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Sunday, December 18, 2016

A Reflection of My Experience in Magic Formula Investing

Author: kcchongnz | Publish date: Sun, 29 Jun 2014, 04:27 PM

A Reflection of My Experience in Magic Formula Investing

“The secret to successful investing is to figure out the value of something and then-pay a lot less”

Joel Greenblatt

I have written an article on the Magic Formula first made popular by Joel Greenblatt in the appended link below:

http://klse.i3investor.com/blogs/kcchongnz/51631.jsp

What Greenblatt did for his funds was finding good companies and bought them when they were selling cheap. This is in fact common sense in investing. He uses the return on capitals as a measure of how good a company is, and earnings yield as a benchmark to gauge if it is selling cheap. The metrics and the formula are as below.

  • Earnings Yield (EY) = EBIT / Enterprise Value
  • Return on Capital (ROIC) = EBIT / (Fixed Assets + Net Working Capital)

Greenblatt’s Magic Formula investing strategy outperformed the S&P500 by a wide margin for the 22 years from 1988 to 2009, with the sharp drop of the equity market in 2009 due to US sublime crisis included. It outperformed S&P 17 out of the 22 years and achieved a compounded annual growth of 23.8% as compared to the 9.6% of S&P.

The article above also explains why the strategy works and it did work even in an efficient market in US.

I copied the principle of the Magic Formula for investment in Bursa, a much less efficient market. I tried finding good companies in Bursa using high ROIC, figuring out their values with earnings yield, and tried paying a lot less to acquire them. I have written an article about my criteria for a good company and what is meant by “cheap” in my context as shown in the link below:

http://klse.i3investor.com/blogs/kcchongnz/45693.jsp

My Experience of the use of the Magic Formula

I have been using the principles of The Magic Formula picking stocks for a couple of portfolios of stocks in Bursa which were published in i3investors at the time of inception. The first portfolio as shown in Table 1 in Appendix was set up on 21st January 2013 with the prevailing return of capitals and earnings yields computed around middle of January 2013. My stock picks are shown in link below:

http://klse.i3investor.com/servlets/pfs/13147.jsp

Most of the stocks were selected with high return on capitals and Earnings yields as shown in Table 1. A ROIC of above 10%-12% would be considered as a good company, and EY > 15% is considered as selling cheap. Hence a combined score of 30 would signal a good buy meeting the Magic Formula principle.

Pantech and NTPM appear to be marginally acceptable investment base on the Magic Formula. However both appeared to have high expected growth then and NTPM has a stable and durable business. Hence even their score is not that high, they were both included in the portfolio.

A number of features were added to the two metrics of the Magic Formula intended to enhance the return of the strategy. Among them companies are preferably to have:
  1. Steady income for at least a few years.
  2. Healthy balance sheet with little or no debts
  3. Good cash flows from operations to confirm good quality of earnings
  4. Positive free cash flows
  • FCF>5% revenue preferable
  • FCF>5% Invested capitals preferable
  • Growth potential, preferable but best comes free

The intrinsic values of the stocks were estimated using discount cash flow analysis and the stocks only bought if the price is well below their intrinsic values, in other words, with a wide margin of safety.

The return of portfolio

After seventeen months, the return of this first portfolio is shown in Figure 1 and Table 2 in the appendix.

Figure 1: Stock returns



The followings are the salient points about the performance of the portfolio as at 27th June 2014.

  1. The portfolio of stocks returned an average of 88.7% for a holding period of 17 months; outperform the return of the broad market of about 18.3% by a very wide margin.
  2. There is not a single stock which had a negative return.
  3. The minimum return is 16.8% for Kumpulan Fima, and the highest 239% for Prestariang.
  4. There are three stocks having three-digit returns; Prestariang (239%), Pintaras Jaya (193%) and Jobstreet (103%).

Encouraged by the good results, another portfolio was set up by me at the beginning of August 2013, basically also using the principles of the Magic Formula. The portfolio only consists of two old stocks, Kumpulan Fima and Pintaras Jaya, and nine new stocks. The stock picks with detail analysis and write up are shown in the link below:

http://klse.i3investor.com/blogs/stock_pick_challenge_2013_2h/blidx.jsp

After 10 months returns of the stocks and the portfolio are as shown in the link here.

http://klse.i3investor.com/servlets/pfs/21089.jsp

The followings are the salient points about the performance of the portfolio after 10 months as at 27th June 2014.
The portfolio return a total gain of 50.7% for a holding period of 10 months as shown in the link above, outperformed the broad market of 6.1% also by a wide margin.
There is only one stock with a small negative return, at just -4.3% for Tien Wah.
There is only another stock which underperformed the market in Haio, which return 2.6%.
There is a multi-baggers in Datasonic with a return of 196%. And the rest are all double digit gains.

I certainly have very good experience in using the magic formula investing, ie buying good companies when they are selling cheap.

Aren’t you interested in using this proven strategy to invest for long-term in the equity market to build up your wealth and for financial freedom? Aren’t you interested in learning some fundamental investing in order to get better investing outcome?

I have been carrying on an online finance and investment course for about two months already. I can say there are many satisfying participants in my course. A number of them can already perform all those analysis and valuation mentioned above. But to me the more important thing those participants would know what to do is to avoid the lemons in the stock markets now with their knowledge in financial statement analysis.

Recently a number of i3investor forumers expressed their interest to join my course. As a result, I have decided to start a new one beginning of July 2014.

Anyone interested please contact me asap at ckc14invest@gmail.com.



KC Chong (29 June 2014)


Appendix
Table 1: ROIC and EY during portfolio inception
Stock
Price
ROIC
EY
Total score
Kfima
2.02
21.6%
26.0%
47.6
Pintaras
1.56
29.3%
19.5%
48.8
ECS
1.06
25.2%
33.1%
58.3
Plenitude
1.85
12.9%
60.0%
72.9
Jobstreest
1.2
253.0%
14.0%
267.0
Pantech
0.78
9.1%
12.1%
21.2
SKPRes
0.340
28.6%
33.9%
62.5
NTPM
0.47
12.4%
10.0%
22.4
Kimlun
1.25
22.8%
15.9%
38.7
Prestariang
0.605
150.0%
7.8%
157.8


Table 2: Portfolio return

Date
1/21/2013
6/27/2014



Stock Name
Ref Price
Price now
Dividend
Gain
% gain
Kfima
2.02
2.27
0.08
0.330
16.3%
Pintaras
1.56
4.38
0.185
3.005
193%
ECS
1.06
1.37
0.13
0.440
41.5%
Plenitude
1.85
2.79
0.06
1.000
54.1%
Jobstreest
1.20
2.37
0.06
1.230
103%
Pantech
0.78
1.07
0.11
0.400
51.3%
SKPRes
0.34
0.555
0.035
0.250
73.5%
NTPM
0.47
0.835
0.05
0.415
88.3%
Kimlun
1.25
1.62
0.05
0.420
33.6%
Prestariang
0.605
1.90
0.16
1.455
240%

    

Average
    
89.4%
FTSE Mid70
12294
14190
369
2265
18.4%
KLSE
1632
1881
49
317
18.3%


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