Interactive Investor

A 'magic formula' for patient investors

21st June 2017 14:15

Ben Hobson from Stockopedia

One of the big challenges faced by stockmarket investors is dealing with periods of underperformance. No matter what the strategy is, there will always be times when it just doesn't work. For those who can bear it, the discipline is in sticking with the rules rather than changing course completely.

One of the most vocal proponents of this discipline is Joel Greenblatt, an American fund manager that we've come across before in this column. His strategy - which we'll come to shortly - is a simple combination of value and quality. It looks for cheaply priced, good stocks, which sounds like a very reasonable approach. Greenblatt himself said that "buying good businesses at bargain prices is the secret to making lots of money".

The trouble is that even cheaply priced, good stocks don't always perform well as a whole in the stockmarket. For instance, investors in US markets have found in recent years that very expensive growth stocks are the most popular. On these occasions, nobody wants to buy value stocks, no matter how good are.

This has been the challenge faced by Greenblatt in his own hedge fund, Gotham Funds. Again, he's found himself explaining why, every so often, cheap, good stocks don't outperform.

Back in December we reported here that a strategy inspired by Greenblatt's 'Magic Formula' was on a bit of a roll. Six months later, it's starting to look like a runaway train. As you can see from this performance chart, the Magic Formula does indeed suffer down years. But the up years like we're seeing now prove just how powerful this approach can be.

A blend of value and quality

Greenblatt set out the Magic Formula in his book, The Little Book That Beats the Market. He uses just two simple ratios: the earnings yield as a measure of 'cheapness' and return on capital as a measure of 'quality'.

Earnings yield tells you how much profit a company is making in relation to its underlying value. The higher the yield, the cheaper the company and the more bang you get for your buck. The return on capital focuses on how good a company is at generating a profit from the investment it makes in itself. Good quality companies are very efficient at delivering high percentage returns from the cash they reinvest to grow.

Greenblatt's strategy scores every company on each ratio and then adds the scores together to get a Magic Formula for each one. To get an idea of the kinds of companies with high Magic Formula scores right now, we've reproduced the current list. The table includes Greenblatt's Magic Formula expressed as a more understandable percentile ranking where zero is worst and 100 is best.

NameMkt Cap £mMagic Formula Rank %ROC % GreenblattEarnings Yield %Sector
LSL Property Services221.998.9203.126.8Financials
Sportech185.298.497.622.3Consumer Cyclicals
Harvey Nash57.898.4120.917.6Industrials
Hogg Robinson214.198.378.419.3Industrials
RM142.198.298.515.6Industrials
Wincanton363.797.991.814.4Industrials
PayPoint674.997.8246.810.9Industrials
Mission Marketing33.597.786.714Consumer Cyclicals
SCS61.497.646.647.6Consumer Cyclicals
DFS Furniture444.797.59213.1Consumer Cyclicals

Leading this list of small-caps is LSL Property Services, which works for estate agency and surveying businesses, followed by Sportech, the pool betting operator. Others include recruitment group Harvey Nash and corporate services firm Hogg Robinson, education supplies group RM and the logistics company Wincanton.

Like many value strategies, the Magic Formula does offer up potentially scary-looking shares. The furniture group DFS recently saw its shares fall hard on a profit warning, but it still scores well against these Greenblatt-inspired rules.

No magic wand

Greenblatt's strategy of targeting cheaply priced, good-quality companies echoes the approaches taken by some of the world's greatest investors. But one of the important lessons imparted by Greenblatt is the need to stick with the strategy even when it endures inevitable periods of underperformance, sometimes lasting years.

He insisted that it needed patience - and for those investors that have held firm with this strategy in recent years, that patience is now paying off.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

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Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook"

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.