There are a number of ways value investors hunt for stocks. Among the techniques is the Magic Formula, a trading strategy first detailed by Joel Greenblatt in his book, The Little Book that Still Beats the Market.
This book was a New York Times bestseller and the book’s web site indicates over 300,000 copies are in print. The book completely explains a formula that screens for value investments. The author maintains a free web site that offers access to lists of stocks meeting the criteria of the Magic Formula right now.
Before addressing the formula, let’s look at the question of whether or not it works. Greenblatt provided test results in his book. The Magic Formula produced an average annual return of 30.8% over a 17 year period. This test used stocks of all market caps. Using only the largest 1,000 stocks, the annual return was 22.9%. In testing, portfolios selected with the Magic Formula beat the market 96% of the time.
It works. Now what is it? Greenblatt says the goal is to buy good companies which he defines as those with high return on capital (ROC). For this formula, ROX is defined as the amount of operating profit divided by net working capital plus net fixed assets.
To profit from good companies, Greenblatt recommends buying them when they are cheap. He defines value with the earnings yield, which is defined as pre-tax operating earnings divided by enterprise value. Companies are ranked by value and this ranking is used to create a buy list.
Greenblatt calculates the ROC and earnings yield of all companies. He then sorts the companies with each category. The highest raw values of ROC and earnings yield are assigned a rank of 1, the next highest are ranked 2 and so on down to the lowest value. The scores are then summed to create the Magic Formula rank.
To implement this strategy, Greenblatt recommended buying the top 30 of the highest ranked companies and holding them for one year. He reviewed the portfolio about twelve months later and recommended selling losers right before a year is up and sell winners right after 12 months for tax benefits.
There are a number of other ways to implement this strategy. For example, many investors will want to hold less than 30 stocks. One reason 30 stocks is recommended is because that number of holdings is believed to reduce the risks of investing.
Analysts group risks into two broad categories. There are market risks and unique risks associated with each company. The unique risks associated with each company are impossible to eliminate. But, by holding 30 stocks, a portfolio should have about the same degree of risk as the broad market.
Holding 30 stocks, therefore, is thought to reduce risks of a portfolios. It does tend to make those risks equal to the market risks. But, it will not always be possible to hold 30 stocks. The Magic Formula could actually be implemented with any number of stocks.
The list could also be reduced to smaller stocks. These are the type of stocks that delivered the largest gains in the Magic Portfolio test.
Tools of technical analysis could also be combined with the Magic Formula. This could include adding a relative strength screen or only buying when a momentum indicator triggers a buy signal. Technicals could also be used to time the selling of each position.
Some Current Recommendations
We used Greenblatt’s web site to screen for Magic Formula buys right now. We restricted our list to low priced stocks since these are the stocks that have the potential to deliver the largest gains in a short amount of time.
Applied Genetic Technologies Corporation (Nasdaq: AGTC) is a clinical-stage biotechnology company that uses its proprietary gene therapy platform to develop products focused on ophthalmology. AGTC’s lead product candidates focus on inherited orphan diseases of the eye, caused by mutations in single genes that significantly affect visual function and currently lack effective medical treatments. The company’s product pipeline includes six named ophthalmology development programs across five targets (X-linked retinoschisis (XLRS), X-linked retinitis pigmentosa (XLRP), achromatopsia, wet age-related macular degeneration and blue cone monochromacy), one non-ophthalmology program (alpha-1 antitrypsin deficiency) and proof-of-concept data in multiple additional indications.
Avid Technology, Inc. (Nasdaq: AVID) develops, markets, sells, and supports software and hardware for digital media content production, management, and distribution worldwide. The company offers professional video creative tools, such as Media Composer product line that is used to edit video content; NewsCutter option and iNews systems for news production; Avid Symphony option, which is used during post-production; and Media Composer | Cloud solution that enables broadcast news professionals to acquire, access, edit, and finish stories. In addition, AVID offers media management solutions comprising Avid MediaCentral | UX Web and mobile-based apps that provide real-time access to media assets for media professionals.
