Interactive Investor

Ten ‘magic formula’ stocks for investors looking for value and quality

This value investing method is not good for the impatient, but long term it can hold up well, Ben Hobson.

30th September 2020 14:27

Ben Hobson from Stockopedia

Joel Greenblatt’s value investing method is not good for the impatient, but long term it can hold up well, Ben Hobson argues.

Value investing has had a rough ride over the past 10 years. The part-art, part-science discipline of buying stocks that are cheap relative to what they earn or what they own is a well-worn strategy, but it’s also a painful one when it’s out of favour.

Over many decades, statistical research shows undeniable outperformance from value strategies over time. But between periods of market-beating returns, value has spells in the wilderness. It’s these moments of agony that mean many value investors - professionals included - struggle to stick with their strategies. And this is what we have seen over the past decade.

Back in 2005, an American investor called Joel Greenblatt came up with a new kind of value strategy that still resonates with investors today. In The Little Book That Beats the Market, he set out an approach that blends value with quality and ranks the entire market for how relatively good and cheap each stock is.

With this approach, Greenblatt said investors could easily find companies that might be genuinely underpriced. Sure, the list would often contain broken and unloved shares. And given that this was still a value strategy, there would certainly be disappointments. But his so-called magic formula would offer a higher probability of success.

A model of the magic formula strategy applied to the UK market shows just how good - but also how variable - the results can be. Between 2017 and 2019 it delivered reasonable returns, but like many other strategies, the market crash of 2020 hit it hard.

Since then, we’ve seen a steady recovery in the performance of magic formula stocks. Moreover, at a time of market uncertainty, it could be an interesting place to start looking for quality shares that are on sale.

How the magic formula works

Greenblatt’s strategy uses two simple ratios: the earnings yield as a measure of cheapness and return on capital as a measure of quality.

Earnings yield tells you how much profit a company is making in relation to its underlying value. To take account of varying levels of cash and debt in companies, a widely used way of working it out is to divide what the company earns in operating profit by its total valuation (known as the enterprise value).

You can then apply this earnings yield to every company in the market to see which are offering the best value – the higher the yield, the cheaper the company and the more bang you get for your buck.

The return on capital focuses on how good a company is at generating a profit from the investment it makes in itself. Good quality companies are very efficient at delivering high percentage returns from the cash they reinvest to grow.

It might be opening new stores, expanding product lines or buying new plant and equipment. The return on capital is the percentage improvement in profits relative to that investment. That makes it a leading indicator of good quality companies that can grow profitably.

Greenblatt’s strategy scores every company on each ratio and then adds the scores together to get a magic formula for each one. The beauty of this approach is that you can rank the market for companies with the best blend of cheapness and quality and always find results. Here is a selection of the current highest-ranking shares:

Name Mkt Cap Magic formula (%) ROC Greenblatt (%) Earnings Yield (%) Relative Strength 
(% 6m)
Smart Metering Systems 706.4 99.1 58.3 31.41 -12.1 Technology
PayPoint 416.3 99 224.3 14.49 3.65 Industrials
Sylvania Platinum 165.7 98.9 52.4 34.58 47.3 Materials
Appreciate 50.9 98.9 60 24.99 -28.7 Industrials
Connect 45.9 98.6 57.4 20.24 -4.91 Cyclicals
Somero Enterprises 145.1 98.5 91.2 15.17 25.3 Industrials
Novacyt Sa 365.6 98.3 182.6 12.33 178 Healthcare
Puretech Health 758.4 98.3 37.6 43.5 7.07 Healthcare
Metal Tiger 37.5 98.3 45.7 23.17 108 Financials
Bushveld Minerals 126.8 98.2 36.8 39.85 10.4 Energy

In bullish conditions, the magic formula screen results can sometimes leave you recoiling. But in these markets, the highest ranked shares have been shaken up. Currently we’re seeing larger and, at times, more mature businesses qualifying - names such as Smart Metering Systems (LSE:SMS), PayPoint (LSE:PAY) and Puretech (LSE:PRTC). Small-cap mining and resource-oriented shares like Sylvania Platinum (LSE:SLP), Metal Tiger (LSE:MTR) and Bushveld Minerals (LSE:BMN) are also up there, as are some long-term magic formula plays like Appreciate (LSE:APP) (formerly Park Group) and Connect (LSE:CNCT).

Waiting for the magic to happen

In the years since Greenblatt introduced the magic formula, there has been a lot of analysis about how (and whether) this approach to stock picking really works. He always acknowledged that it was a difficult strategy for investors to follow consistently because, he said, it lacks excitement and requires patience.

That’s an observation that can be applied to many value-focused investing strategies. But in recent months, the magic formula has shown that it can hold up well - and find interesting ideas - in uncertain markets.

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