This week, I tried something different for our #askdrwealth series. We explored the Magic Formula and explore a free tool that allows us to screen for Magic Formula stocks.
You can read on for my summary, or watch the full session here:
The “Magic Formula” sounds like a hyped up, get rich quick concept. But, it’s actually a legit (and relatively famous) value investing strategy devised by Joel Greenblatt.
Who is Joel Greenblatt?
A hedge fund manager and adjunct professor at Colombia Business School, Joel Greenblatt runs Gotham Funds, an equity management firm.
Although he isn’t as famous as Warren Buffett or Ray Dalio, Joel Greenblatt is one of the forerunners in modern value investing.
He first introduced the Magic Formula in his book, The Little Book that Beats the Market.
What is the Magic Formula?
In a nutshell, the Magic Formula is about buying good companies at bargain prices.
It combines the best investing ideas from both Benjamin Graham (buying cheap businesses) and Warren Buffett (buy wonderful businesses).
Hence, there are just 2 rules to Magic Formula Investing:
- Find Good Companies – the Magic Formula defines a good company as one with High Return on Capital.
- Find Cheap Companies – the Magic Formula defines a cheap company as one with High Earning Yields.
I’ve written about the Magic Formula in depth previously and will not go into the exact formulas in this article. You can read all about the Magic Formula and how to implement it on your own here.
With the formulas in hand, the next common question that investors would ask is “how high is high?”;
How to implement the Magic Formula?
Now, understand that the Magic Formula gives us a relative valuation, rather than an absolute one.
This means that instead of giving you the absolute value of a stock, the Magic Formula works more like a ranking system – it helps you rank for the good companies at cheapest prices, from a basket of stocks.
To implement it, you’ll need to:
- Calculate the Return on Capital and Earning Yields of all the businesses in your basket of stocks
- Rank the stocks based on both criteria
- Buy the top 30 stocks
- Repeat your analysis annually, updating your portfolio with new list of top 30 stocks.
(Skip to 13.00 of the video above for an example)
Does the Magic Formula work?
Joel Greenblatt has published his results in his books previously:
The Magic Formula continued to beat the S&P 500 index, even after the 2008 crash.
The formula remains robust today. Although I don’t have access to Greenblatt’s official results after 2010, it has been covered by various investors. You can find results from other investors if you do a quick Google search.
Where to find for Magic Formula stocks?
Good news – you don’t have to do the calculations or ranking manually.
Instead, there are free screeners available for you, I shared 2 of them in my talk;
1 – Magic Formula Investing
The official website for the Magic Formula is managed by Joel Greenblatt and comes with a screener. All you need to do is to sign up for a free account.
The downside is that it is limited only to US stocks.
Our webapp also comes a Magic Formula screener, it is built based on the formula in Greenblatt’s book.
The best part? It’s free to use, without having to sign up for an account.
At the point of writing, this screener covers the Singapore, US, Hong Kong, China, Vietnam, Indonesia, Malaysia and Japan markets.
In the next section, I’ll go through the steps to screening for Magic Formula stocks.
If you prefer to watch my demonstration via the Dr Wealth app, watch the above video from 19.00 onwards.
How to screen for Magic Formula stocks?
To access the Dr Wealth App, go to app.drwealth.com.
This is a web app, you do not need to download it. It is accessible on any device via a browser:
Click on the ‘Discover’ icon at the bottom of your screen to view our range of screeners.
To select the market(s) that you’d like to screen in, tap on the funnel icon (top right).
Once you’ve load the Magic Formula screen, you’ll see a list of stocks, their ranking, as well as their Earnings Yield and Return on Capital.
If any stock piques your interest, you can tap the stock name to see more details such as;
- Financial Metrics: Price to Book, Dividend Yield, Return on Equity, etc
- Company Information
- News: as pulled from top new sources like Business Times, The Edge
- Additional Analysis: if specific analysts cover the stock, you’ll see their reports in the app
That’s basically it. You can select the Magic Formula stocks based on the list, or choose to analyse each company further by clicking into it.
Prior to the live session on Monday, I had not taken a look at the latest list of Magic Formula stocks.
I was pleasantly surprised to find some new ideas during the session. I highlight some of the here:
16 Magic Formula stocks listed in SGX
|Magic Formula Ranking||Return on Capital||Earnings Yield|
|Medtecs International (SGX:546)||219||60.94%||83.7%|
|Union Gas Holdings (SGX:1F2)||680||39.81%||32.19%|
|AEM Holdings (SGX:AWX)||830||80.43%||21.95%|
|Cortina Holdings (SGX:C41)||1198||26.03%||30.56%|
|Top Glove (SGX:BVA)||1321||84.88%||16.13%|
|Hyphens Pharma International (SGX:1J5)||2021||21.18%||20.72%|
|Addvalue Technologies (SGX:A31)||2253||543.35%||11.21%|
|Singapore Medical Group (SGX:5OT)||2511||56.52%||10.81%|
|Avi-Tech Electronics (SGX:BKY)||2636||13.78%||69.22%|
|Frencken Group (SGX:E28)||2689||18.96%||16.53%|
|Hour Glass (SGX:AGS)||2711||15.07%||27.26%|
|Singapore O&G (SGX:1D8)||2834||45.67%||10.01%|
2 things to look out for when implementing the Magic Formula
The Magic Formula is a quantitative, data-driven method to picking stocks. Hence, if you are trying to implement it on your own, there may be a few issues you want to take note:
Joel Greenblatt warns against nitpicking from the pool of Magic Formula stocks because this process tend to introduce biases which may work against us.
The best way to implement the Magic Formula is to buy the best stocks on the list, at equal weights.
That said, investing requires conviction. It is easy to get cold feet and end up selling at a loss when the markets go down. Hence, most investors will inevitably do some sort of nitpicking when trying to implement the Magic Formula.
In my opinion, the process of ‘nitpicking’ tends to give investors more confidence over their choices, hence it is difficult to avoid it.
Since you’re most likely going to be nitpicking, might as well…
Improve your picks with Qualitative Analysis
A quantitative screen analyses companies based on the numbers they release.
Unfortunately, this means that it is not able to tell the quality of the business, detect competitive advantages, determine the competitors, decide if the management is good or not.
So, if you plan to nitpick, put in the extra effort and time to carry out qualitative analysis to understand the business(es) better.
I’ve talked about Joel Greenblatt’s Magic Formula, how it was devised, the criteria it uses to pick for stocks and how you can implement it.
I’ve also shared 2 free screeners that you can use to screen for Magic Formula stocks – of which, the Dr Wealth app covers a wide range of stock markets.
I hope this helps you to find more investing ideas.
All the best!