Dec 2008 Picks: VCLK, DELL, ACN, KFY, ASF

MFF1 picks: VCLK, DELL, ACN
MFF2 picks: VCLK, KFY, ASF

Performance details for Month 17

As of 12/2/2008, my 17 month old Magic Formula Fund (MFF1) is trailing the SP500 by 0.19% (2.65% annualized). This is down from a month ago of beating the SP500 by 1.74% (0.98% annualized). My second fund, the 3 month old MFF2 fund, is trailing the SP500 by 10.80%. Click on the images below to see further details for MFF1.

Nov 2008 Picks: DAR, DHX, PRFT

Here are my November picks for both MFF1 and MFF2:

DAR, DHX, PRFT

Performance details for Month 16

As of 10/31/2008, my 16 month old Magic Formula Fund (MFF1) was beating the SP500 by 1.74% (0.98% annualized). This is down significantly from a month ago of 8.47% (11.32% annualized). In the meantime my second fund, the 2 month old MFF2 fund, is trailing the SP500 by 8.32%. Click on the images below to see further details for MFF1.

Below is a graph that shows the delta of annualized returns for MFF1 vs SP500 in the last 3 months. Obviously one cannot conclude much from this volatity for or against the premise of Magic Formula.  I am still optimistic that the Magic Formula could work in the long run. I certainly intend to continue testing it for a while.

Oct 2008 Picks: EBAY, CALM, CF

Here are my October picks:

MFF1: EBAY, CALM, CF

MFF2: EBAY, WFR, KBR

I was a bit late in picking my October stocks. I usually try to pick my stocks within the first 10 days of each month. I will try to stick to that rule going forward.

I have not had much time to research my above picks because I have been spending my "investing time" reading another best seller investing book called "Rule No.1" by Phil Town.

I will continue to run my two Magic Formula Funds. I am thinking of starting one other fund in which I plan to hold a maximum of 6 really-well-researched positions as advised by Phil Town in his Rule No.1 book. 

I have been spending most of my time following his advice to identify a few winners. I plan to commit up to 50k to that fund. I have not yet identified any winner stocks for this new fund which I will call - RULE1. 

Btw, MFF2 is doing horribly so far. Given the craziness of the markets of last 2 weeks, it has been beaten down really badly. I think it is still too early to deduct any conclusive ideas given its short life time and the crazy few past weeks. As of Oct 13 market close (after a historic and record breaking 10% up day), my MFF2 (which started its life on Sep 5, 2008) is down 25.05% (versus SP500 which is down 18.54%). So I am lagging the SP500 by 6.50% on a straight basis. I am not even calculating annualized numbers for this fund at this point.

The performance of my MFF1 has also suffered majorly in the last 2 weeks. MFF1 is now beating the SP500 only by 2.78% (2.39% annualized).

Performance details for Month 15

I am posting this update 13 days late. Given the crazy behaviour of markets in the last 2 weeks, I am not even sure if this is even relevant any more. But here are my results anyway.

As of Sep 30, 2008, my MFF1 was beating the SP500 by 8.47% (11.32% annualized).

Sector breakdown analysis of my Magic Formula Fund

About a month ago, some friends were suggesting that perhaps the reason that my Magic Formula Fund (MFF1) is outperforming the Market (S&P 500) is simply because Magic Formula explicitly avoids purchasing any Financial (Banks, Insurance Cos, Mutual Funds, etc) and Utilities stocks. (The underlying reason for this is explained in some detail in the Little Book. I will not get into it here.) I was intrigued by my friends' arguments. So I did some analysis.

I was able to find that the Finance and Utilities sectors made up about 15% and 4% of the S&P. Here is a breakdown of all sectors:

source: http://quicktake.morningstar.com/etfnet/Snapshot.aspx?Country=USA&Symbol=IVV


And, in the last 14 months, the performance for the finance and utilities sectors have been about -20% and +12% respectively.

source: http://stockcharts.com/charts/performance/SPSectors.html


So the combined effect of those 2 sectors on the S&P500 index has been about -2.52% ((0.15 x -0.20) + (0.04 x 0.12)). Still quite short of the 10%+ difference my Magic Formula Fund has achieved so far.

Going through this exercise made me to look into my own Magic Formula Fund's sector breakdown in more detail. Below is the details of my analysis (as of about 1 month ago)  which suggests that I have invested more heavily in certain sectors than a S&P500 distribution would suggest.

Yellow colors indicate the number of stocks (out of 36) that I should have allocated to each sector. The green colors display the actual positions that I took in each sector. So I am heavy on the Service Sector (especially Business Services) and light on Manufacturing and Information sectors.

