A great year for modified magic formula investing

A year ago I started a trial of three model portfolios based on Joel Greenblatt’s magic formula approach (click here to read more about this). I wanted to see how this strategy would work in the real world and with all investing costs taken into account as many studies of investment strategies ignore costs.

The portfolios are also based on something that a private investor might be able to do in practice. A portfolio of 20 shares is just about manageable for most investors although the costs of buying and selling shares every year does mount up and reduces returns.

I like the magic formula because of its focus on two simple but crucial determinants of successful investing:

  1. Buying high-quality companies – ones with a high return on capital employed (ROCE)
  2. Buying cheap companies – ones with a high earnings yield

If you are just starting out on your investing journey then I recommend you buy a copy of Greenblatt’s book – The Little Book that Beats the Market. It is very easy to read and is not very long. If you are a more experienced investor you should read it too. It might convince you that investing really doesn’t have to be complicated.

Despite liking the magic formula approach, I had my concerns about it. Namely because it ignores the impact of:

  • Intangible assets
  • Significant liabilities such as pension fund deficits
  • Hidden, off-balance sheet debts due to rented assets
  • The ability of a company to turn its profits into cash

So I set up three test portfolios with the same amount of money invested in twenty shares from different sectors of the stock market to see which one would perform the best.

They were based on:

  1. A simple magic formula approach based on Greenblatt’s book
  2. A lease-adjusted version where the ROCE calculation and earnings yield were adjusted for pension fund deficits and hidden debts
  3. A lease-adjusted earnings yield – buying cheap shares regardless of quality

The results

Whilst one year is nowhere near long enough to reach any clear cut views on whether a strategy is any good or not, 2016 saw the lease-adjusted magic formula trounce the simple version. It delivered a very impressive total return after costs.

But just buying cheap shares was nearly as good.

Portfolio Starting value Closing Value Total return Gainers Losers
Simple Magic Formula £100,000 £121,749 21.75% 14 6
Lease-adjusted Magic Formula £100,000 £143,575 43.58% 13 7
Lease-adjusted EBIT yield £100,000 £140,193 40.19% 12 8

All three strategies beat the FTSE All-Share index which delivered a total return of just under 17% in 2016.

The simple magic formula produced more winning shares and fewer losers than the other portfolios.

Simple Magic Formula portfolio
Top 5 gainers Total return % Top 5 losers Total return %
IQE 86.2 Hvivo* -29.6
Wireless Group 75.9 Independent News & Media -22.1
Indivior 68 RM -16.8
Rotork 48.5 Eurocell -3.8
McColl’s Retail 39.4 Wizz Air -2.9
Lease-adjusted Magic Formula

This version captured Ferrexpo which produced a stunning gain in value. Its top 5 winners also trumped the simple magic formula thanks to contributions from the likes of Dialight and Central Asia Metals.

Top 5 gainers Total return % Top 5 losers Total return %
Ferrexpo 513.1 NAHL -33.5
IQE 86.2 Hvivo* -29.6
Dialight 72.9 STV -27.5
Indivior 68 Berkeley Group -17.3
Central Asia Metals 61.8 RM -16.8
Lease-adjusted earnings yield

Buying shares solely on their cheapness beat the simple magic formula and almost performed as well as the lease-adjusted version. For 2016 at least, it begs the question does quality matter? Should we just focus on cheapness instead?

As an investor who puts a very strong emphasis on buying quality companies this is not something that sits easily with me. It will take a good few years of very good returns from a simple cheap portfolio for me to be convinced.

Top 5 gainers Total return % Top 5 losers Total return %
Ferrexpo 513.1 GAME Digital -39.4
IQE 86.2 NAHL -33.5
Drax 71.7 Hvivo* -29.6
Indivior 68 Independent News & Media -22.1
Central Asia Metals 61.8 RM -16.9

This very simple portfolio picked up many of the same winners as the lease-adjusted version but added a different significant winner in the form of Drax.

