Magic Formula Part 2

If this is your first visit to Three Grahamian Virtues, please take a moment to read the welcome message and site philosophy: http://3gv.blogspot.com/2006/01/welcome-and-3gv-philosophy.html

Magic Formula companies come in different shapes and sizes, some demonstrably better than others. For this reason, I believe that investors can weed out highly rated Magic Formula companies which have justifiably lower expectations. A very simple notion is to look at long-term track records of returns on capital. A quick examination of Magic Formula companies shows that many actually have poor long-term profitability, others seem to be on the upswing over the last few years, and others have enjoyed very high ROC for many years. For my purposes, I chose to divide them into three categories called Wheat, Chaff, and Germinators. Rather than ROC (which is cumbersome to compute manually and not readily accessible on a year-by-year breakout from the free finance sites with which I am familiar), I use Return on Total Assets (ROA). As a threshold for classifying a company as good, I chose a 10% ROA.

• Wheat companies have five or more years of ROA above 10%.
  
• Chaff have only excelled in the past twelve months.
  
• Germinators have had high ROA for two to four years.

I'm inclined to believe that the long-term outperformers have the most staying power, the greatest chance of reversion to the mean, and best expected return. However, I'm willing to give credit to the Germinators as they may permit investors to buy companies that are fundamentally improving in a permanent way (but whose valuations may not have caught up with the improving long-term prospects). It's hard for me to get excited about the Chaff, because these strike me as one hit wonders that will quickly fall back into the pack.

On this basis, I examined the top 25 Magic Formula companies. Here's how the chips fell:

1. WHEAT Block H & R Inc HRB
   
2. WHEAT Cherokee Inc CHKE
   
3. WHEAT Deluxe Corp DLX
   
4. WHEAT K-Swiss Inc KSWS

1. GERMINATOR Anika Therapeutics Inc ANIK
   
2. GERMINATOR Callwave Inc CALL
   
3. GERMINATOR Forward Industries Inc FORD
   
4. GERMINATOR Grubb & Ellis Co GBEL
   
5. GERMINATOR Infospace Inc INSP
   
6. GERMINATOR Innovative Soltns & Supp Inc ISSC
   
7. GERMINATOR Kos Pharmaceuticals Inc KOSP
   
8. GERMINATOR Mannatech Inc MTEX
   
9. GERMINATOR Marvel Entertainment Inc MVL
   
10. GERMINATOR New Frontier Media Inc NOOF
    
11. GERMINATOR Vaalco Energy Inc EGY

1. CHAFF Catapult Communications Corp CATT
   
2. CHAFF Cbs Corp CBS
   
3. CHAFF Ftd Group Inc FTD
   
4. CHAFF Intervideo Inc IVII
   
5. CHAFF Jakks Pacific Inc JAKK
   
6. CHAFF King Pharmaceuticals Inc KG
   
7. CHAFF Korn/Ferry International KFY
   
8. CHAFF Magellan Health Services Inc MGLN
   
9. CHAFF Phoenix Technologies Ltd PTEC
   
10. CHAFF Vertrue Inc VTRU

So, now we have enough to construct four portfolios: an index of the top 25 Magic Formula businesses, and baskets of companies from within the index that represent varying track records of performance: flashes in the pan, up and comers, and long term over-achievers.

Magic Formula Index
Inception Date 12 Jan 2006
ANIK.........$10.97

CALL.............4.71 ]

CATT...........14.57

CBS..............25.99

CHKE..........35.00

DLX.............30.86

EGY...............4.74

FORD..........10.72

FTD...............9.60

GBEL...........13.36

HRB.............25.50

INSP............23.75

ISSC.............13.48

IVII..............11.08

JAKK...........20.05

KFY..............19.53

KG................18.76

KOSP...........47.97

KSWS...........30.21

MGLN..........31.83

MTEX..........12.49

MVL.............16.50

NOOF............6.50

PTEC.............6.48

VTRU..........35.97

Wheat Basket
Inception Date 12 Jan 2006
HRB.............25.50
CHKE..........35.00
DLX.............30.86
KSWS...........30.21

Germinator Basket
Inception Date 12 Jan 2006
ANIK.........$10.97
CALL.............4.71
FORD..........10.72
GBEL...........13.36
INSP............23.75
ISSC.............13.48
KOSP...........47.97
MTEX..........12.49
MVL.............16.50
NOOF............6.50
EGY...............4.74

Chaff Basket
Inception Date 12 Jan 2006
CATT...........14.57
CBS..............25.99
FTD...............9.60
IVII..............11.08
JAKK...........20.05
KG................18.76
KFY..............19.53
MGLN..........31.83
PTEC.............6.48
VTRU..........35.97

I will periodically update the performance of these portfolios and compare them against each other, against other formula-based investment methodologies that I will present later, and against the S&P 500. I will "sell" the portfolio after a year. Each quarter, I will construct an additional index and baskets and track them, as well.

- Ian