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

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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.

PortfolioStarting valueClosing ValueTotal returnGainersLosers
Simple Magic Formula£100,000£121,74921.75%146
Lease-adjusted Magic Formula£100,000£143,57543.58%137
Lease-adjusted EBIT yield£100,000£140,19340.19%128

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 gainersTotal return %Top 5 losersTotal return %
Wireless Group75.9Independent News & Media-22.1
McColl's Retail39.4Wizz 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 gainersTotal return %Top 5 losersTotal return %
Indivior68Berkeley Group-17.3
Central Asia Metals61.8RM-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 gainersTotal return %Top 5 losersTotal return %
Ferrexpo513.1GAME Digital-39.4
Indivior68Independent News & Media-22.1
Central Asia Metals61.8RM-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
NameMagic Formula rankMarket Cap. (current)ROCE (ex intg)EBIT yieldSubsector
DFS Furniture PLC1£472.20314.612.2Home Improvement Retailers
Indivior PLC3£2,133.70148.811.4Pharmaceuticals
Connect Group PLC4£386.20168.910.9Business Support Services
Motorpoint Group PLC6£127.8058.816.3Specialty Retailers
Next PLC10£7,053.606210.6Apparel Retailers
SThree PLC14£400.1068.110.1Business Training & Employment Agencies
KCOM Group PLC15£481.1061.410.5Fixed Line Telecommunications
Wizz Air Holding PLC16£1,029.3036.537.8Airlines
ITV PLC18£8,262.20127.98.7Broadcasting & Entertainment
Rank Group (The) PLC21£758.7056.210.5Gambling
McColl's Retail Group Ltd25£212.60589.6Food Retailers & Wholesalers
Tarsus PLC31£321.00275.37.4Media Agencies
Howden Joinery Group PLC34£2,407.9048.19.7Industrial Suppliers
PayPoint PLC47£701.00598.4Financial Administration
NCC Group PLC48£516.30152.46.8Computer Services
Restaurant Group (The) PLC53£666.5030.513Restaurants & Bars
Berkeley Group Holdings (The) PLC54£3,935.1028.614.2Home Construction
Keller Group PLC56£607.5026.615.5Heavy Construction
Kainos Group Ltd59£240.2061.76.9Software
XP Power Ltd64£336.3050.17.5Electrical Components & Equipment
Lease-adjusted Magic Formula
NameLease-adj Magic Formula rankMarket Cap. (current)Lease-adj ROCE (7x, 7%)Lease-adj EBIT yield (7x, 7%)Subsector
Motorpoint Group PLC2£127.803914.8Specialty Retailers
Indivior PLC5£2,172.2098.411.3Pharmaceuticals
Berkeley Group Holdings (The) PLC7£3,925.3028.114.1Home Construction
Next PLC13£7,090.4033.210.1Apparel Retailers
KCOM Group PLC16£485.6026.310.3Fixed Line Telecommunications
SThree PLC18£404.3031.29.6Business Training & Employment Agencies
STV Group PLC20£141.8024.910.3Broadcasting & Entertainment
Softcat PLC23£587.6048.58.8Computer Services
Howden Joinery Group PLC24£2,406.0028.69.3Industrial Suppliers
Ashley (Laura) Holdings PLC26£144.6020.710.5Home Improvement Retailers
PayPoint PLC29£688.4049.68.4Financial Administration
Gocompare.com Group PLC36£286.3077.37.8Media Agencies
QinetiQ Group PLC39£1,506.2028.48.4Defense
Connect Group PLC41£381.6019.19.8Business Support Services
Forterra PLC44£351.8027.68.3Building Materials & Fixtures
Gulf Marine Services PLC50£184.2014.517.1Oil Equipment & Services
Kainos Group Ltd56£240.9049.66.9Software
Keller Group PLC58£609.5014.612.6Heavy Construction
Britvic PLC59£1,503.5017.39Soft Drinks
Gem Diamonds Ltd60£151.0013.316.5Diamonds & Gemstones
Lease-adjusted EBIT yield
NameMarket Cap. (current)Lease-adj EBIT yield (7x, 7%)Subsector
Lonmin PLC£418.7028.1Platinum & Precious Metals
Lamprell PLC£320.8024.1Oil Equipment & Services
UNITE Group PLC£1,321.5022.5Real Estate Holding & Development
CMC Markets PLC£322.8021Investment Services
Pendragon PLC£454.4019.2Specialty Retailers
Sports Direct International PLC£1,653.9018.2Apparel Retailers
Barratt Developments PLC£4,672.3017.4Home Construction
International Personal Finance PLC£387.3016.5Consumer Finance
Gem Diamonds Ltd£151.0016.5Diamonds & Gemstones
LSL Property Services PLC£240.9016.3Real Estate Services
Thomas Cook Group PLC£1,344.3015Travel & Tourism
Trinity Mirror PLC£298.9014.8Publishing
Premier Oil PLC£392.7012Exploration & Production
easyJet PLC£4,009.8011.5Airlines
Indivior PLC£2,171.9011.3Pharmaceuticals
Carillion PLC£1,010.0011.2Business Support Services
Vedanta Resources PLC£2,430.4011.2General Mining
Drax Group PLC£1,555.6011Conventional Electricity
John Laing Group PLC£995.5010.6Specialty Finance
Ashley (Laura) Holdings PLC£144.6010.5Home 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.

Phil Oakley's debut book - out now!

Phil shares his investment approach in his new book How to Pick Quality Shares. If you've enjoyed his weekly articles, newsletters and Step-by-Step Guide to Stock Analysis, this book is for you.

Find out more

If you have found this article of interest, please feel free to share it with your friends and colleagues:

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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.