THE ‘MAGIC’ FORMULA FOR STOCK SELECTION

 

 

(Source : Cartoonresource/Shutterstock)

 

Stock Selection

 

Is there a ‘magic’ formula for selecting stocks? I came across one in a book titled ‘The Little Book That (still) Beats the Market’ .  We have all heard of the methods of the legendary investors like Warren Buffet, Charlie Munger, Seth Klarman. How they buy stocks quoting well below their intrinsic values. Concepts like ‘margin of safety’ while buying any stock have been talked about and written about almost everywhere. Also the reference to Benjamin Graham and his methods is universal. The trillion-dollar question is, how does an investor  understand whether a stock is under, over or fairly valued. Joel Greenblatt addresses the issue in a very lucid way, in the book mentioned above. I thought it was a good idea to share it with the readers of this blog. I strongly recommend reading this book, it is written for you and me, people who do not like too much of accounting mumbo- jumbo. The ‘magic’ formula helps us find above average companies at below average prices. In the book the author gives us a ‘magic’ formula, whereby one can select stocks which combine both these features, i.e. great businesses at reasonable valuations.

The Magic Formula

 

 The ‘magic’ formula uses just two variables – Return on Invested Capital and Earnings Yield. The ‘magic’ formula integrates these two variables and arrives at a list of stocks which are  ‘good’ and ‘cheap’.  It is basically a ranking formula. The method adopted for using the ‘magic’ formula can be summarized as follows:

1. The first step involves ranking all the stocks according to their Return on Capital (ROC). This ratio is freely available. In layman terms,  ROC is the rate at which the company can invest its own money in its business. The method involves giving a rank to all companies based on their ROC, so the company with the highest ROC gets a rank of 1 and so on and so forth.

• The next step is to rank all stocks according to their Earnings yield. The Earnings yield is the reciprocal of the Price Earnings (P/E), which almost all investors are familiar with. So the company with the highest Earning yield gets a rank of 1, the next 2 and so on.
• The third step involves combining these two rankings and arranging them in ascending order. This ensures that companies with the highest ROC, and the highest Earnings yield, are at the top of the heap. So if a company has a rank of 1 in the ROC metric and rank of 20 in the earnings metric it will have a combined rank of 21.  In other words companies with a high-ranking in both the categories are winners.
• The book talks about investing in the top 30 companies in the list arrived at in step no 3.

I proceeded to apply the ‘magic’ formula to the benchmark CNX Nifty, CNX Small Cap and CNX Midcap indices. The top 20 stocks using the ‘magic’ formula are shown below:

SMALL CAP

MID CAP

NIFTY

SYMBOL	CMP	SYMBOL	CMP	SYMBOL	CMP
DEEPAKFERT	153.20	BRITANNIA	1242.90	NMDC	169.55
ALOKTEXT	12.70	EICHERMOT	9755.95	CAIRN	326.25
GMDCLTD	145.45	BATAINDIA	1278.00	COALINDIA	356.10
ROLTA	104.35	GSKCONS	5332.60	BPCL	694.30
MOIL	295.30	APOLLOTYRE	165.30	GAIL	443.40
NIITTECH	359.60	PGHH	5303.85	TATASTEEL	513.15
HEXAWARE	159.90	SANOFI	3040.80	BAJAJ-AUTO	2258.70
GUJRATGAS	446.30	CROMPGREAV	194.75	WIPRO	565.25
MUTHOOTFIN	195.60	AMARAJABAT	552.15	HCLTECH	1630.75
ECLERX	1360.25	EXIDE	162.90	LUPIN	1285.40
AJANTPHARM	1589.95	CMC	2150.75	ONGC	435.00
DHFL	356.65	KANSAINER	1616.70	INFY	3598.80
SJVN	24.05	BHARATFORG	791.70	TCS	2522.35
FDC	159.15	MRF	24030.95	NTPC	137.40
TATACOFFEE	898.40	ARVIND	286.70	TECHM	2363.00
SINTEX	72.95	CRISIL	1895.25	DRREDDY	2947.90
ZYDUS	612.55	MAX	325.50	HEROMOTOCO	2604.80
PFIZER	1422.95	SHREECEM	7889.50	RELIANCE	998.70
GNFC	85.90	PIDILITIND	410.50	IDFC	144.25
AIL	487.15	MOTHERSUMI	371.95	ITC	355.30

There is a school of thought that says that this ‘magic’ formula works better with small and mid cap stocks. Please note, I have not adjusted the earnings in the calculation above. In other words the historical data has not been adjusted for abnormal items.

