Live Interview with the founder of MagicDiligence

MagicDiligence is a service that provides research and opinions on Magic Formula stocks. Every two weeks the service provides a "Top Buy" pick, which is an MFI stock with durable competitive advantages. These "Top Buy" picks are then held for at least a year, and the service provides quarterly updates on them. Also, MagicDiligence provides 1-2 "Quick Takes" each week, which are research and opinion write-ups on current Magic Formula entries, for MFI investors who are interested in learning more about potential picks.

Nearly every review I read of The Little Book that Beats the Market, including yours, George, concluded with the opinion that Magic Formula Investing was a great resource for finding investment ideas, but research was needed before buying. I looked around for someone that provided this "missing link" and found nothing. So, I decided to start MagicDiligence to fill that gap and keep investors that decided to follow the MFI strategy away from the obviously bad picks.

There are really 3 common traits of bad MFI stocks. The strategy turns up fad stocks pretty consistently, and always once the fad has run it's course and is on the down side. Examples of this would be Heely's, NutriSystem, or Crox.

The second thing is similar - stocks in once good businesses that are in terminal decline. For example USA Mobility is a pager company. Pagers are clearly going the way of the dodo, and USA Mobility really has no backup plan. Or Gannett, who runs a bunch of newspapers. That's a business that's going to have trouble meeting it's fixed costs as ad dollars move to the Internet.

The third and final trait that MFI picks up are commodity stocks on the downside of the cycle. Cal-Maine Foods, an egg producer, has benefitted tremendously from record high egg prices. The inflated price of eggs has made Cal-Maine look like an extraordinarily profitable company, but in normal times the company struggles to pull a profit.

MFI investors want to choose companies that can maintain their high return on capital for long periods of time. This is what the great investors like Buffett, Munger, even Greenblatt do when they invest. Think of it this way - there are two ways a company can fall off the Magic Formula screen. Either return on capital deteriorates due to business weakness or the earnings yield falls due to price appreciation. Clearly, MagicDiligence wants the second outcome for MFI investors. By picking wide moat stocks, we protect against the deterioration of return on capital. The Magic Formula screen turns up both truly great companies and mirages like fads, inflated commodities, and declining businesses. MagicDiligence recommends the former and warns against the latter.

We're a fairly young service, starting in January of this year. Obviously, the market has been atrocious since then. As I look now (10/30), MagicDiligence's Top Buy portfolio is down about 23% vs. the S&P 500's drop of about 25%, so we're outperforming the market by about 2% over the first 10 months.

Interestingly, the Magic Formula overall has pretty significantly underperformed the market since about May. Most days since then I'm showing about a 5-7% underperformance against the S&P 500 ETF ticker SPY for the two screens MD uses (that's the top 100 stocks over 50 million and the top 50 over 2 billion). Value stocks seem to be out of favor during the current downturn, which is curious to say the least.

The performance against the un-researched Magic Formula screens has been even better than the performance against the S&P. By my last calculation, the Top Buys portfolio is outperforming the 100 over 50 million screen by about 4.5%, and the 50 over 2 billion screen by about 6.5%.

That's a good question and one I've thought about a lot. I think the first thing to realize is that the official site should be able to keep trucking for some time. Right now there is no monetization of it and there are plenty of opportunities if the need arose. The site has good traffic numbers and could easily make money through selling ad space. They could also make it a pay screen as it already requires a login. Plenty of buyers for the site may emerge also... So, I think the official site will be up for some time.

If it did close up shop, it wouldn't be the end of the world, either. There are a couple people that have created "unofficial" MFI ranking screens, some of which are very good and correlate well with the official one. The Little Book itself provides a formula for using widely available stock screens to approximate the Magic Formula using P/E ratio and return on assets or equity. MagicDiligence would use one of these methods, or potentially create a screen of it's own.

The Magic Formula screen certainly prefers certain kinds of industries and hates others. Consulting firms are very popular, especially on the small cap screens. Healthcare firms, especially pharamaceutical companies, are frequent entries. You find very few heavy manufacturing companies on the Magic Formula screen... it's just too hard for these companies to maintain high return on capital when there are so many capital expenditures and hard assets required.

Also, commodity and fad stocks are pretty common. Commodities are volatile, and you'll often see them appear in the screen coming off a cyclical high, which is usually a pretty bad time to buy. Fad stocks like Heely's, Crox, NutriSystem are common but always show up when their time in the sun is in decline. Acquisitive companies are pretty popular as much of their book value is in goodwill, which the Magic Formula subtracts out.

One other thing I've noticed is that the truly great MFI picks tend to stay on the screen for long periods of time, often years, while the poor ones fall out relatively quickly. This is great as it allows you to buy excellent companies at low prices and then hold them for longer periods of time.

I have pretty convincing data that confirms that the small cap screen does drastically outperform the large cap one (in aggregate) as Greenblatt illustrates in the book. I also have convincing data that the small cap screen is significantly more volatile and more prone to turn up huge losers.

The last thing I'll mention is that the best MFI picks are not necessarily the highest ranked ones. In fact, I would say that the stocks listed as ranked #25-100 are generally better investment opportunities than the ones ranked #1-24, regardless of market cap limitation. Value traps have a tendency to get cheaper than true quality companies!

Alex - as I mentioned in a previous answer, the Magic Formula has been underperforming the S&P since about May, at about a 5-7% clip. That underperformance has accelerated since Lehman went down on September 15. For September 16, the 100 over 50m screen has underperformed by 8.6%, and the 50 over 2 billion screen has underperformed by 7.3%. MagicDiligence was up on the market by over 10% heading into September, now we're only up 2%.

It's hard to explain why a strategy that throws out financial and insurance stocks is underperforming so drastically. But I think you need to keep a 3-5 year perspective. Over that period, I'm confident the strategy will continue to outperform.

The more I follow it, the more I think Greenblatt's modifications make a ton of sense and add a lot of value to traditional screening methods. I think MFI is the best stock screen out there for value focused investors. Using enterprise value instead of market cap makes it more difficult for debt-laden companies to show up. Subtracting out intangibles makes a fair comparison possible between a company that books intangible value, like Coca-Cola (KO), to be compared against one that doesn't, like Harley-Davidson (HOG). I've found that MFI also does a very good job at removing one-time events from operating earnings, which can skew both earnings yield and return on capital figures.

There are two things that I might suggest for a "Magic Formula 2.0", if you will. First, subtracting out goodwill makes companies that overpay for acquisitions look better than they should. Goodwill is, of course, the amount an acquirer pays above book value for a purchase. By removing this from invested capital, it makes it look like the acquirer never overpays, when actually they may not be efficiently investing shareholder capital in high priced acquisitions.

Second, and less important, it might be useful to use a 5-year average return on capital figure. This would help to weed out some of the short-term fad and commodity stocks. However, you would also lose some of the high quality spin-offs that occassionaly find their way into the screen.

As far as calculating intrinsic value, I do a discounted free cash flow valuation before recommending Top Buys. As you know though, DFCF involves a lot of assumptions about the future. I tend to keep it simpler - if I think a stock is quite undervalued based on what it has produced in the past, and it is likely to again reach that level of performance, then you are looking at a solid investment opportunity.

Commodities can certainly earn you a fair buck in a hurry if you can frequently time them correctly. The problem with buying them on the MFI screen is that they usually appear on the downside of the price cycle, and this can *cost* you a fair buck in a hurry!

There are many ways to be successful in the market. Commodity stock traders can do well with a short horizon, but very few commodity-based stocks have true competitive advantages by definition (commodity = no distinguishing factor other than price). MagicDiligence is looking for MFI stocks with durable competitive advantages.