Magic Formula Part 4

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 article discusses how I actually invest money. Below is a pasting of an email I sent to some outstanding investors (whose incredible sites happen to be linked to from my front page) that details the process I used to form my portfolio on the first trading day of 2006.

Name: Magic Formula 20/20

Source: Magic Formula Top 100

Goal: To buy statistically cheap baskets of Magic Formula stocks most dampened by depressed current expectations

Rationale: This basket hopefully represents the lowest expectation stocks of decent companies in the top 100 of the Magic Formula. They may not all perform swimingly, but I hope any sinking is minimized by the selection process and that they will be positively reassessed by Mr. Market in the coming year

Process:

Measure distance of each stock's price from its 52 week low -- take only those within 20% of their yearly low (38 companies pass)

Of those within 20% of their annual low, compare each stock's P/S ratio to the bottom 20% of its three year P/S range (hence the 20/20 namesake), and take only those within these bottom two deciles (20 companies pass)

Calculate the earnings quality of each (accruals ratio) and take only those with a negative (good) ratio (Down to 7 companies)

Run a conservative intrinsic value calculation to see what expected rate of return a long-term owner might expect from current price (enterprise value) given my set of assumptions. Frankly, this is just a feel-good sanity check. The real return I expect to garner will come from a reassessment of each company's worth and an upward revaluation one year hence.

Here are the 7 companies, some stats, their expected return, and growth and free cash flow assumptions (note: FCF is derived from three year average operating cash flow margins on current revenue less 1/2 capital expenditure margins [a wag at maintenance CapEx]; also, growth rates are loosely based on historical sales/earnings growth and are mostly a function of judgement on my part)

Lexmark (LXK) $5428 million enterprise value; 14% above 52 week low; 48% below upper bound of second lowest P/S decile; -10.3% accrual ratio (anything below -5% is really solid, anything negative is desirable)
Expected Return: 19%
Free Cash Flow: $500 million
Three stage growth: 10% for five years; 5% for five years; 4% terminal growth
Price Paid: $44.87

Valassis Communications (VCI) $1405 million EV; 1% above 52 week low; 27% below P/S decile 2; -6.8% accrual ratio
Expected Return: 14% Free Cash Flow: $141 million Three stage growth: 4/4/4
Price Paid: $29.10

Harvest Natural Resources (HNR) $336 EV; 10% above 52 week low; 34% below P/S decile 2; -5.8% accrual ratio
Expected Return: 41%
Free Cash Flow: $62 million
Three stage growth: 10/5/0
Price Paid: $8.88

Westwood One (WON) $1456 EV; 5% above low; 49% below P/S; -2.9% accrual ratio
Expected Return: 11%
Free Cash Flow: $121 million
Three stage growth: 8/5/0
Price Paid: $16.30

Harley Davidson (HDI) $14327 EV; 16% above low; 15% below P/S; -2% accrual ratio Expected Return: 14%
Free Cash Flow: $903 million
Three stage growth: 10/5/4
Price Paid: $51.44

Boston Scientific (BSX) $20274 EV; 7% above low; 47% below P/S; -.7% accrual ratio
Expected Return: 11%
Free Cash Flow: $1,341 million
Three stage growth: 10/5/2
Price Paid: $24.51

Tribune (TRB) $9438 EV; 1% above; 32% below P/S; -.5% accrual ratio
Expected Return: 13%
Free Cash Flow: $969 million
Three stage growth: 8/5/2
Price Paid: $30.29

An observation that jumps out is that this list truly reflects the undervalued nature of large cap stocks (only one of these sports a sub-$1 billion enterprise value). This selection process is to be repeated every three months to form rotating mini-portfolios of the most currently beaten down names that have solid economic foundations and earnings quality (total number of companies to be owned will probably vary between 30-40).