Magic Formula Part 3

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

This continues the series wherein we poke, prod, and tease out the best stocks churned up by Greenblatt's Magic Formula. Real-time picks here; we're testing this stuff!

This installment covers what I will call the Modified Magic Formula (MMF). It derives from the wise words Greenblatt directed toward those wishing to find the best the MF has to offer. In picking out stocks from our MF universe, I attempt to improve the earnings component of the earnings yield by "normalizing" them to reflect earnings under more regular circumstances (as opposed to last year), and give them an added dimension of information content by accounting for capital intensity.

For this exercise, we will take the average operating cash flow margin of the last three fiscal years, not counting the trailing twelve months (though, depending on the time of year in which we do this, the last fiscal year may overlap the trailing twelve months somewhat -- this is a simplistic way to capture a more normal operating environment's earnings potential, so roughly right will do). We will do the same for capital expenditures, and then attempt to approximate maintenance CapEx by cutting this in half (to hopefully reflect steady-state reinvestment needs). This normalized free cash margin will be applied to current revenues to produce the earnings figure we will work with.

Finally, we will rank the top 25 MF stocks constituting our MF index fund by an earnings yield of Normalized Earnings-to-Enterprise Value and "buy" the top ten. If the concepts of normalized earnings and capital intensity hold any water (and they are central tenets of value-oriented investing), then we should improve upon the index.

Here's what we get (the bolded stocks are the top 10 which will comprise the MMF portfolio):
....................NORMALIZED
................EARNINGS YIELD
JAKK............24%
IVII..............20%
CALL............20%
ANIK.............16%
MGLN...........13%
MTEX............11%
ISSC...............10%
MVL................9%
KFY.................8%
HRB................8%
NOOF..............8%
CATT...............7%
FORD..............7%
KSWS..............7%
KG...................7%
DLX.................7%
CHKE..............6%
KOSP..............4%
PTEC...............2%
VTRU..............2%
EGY.................2%
GBEL...............1%
FTD..................0%
INSP.............-1.7%
CBS................N/A (Data not readily available, but not a factor)

By way of comparison, the normalized earnings yield of Anheuser Busch and Walmart are in the 4.5%-6% range at recent prices where big-time value investors have been piling in. Of course, they are corporate imperial palaces with moats as wide as the Pacific Ocean, but it is still a point of reference. To get into a more central valuation on this earnings yield basis, the ten MMF companies will have to appreciate substantially, so there is probably high expected returns and low downside to this basket (or so I would like to believe).

-Ian