Catapult Communications Corp (CATT)
• Collectors Universe Inc (CLCT)
• Deluxe Corp (DLX)
• Forward Industries Inc (FORD)
• Ftd Group Inc (FTD)
• Grubb & Ellis Co (GBEL)
• Infospace Inc (INSP)
• Innovative Soltns & Supp Inc (ISSC)
• Intervideo Inc (IVII)
• Jakks Pacific Inc (JAKK)
• K-Swiss Inc -Cl A (KSWS)
• King Pharmaceuticals Inc (KG)
• Korn/Ferry International (KFY)
• Kos Pharmaceuticals Inc (KOSP)
• Magellan Health Services Inc (MGLN)
• Mannatech Inc (MTEX)
• Marvel Entertainment Inc (MVL)
• New Frontier Media Inc (NOOF)
• United Online Inc (UNTD)
• Vaalco Energy Inc (EGY)
• Vertrue Inc (VTRU)

The first thing I noticed was that this list wasn’t ranked by the two factors, but was just an alphabetical list of the top ranked stocks with market caps great than $25 million.  There are quite a few familiar names on that list, but there are several new companies on that list that I know nothing about.

I have decided that I’m going to research each of these companies.  But before I do that, I read a comment by Rick on Shai’s blog that got me thinking.  The comment by Rick notes:

“Screening by using a “magic formula” is merely the first step. I wouldn’t get caught up in the “formula” per se. It merely screens for businesses that have the highest ROIC and matches them with a valuation tool, earnings yield. This inherently is what all successful value investors of Buffett discipline would ascribe to. Not just a cheap price for a cigar butt investment! The real magic in my opinion comes from the determination of two things: (1) How sustainable is the competitive advantage, i.e. How long can we sustain these superior ROIC? and (2) When we utilize earnings yield, are we using normalized earnings or are we dealing with overstated or super-normal earnings? In this way, the discipline becomes far less formulaic and becomes more analytic and more of an art.”

I totally agree with Rick.  I think the Magic Formula provides a great starting point to identify investment candidates.  However, I think determining the sustainability of these companies’ competitive advantages is critical.  Right off hand I note a few fashion stocks on the list above that may have a very fleeting competitive advantage that could disappear very quickly if consumer tastes change suddenly.  In addition, accounting shenanigans could mask whether or not these companies are really selling at bargain prices.

Kicking the tires 

I’m going to kick the tires of these companies over the next few weeks.  I’ll figure out what they do and how they do it.  After a few kicks, I’ll figure out if the above stocks truly have a durable competitive advantage or whether they are going to potentially run out of gas, break down or require lots of maintenance.

I’m also going to be testing out the Magic Formula independently to see how it performed in the past.  I even have an idea of how to turbo charge this little engine.  This is all going to take some hard work, so expect a lot of activity here at Fat Pitch Financials over the next few weeks regarding the Magic Formula.

1.  What do you think of going private transactions in this post Sarbanes Oxley Act environment that didn’t exist when you wrote ”You Can Be A Stock Market Genius”?  Do you think it is profitable for small investors to participate in these risk arbitrage opportunities associated with the reverse split/fractional shareholder cash outs used for some going private transactions?  How should investors be evaluating which of these opportunities are good and which ones are bad? 2. The Magic Formula produces an interesting list of companies.  Some of the profitable companies on this list however don’t appear to have sustainable competitive advantages and their high profits may be temporary.  When you personally use the results of the Magic Formula do you try to sort out which companies have sustainable competitive advantages versus the ones that don’t?  What other criteria do you use to select which companies to invest in from the result of the Magic Formula?

Do you have any other questions that you would like answered by Mr. Greenblatt?  Please post your questions below or send them along to Shai or me.

I wish Shai the best of luck with the interview.  I look forward to reading about his experience soon.  I’ll post a link to it when Shai posts his notes about the meeting with Joel Greenblatt.