Joel Greenblatt's Magic Formula Investing (MFI) strategy is a very simple but very effective design. The two screen components are
earnings yield (basically the inverse of P/E, using operating earnings) and
return on capital. Stocks with a high earnings yield indicate that they may be under-priced based on past levels of profitability. Stocks with high returns on capital indicate good businesses - ones that possess some kind of competitive advantage, be it structural or managerial, that allows them to earn outstanding returns on shareholders' capital. Combine the two and you get "good companies at cheap prices" - a winning investment recipe, proven through
numerous back-tested studies to outperform the market at large.
However, any experienced investor can spot obvious frauds just by perusing the top 50 stocks on the official MFI screen for any given day. Simply because of the way the MFI screen components are calculated, imposters can find their way into the list. Some examples of these imposters are: heavily cyclical commodity stocks after a boom period; fad stocks with no second act that have outlived their year or 2 in the sun; declining businesses in run-off mode with little hope of future growth; and firms that grow exclusively through expensive and risky acquisitions that are hidden by the MFI tactic of removing goodwill assets from return on capital calculations.
MagicDiligence feels there are very few outright terrible choices on the MFI screen - usually a cheap stock price alone gives the investor some reasonable expectation of a profitable investment. And there are numerous "lottery tickets" in MFI - small pharmaceutical companies betting the bank on one or two developmental drugs are just one example of a pick that could earn 500% or more, or go bust. However, the best long term MFI performance is going to come from choosing the truly great businesses that get cheap enough to make enticing investments. So, when analyzing MFI stocks, these three factors are the main things MagicDiligence looks for. They are not the only considerations, but a stock meeting all 3 of them is in most cases an interesting choice for a one year MFI position:
1) Growth Potential
Stocks with low growth potential get tagged with a low P/E ratio (or high earnings yield) - simple as that. This makes sense, of course. Without revenue growth, there is only so much management can do to increase profit margins, the only way to grow earnings.