Finjan Holdings, Inc. (Nasdaq: FNJN) is a cybersecurity company, providing intellectual property licensing and enforcement services. The company owns a portfolio of patents related to software and hardware technologies that proactively detect malicious code and thereby protects end users from identity and data theft, spyware, malware, phishing, trojans, and other Web and network threats. Its patented technologies are used in specific cybersecurity technology areas, including endpoint/cloud software, Web gateway/Internet infrastructure, networking equipment markets, and mobile security.
Lifevantage Corporation (Nasdaq: LFVN) focuses on the identification, research, development, and distribution of nutraceutical dietary supplements and skin care products. It offers Protandim, a scientifically-validated dietary supplement; LifeVantage TrueScience, an anti-aging skin care product; Axio energy drink mixes; and PhysIQ, a weight management system, as well as Canine Health, a companion pet supplement formulated to combat oxidative stress in dogs. In addition, LFVN provides skin care products under the LifeVantage TrueScience brand name. It sells its products through a network of independent distributors, and preferred and retail customers in the United States, Japan, Hong Kong, Australia, Canada, Philippines, Mexico, Thailand, the United Kingdom, and the Netherlands.
Network-1 Technologies, Inc. (NYSE: NTIP) develops, licenses, and protects intellectual property assets. The company owns 33 patents, including the remote power patent covering the delivery of power over Ethernet cables for the purpose of remotely powering network devices, such as wireless access ports, IP phones, and network based cameras; and the Mirror Worlds patent portfolio relating to foundational technologies that enable unified search and indexing, displaying, and archiving of documents in a computer system. Its patents also comprise the Cox patent portfolio relating to enabling technology for identifying media content on the Internet; and the quality of service (QoS) patents covering systems and methods for the transmission of audio, video, and data in order to achieve high QoS over computer and telephony networks.
North European Oil Royalty Trust (NYSE: NRT) a grantor trust, holds overriding royalty rights covering gas and oil production in concessions or leases in the Federal Republic of Germany. It holds rights under contracts with German exploration and development subsidiaries of ExxonMobil Corp. and the Royal Dutch/Shell Group of Companies. The company holds royalties for the sale of well gas, oil well gas, crude oil, condensate, and sulfur.
PDL BioPharma, Inc. (Nasdaq: PDLI) acquires and manages companies, products, royalty agreements, and debt facilities in the biotech, pharmaceutical, and medical device industries in the United States, Europe, and internationally. The company operates through two segments, Income Generating Assets and Product Sales. The Income Generating Assets segment consists of royalties from issued patents covering the humanization of antibodies, including Avastin, Herceptin, Xolair, Lucentis, Perjeta, Kadcyla, and Tysabri; and notes and other long-term receivables, royalty rights, hybrid notes/royalties receivable, and equity investments in healthcare companies. The Product Sales segment, through its equity and loan investments, manufactures, markets, and sells prescription pharmaceutical products under the Tekturna and Tekturna HCT names in the United States; and Rasilez and Rasilez HCT names internationally for the treatment of hypertension. This segment sells its products primarily to wholesalers.
Sequential Brands Group, Inc. (Nasdaq: SQBG) owns, promotes, markets, and licenses a portfolio of consumer brands in the United States and internationally. It offers products in the apparel, footwear, eyewear, fashion accessories, and home goods categories under the Jessica Simpson, AND1, Avia, GAIAM, Joe’s Jeans, Ellen Tracy, Emeril Lagasse, William Rast, Heelys, Revo, Caribbean Joe, DVS, The Franklin Mint, Linens N Things, SPRI, Nevados, and FUL brand names; and other categories under the Martha Stewart brand name.
Any or all of these stocks could be buys now. They could also be the starting point for your own Magic Portfolio investment portfolio that can be maintained in the future.