Pros

• With the index trading at new highs this ‘magic’ formula, if used judiciously, can  throw up neglected stocks which may not yet have been discovered by the market. In other words, one can discover pockets of value which have gone unnoticed.

• There is an in-built ‘safety net’ in this ‘magic’ formula, since you will end up buying only those companies which are high on earnings and are yet trading at cheap multiples.

• This formula tends to throw up companies which are being viewed with a lot of skepticism by investors, albeit temporarily. This happens many times, particularly when a company reports bad quarterly numbers, or the price suffers on account of a bad news report.

• The ‘magic’ formula talks of owning 30 stocks, then reviewing their performance, and making portfolio adjustments. This ensures that one’s portfolio does not get unwieldy. In my opinion, even 30 is too large a number, but that is the maximum, you can say. Each investor can tweak this number to suit himself, as long as he does not vitiate the basic principles of the  ‘magic’ formula.

• Are we buying a good business or a bad business? The ‘magic’ formula ensures that you buy good businesses at bargain prices. This is the ‘Magic’ in the formula.

 

Cons

 

• The ‘magic’ formula looks at historical data. This may not correctly predict future earnings. After short listing the stocks, investors will have to take a call on  the future prospects of the companies that are short listed. In other words, investors will have to filter the data to see if any abnormal or non recurring items are reflected in the past data. To a certain extent, this criticism is valid.

• There is a criticism that the formula tends to pay too high a price for quality. This, in my opinion, is not correct. Since, in the current scenario stocks of quality companies are trading at abnormal valuations, thereby justifying the use of the ‘magic’ formula.

• The definition of Earnings Yield and Return on Capital are critical to the efficacy of the ‘magic’ formula. Hence, one should ensure that this is adhered to.

• The formula has to judged in the long-term (3 to 5 years). This is a valid. The formula does not work in the short-term. This, however, applies to all methods of stock selection. In fact investment in stocks is a long-term idea and not for the short-sighted. The unpredictable nature of the market and peer pressure make it difficult to stick to a strategy which may not work in the short-term. That is the reason the ‘magic’ formula works. Everyone does not use it, due to it being a long-term strategy. If everyone started using it, it would not work!! Most people invest money in stocks that are expected to move in the short-term. Investors will have to stick to the strategy for a minimum period of 3 years. They can do a yearly review, but not before that. A very important lesson to be learnt from this ‘magic’ formula, is the principle, that if you buy a good business, the market will agree with you. This can typically take two to three years.

 

Conclusion

 

With the market being what it is, and where it is, one of the most important things that an investor has to get right is the selection of stocks in his portfolio. There are many instances where the benchmark indices have moved up, but the stocks in our portfolio just don’t budge (sometimes they go down!!). Hence, for investors who invest directly into the secondary market, the process of stock selection is critical. There are many ways of stock selection, but there is no foolproof method which can guarantee success. Also, there is an element of luck involved. Apart from selecting the stock, the timing of the buy and sell decision is equally critical. The ‘magic’ formula does achieve the following:

•  I do not think, currently investors use any method for stock selection. With this in mind, I think this formula is a good way to start. One has to be careful while using this formula. Why? Investors tend to use their own biases while selecting the eligible stocks, this is not allowed. The method has to be followed by rote, there is no other way to unlock the ‘magic’ in this formula.

• Is there any ‘magic’ in the formula? Actually no. What the formula effectively does is to inculcates a diversified and patient approach into the investment process. It is a fantastic timing tool. 

• The formula has been back tested extensively. Hence, I have no doubt in my mind that the ‘magic’ formula, used judiciously, will end up beating the indices in the longer term.