I have taken these facts into account in my last month's picks, and I plan to follow similar thinking during the upcoming months. I will try to balance out my portfolio's sector distribution similar to the S&P500's. After all, I would like to beat the S&P500 index with as close a sector distribution as possible.

Having said that, I am fully aware that sometimes the nature of the Magic Formula approach will favor certain sectors over others simply because a sector is beaten down and it just offers many good opportunities to buy good companies at cheap prices. And I might just take advantage of those opportunities.

I just upped the ante!

Since my initial Magic Formula Fund is doing so well, I decided to start a second MF fund.  So on last Friday, I sold all assets in my current retirement account (~$142k) and invested them in 36 hand picked MF stocks. I will call this new group of stocks my second Magic Formula Fund - MFF2. There is about a 80% overlap with my initial Magic Formula Fund (MFF1) stocks. 

After 4 days, my MFF2 is lagging the market by about -0.13%.  Here are the details on my second fund's (MFF2) positions:

My approach in my second fund is a little different than the one I followed in my first fund (and the one mentioned in the Little book). The book suggests to invest equal amounts each month (or quarter) for a full year and then to cycle out and in each period going forward.

I had followed this approach in my first fund (MFF1) as it took me a full year to reach approximately 36k of invested capital  in 12 months. ~36 positions of ~1k each, about 3 positions per month. And after the 12th month, I have been cycling out 3 stocks ea month and investing in 3 new ones. 

In this 2nd fund (MFF2) I committed all 36 positions at once (each position is about $2750). The question is how should I cycle them out? 3 each month starting at month 1 or month 13 or month 7? And which ones should I cycle out first? Worst performers? Or randomly?

I think I will start cycling out 3 stocks starting at month 1. I am thinking of cycling out the worst performers first.  But before deciding on this 100%, I will do a little bit more analysis on how the bad performers of month1 of MFF1 did during the rest of the year. 

Sep 2008 Picks: VSNT, ROK, VLCM

ROK - First identified last month. Looks like a strong company with solid fundamentals.
VSNT - Looks like a decent software company. Probably should have asked my friends Andy and Matt what they think of this company before buying it...
VLCM - cool products. Plus, I wanted to increase my exposure in consumer goods sector.


Also considered but passed:
BR - currently affected from the downturn in finance sector, otherwise good company.
PRXI - too small, not great track record for the time they have been public.
VCLK - not growing in a growing market. Somethings must be fundamentally wrong. Not sure if the next big Internet company will be a potential acquirer for this ad network.
MDP - Looks like a decent Media company. Maybe next month.
CF - Looks like a solid company. Maybe next month.
MSFT - Very interesting fact I noticed while I was looking more deeply in Microsoft. Their stock has pretty much been flat for the last 10 years, despite decent profit growth. Having said that, I am not sure if the future looks bright for MSFT. So I will pass for now.

Which index to benchmark against?

Some people suggested that I should not compare my results only against the S&P500 index, but I should compare them against a number of indexes, especially the Small and Mid Cap indexes as most of my stocks fall under those categories. I just did that analysis.

As you can see in the below graph, the leading indexes were all down anywhere from -9% to -15% in the last 14 months. During the same period, my Magic Formula Fund has returned 0.45%. So far my Magic Formula Fund is beating all major indexes by at least 10%. Not bad.

Indexes:
S&P500 index (S&P500)
S&P 600 Small Cap index (.SPCY)
S&P 400 Mid Cap index (.IDX)
Russell 2000 index (IWM)

Performance details for Month 14

As of 8/31/2008, my 14 month old Magic Formula Fund was beating the SP500 by 7.72% (14.45% annualized). Click on the images below to see the further details.

Same data better graph

Some people suggested that the graphs I used in my previous posts were not so easy to understand. I agree.

Here is a better look at the same data. The below graph shows the basic and annualized returns for my Magic Formula Fund versus similar timed investments in the S&P500 index.

How do I know if my Magic Formula Fund will continue to beat the market?

16.84% is by how much my Magic Formula Fund is beating the S&P500 as of today. How do I know if my Magic Formula Fund will continue to beat the market?

I don't. Nobody does. Actually many people argue that when more than one person knows about a back-test-proven system (like the Magic Formula method), the system would not longer work because of the efficient market theory.

So since the Magic Formula has been out and public for 2 years (and is somewhat popular), people even claim that there are anti-Magic Formula funds that do exactly the opposite of the Magic Formula method - shorting MF recommendations.