Magic formula shares for 2017

I am going to carry on with these portfolios for 2017. Whilst I am not saying that investors should blindly follow a formula approach, screening for shares that meet the Magic Formula criteria may throw up some interesting individual ideas.

The other interesting aspect of testing investment strategies is that the results can help investors learn about what type of strategy might work in certain types of market conditions. I therefore think it is a useful thing to do.

The most important thing to remember with screening strategies is that you need to go all in. The success of screens like Greenblatt’s Magic Formula is based on the assumption of buying a basket of shares.

In most years, the basket will contain winners and losers. So if you just pick one or two shares from the basket – like STV for example – you could pick a big loser. You might also pick a big winner but as an investor you should be looking to reduce your risks.

There are two main ways you can reduce your risk when investing in shares. One is to buy lots of shares so that your portfolio is not dependent on the fortunes of one or two shares. This spreads your risks but also tends to dilute your potential returns. If you own too many shares because you are frightened by the risks involved then you might as well buy a cheap index tracking fund instead.

The second – and better – way is to concentrate your portfolio into a smaller number of shares (say 10-15). You then reduce your risk by focusing your investments on high quality companies and not overpaying for them. This requires a bit of time and research.

So if you want to use the screen as a way to find investment ideas, you should subject your list of stocks to a reasonable level of analysis before buying. Using the Carousel on SharePad’s Financial Summary view should be the absolute minimum.

A very important point to realise with Greenblatt’s Magic Formula is that its results are based on only the most recent values for a company’s ROCE and earnings yield. This can mean it qualifies by having a temporarily high ROCE or that its shares have a high earnings yield (they look cheap) because it has poor growth prospects.

Let’s take STV for example, a look at its long-term ROCE chart would tell the investor that it is a cyclical business. Reading its annual report would also show you that the business was very reliant on advertising revenues which are very dependent on the fortunes of the economy.

Its 2014 and 2015 ROCE figures look to be at or close to a cyclical peak and have started to trend down. This would probably have been enough to put me off buying STV as an individual investment rather than part of a basket.

Now on to 2017’s list of shares.

The 2016 ending values of all three portfolios will be rebalanced into 20 equal-sized investments in the shares shown below. I will provide an update on their progress at the end of June.

