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.