On a related but opposite note, I also heard that, in the last year some investment banks started their own internal Magic Formula funds and are outperforming the market with long/short positions following the MF method.

So to answer the question, I don;t know for sure that the Magic Formula will continue to work for me in the long term. So far it has been working well. Therefore I will continue to invest, test, and tweak as long as it is outperfoming the market on average.

As of 8/16/2008, my Magic Formula Fund is beating the S&P500 index by 16.84% (annualized):

In the past 13.5 months, I invested 35,961.89 following the Magic Formula method, and my fund's asset value is now (as of 8/16/2008) 36,595, representing a 1.76% return (4.69% annualized). If I had invested the same amount into an S&P 500 index fund, my asset value would have been $33,745 representing a -6.16% return (-12.15% annualized).

Since Magic Formula is working well for me, I am thinking of starting my second Magic Formula Fund. This time I plan to invest 3 x $3000 each month, reaching $144,000 in invested assets within 12 months.

This will be a fun experiment and exercise testig the validity of the Magic Formula method as well as my investment skills. I will follow the Magic Formula method, but then I will try to take that to a higher level by picking my own picks amongst MF recomendations, rather than randomly picking any 3 stocks from top 100 each month as the MF suggests.

How does the Magic Formula work?

Here is one of the best short descriptions of Magic Formula that I was able to find on the web:

The Magic Formula has only two inputs:

1) Return on capital -- defined as EBIT/[Net Fixed Assets + Working Capital]

2) Earnings yield -- defined as EBIT/EV

The rationale is straightforward. Buy shares in:

1) Profitable businesses (measured by return on capital)

2) Only when they're available at bargain prices (defined as a high earnings yield)

The magic formula looks for companies that have the best combination of earnings yield and return on capital, with each input weighed equally.

Magic Formula ranks the universe of about 10,000 public US and Canadian Stocks on both criteria. If an outstanding company with an expensive stock ranked, say, first for return on capital but 1,999th on earnings yield, would have the same combined ranking of 2,000 as a low return on capital company within expensively priced shares, ranking 1,999th in return on capital but first on earnings yield.

Using this approach to create a regularly updated portfolio of about 36 stocks with the highest combined rankings, Mr Greenblatt tested his formula between 1988 and 2004. The results were remarkable: with only one down year, the magic portfolio would have returned 30.8 per cent a year, against a 12.4 percent annual return for the S&P 500.

Mr Greenblatt has created a free website that ranks stocks based on his approach (www.magicformulainvesting.com).

Source: http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471733067,descCd-reviews.html

What is a Magic Formula Fund?

Magic Formula is an investing methodology of Joel Greenblatt, described in detail in his WSJ best-seller book called The Little Book that Beats the Market. The Little Book is recognized as one of the best books written on value investing. I first read the Little Book about 13 months ago.

Shortly after reading it, I started a mini Magic Formula Fund with my own $36,000 ($35,961.89 to be exact). Now 13 months into it, I am beating the market by 5.64% (12.16% annualized). Here is what an Amazon.com reviewer has to say about the "The Little Book that beats the Market":

"The beauty of the Little Book is as follows:
1) It is simple.
2) It works.
3) Most investment professionals cannot follow the Little Book's strategy and that makes this strategy one of the only instances where small investors have a HUGE advantage over professionals.
4) The people who have recommended this book are some fothe most successful investors in the history of Wall Street."

Aug 2008 Picks: KFY, ARP, THO

KFY - Did well in last 12 months vs SP500. Still in MF territory. I am holding it for next 12 months.
ARP - mature market, growing by acquisitions.
THO - stable company, mature market, leading mkt share.

Also considered but passed:
LOJN - will lose out to GPS devices in the long term.
APKT - Did not understand what they did.
UEPS - Risky market initiatives (Iraq etc).
ROK - Looked good, maybe will buy next month if still in MF territory.
NTRI - Not sure if they are investing in R&D. Seems like Mkt costs are starting to eat into profits.
GYMB - I don' like retail plays.
CUTR - Lost my shirt on this last year. Might do well in next 12 months, but not a long term winner I think.

Performance details for first 13 Months

As of 7/31/2008, my 13 month old Magic Formula Fund was beating the SP500 by 5.64% (12.16% annualized). Click on the table below to see the performance details for each position.

Beating the SP500 by 12.16%

As of 7/31/2008, my 13 month old Magic Formula Fund is beating the SP500 by 5.64% (12.16% annualized). Click on graphs to see detail.