Simple Magic Formula
Name Magic Formula rank Market Cap. (current) ROCE (ex intg) EBIT yield Subsector
DFS Furniture PLC 1 £472.20 314.6 12.2 Home Improvement Retailers
Indivior PLC 3 £2,133.70 148.8 11.4 Pharmaceuticals
Connect Group PLC 4 £386.20 168.9 10.9 Business Support Services
Motorpoint Group PLC 6 £127.80 58.8 16.3 Specialty Retailers
Next PLC 10 £7,053.60 62 10.6 Apparel Retailers
SThree PLC 14 £400.10 68.1 10.1 Business Training & Employment Agencies
KCOM Group PLC 15 £481.10 61.4 10.5 Fixed Line Telecommunications
Wizz Air Holding PLC 16 £1,029.30 36.5 37.8 Airlines
ITV PLC 18 £8,262.20 127.9 8.7 Broadcasting & Entertainment
Rank Group (The) PLC 21 £758.70 56.2 10.5 Gambling
McColl’s Retail Group Ltd 25 £212.60 58 9.6 Food Retailers & Wholesalers
Tarsus PLC 31 £321.00 275.3 7.4 Media Agencies
Howden Joinery Group PLC 34 £2,407.90 48.1 9.7 Industrial Suppliers
PayPoint PLC 47 £701.00 59 8.4 Financial Administration
NCC Group PLC 48 £516.30 152.4 6.8 Computer Services
Restaurant Group (The) PLC 53 £666.50 30.5 13 Restaurants & Bars
Berkeley Group Holdings (The) PLC 54 £3,935.10 28.6 14.2 Home Construction
Keller Group PLC 56 £607.50 26.6 15.5 Heavy Construction
Kainos Group Ltd 59 £240.20 61.7 6.9 Software
XP Power Ltd 64 £336.30 50.1 7.5 Electrical Components & Equipment
Lease-adjusted Magic Formula
Name Lease-adj Magic Formula rank Market Cap. (current) Lease-adj ROCE (7x, 7%) Lease-adj EBIT yield (7x, 7%) Subsector
Motorpoint Group PLC 2 £127.80 39 14.8 Specialty Retailers
Indivior PLC 5 £2,172.20 98.4 11.3 Pharmaceuticals
Berkeley Group Holdings (The) PLC 7 £3,925.30 28.1 14.1 Home Construction
Next PLC 13 £7,090.40 33.2 10.1 Apparel Retailers
KCOM Group PLC 16 £485.60 26.3 10.3 Fixed Line Telecommunications
SThree PLC 18 £404.30 31.2 9.6 Business Training & Employment Agencies
STV Group PLC 20 £141.80 24.9 10.3 Broadcasting & Entertainment
Softcat PLC 23 £587.60 48.5 8.8 Computer Services
Howden Joinery Group PLC 24 £2,406.00 28.6 9.3 Industrial Suppliers
Ashley (Laura) Holdings PLC 26 £144.60 20.7 10.5 Home Improvement Retailers
PayPoint PLC 29 £688.40 49.6 8.4 Financial Administration
Gocompare.com Group PLC 36 £286.30 77.3 7.8 Media Agencies
QinetiQ Group PLC 39 £1,506.20 28.4 8.4 Defense
Connect Group PLC 41 £381.60 19.1 9.8 Business Support Services
Forterra PLC 44 £351.80 27.6 8.3 Building Materials & Fixtures
Gulf Marine Services PLC 50 £184.20 14.5 17.1 Oil Equipment & Services
Kainos Group Ltd 56 £240.90 49.6 6.9 Software
Keller Group PLC 58 £609.50 14.6 12.6 Heavy Construction
Britvic PLC 59 £1,503.50 17.3 9 Soft Drinks
Gem Diamonds Ltd 60 £151.00 13.3 16.5 Diamonds & Gemstones
Lease-adjusted EBIT yield
Name Market Cap. (current) Lease-adj EBIT yield (7x, 7%) Subsector
Lonmin PLC £418.70 28.1 Platinum & Precious Metals
Lamprell PLC £320.80 24.1 Oil Equipment & Services
UNITE Group PLC £1,321.50 22.5 Real Estate Holding & Development
CMC Markets PLC £322.80 21 Investment Services
Pendragon PLC £454.40 19.2 Specialty Retailers
Sports Direct International PLC £1,653.90 18.2 Apparel Retailers
Barratt Developments PLC £4,672.30 17.4 Home Construction
International Personal Finance PLC £387.30 16.5 Consumer Finance
Gem Diamonds Ltd £151.00 16.5 Diamonds & Gemstones
LSL Property Services PLC £240.90 16.3 Real Estate Services
Thomas Cook Group PLC £1,344.30 15 Travel & Tourism
Trinity Mirror PLC £298.90 14.8 Publishing
Premier Oil PLC £392.70 12 Exploration & Production
easyJet PLC £4,009.80 11.5 Airlines
Indivior PLC £2,171.90 11.3 Pharmaceuticals
Carillion PLC £1,010.00 11.2 Business Support Services
Vedanta Resources PLC £2,430.40 11.2 General Mining
Drax Group PLC £1,555.60 11 Conventional Electricity
John Laing Group PLC £995.50 10.6 Specialty Finance
Ashley (Laura) Holdings PLC £144.60 10.5 Home Improvement Retailers

* An error in the data for Hvivo meant that it was incorrectly included in each of the original portfolios. However, as each portfolio was equally weighted it had the same negative effect in each portfolio. As one of the largest fallers in each portfolio, the performance of them is most likely understated. All the stocks in the 2017 portfolios merit their inclusion.