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What we know for certain about the screening criteria at the official Magic Formula site is detailed in The Little Book that Beats the Market and on the site itself. The appendix in particular of Joel Greenblatt's book provides some details as to how both earnings yield and return on capital are calculated. Many (including MagicDiligence) have tried to recreate the statistics to meet those from the screen, and in general have gotten pretty close. But the exact formulas remain, like Coca-Cola (KO), a well-kept secret (the "new" official site doesn't even list them anymore).

This has led to some questions as to why certain stocks that certainly appear to have Magic Formula statistics don't appear on the screen. Using an alternative MFI screen at Magic Formula Investing EU, I've dug up and verified 3 interesting micro-cap stocks that seem to have MFI-worthy statistics yet do not appear on any of the official screens. They might be worth some additional research by both MFI and value investors in general.

Universal Travel Group (UTA)

Market Cap: 158 million

MFI Earnings Yield: 20.7%

MFI Return on Capital: 78.4%

5-year Expected Growth Rate: 25%

Dividend Yield: N/A

Comments: Universal Travel is a small online travel booking service in China, focusing on two provinces in southeastern China. While facing the duopoly of Ctrip (CTRP) and eLong (LONG), UTA is still growing sales at near-20% rates, and the overall Chinese travel market is growing at nearly 15% a year. A 21% earnings yield is quite a cheap valuation for that kind of growth, plus a debt-free balance sheet. On the risk side, the company has been highly dilutive and could have trouble managing their breakneck expansion.

HealthTronics (HTRN)

Market Cap: 168 million

MFI Earnings Yield: 27.3%

MFI Return on Capital: 81.5%

5-year Expected Growth Rate: 15%

Dividend Yield: N/A

Comments: HealthTronics provides services and equipment for urology. Some examples include lithotripsy, a non-invasive technique to break up kidney stones, and also prostate and kidney problems. The company is growing sales at about 10-15%, has a good balance sheet, and a well-respected, young CEO in James Whittenberg. 2010 forecasts puts the forward P/E at under 12, which is quite cheap. On an MFI basis it is exceptionally cheap with an earnings yield over 25%. Like Universal Travel, HealthTronics has appeared in the MFI screen before but has mysteriously disappeared recently.

Fuqi International (FUQI)

Market Cap: 325 million

MFI Earnings Yield: 30.9%

MFI Return on Capital: 38.8%

5-year Expected Growth Rate: 20%

Dividend Yield: N/A

Comments: Fuqi develops gold, diamond, and other precious metal jewelry and sells it to distributors in China. Small-cap Chinese is where the value is right now, and one of the concerns seem to be common amongst them - uncertainty over accounting. Fuqi has failed to file their Q4 results in a timely matter, receiving a de-listing notice, and cash flow continues to come in negative, while reported earnings skyrocket (Q3 sales grew 36% and profits 192% year-over-year). However, at a 31% earnings yield with 20% expected growth, there just might be enough risk priced into the stock to earn big returns here.

Steve owns no position in any stocks discussed in this article.

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Comments

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Posted by apmurray on 2010-04-17 12:41:06

Steve,

I have been following your work for some time now and while I haven't registered for your premium service, I do wish to thank you for your work.

I read Greenblatt's book about 2 years ago and since that time I have matured as an investor and understand the financial statements better. However, I find that I have some questions pertaining to his calculation for ROIC - maybe you can answer it: I cannot understand his logic for leaving long term debt out of the equation for invested capital. It seems to me that long term debt is indeed invested capital and one that comes at a cost (interest). How can a company's earnings not take that into account when trying to truly evaluate the ROI? Any guidance you can provide is extremely welcome. FYI - in my own work, I have been including long term debt. In the case of ORCL it makes a big difference. The last 5 years w/o the long term debt, the ROIC ranged from 130% to 215%. When it is included the range is a more realistic 40-70%.

Thanks for your time,
Aaron Murray

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Posted by cookedc on 2010-04-17 20:28:12

Aaron, Pony up the annual membership fee. It's well worth it. I have made many times the fee in stocks MagicDiligence has profiled such as IDCC, PACR, GD and GME. And even some that he's panned such as AMED. It helps that we've seen an astounding bull market over the past 12 months. Also, I admit that I haven't stuck religiously to the 1-year holding period.

Steve, UTA and FUQI are shown high on the list of this screen (that's linked to from MagicDiligenc's "Tools" section):

Greenblatt Index Scans

Publicly Traded U.S. (Liquidity > $250K/Day, Any Cap. - Greater than $100 Million)

#4 UTA
#16 FUQI

http://members.cox.net/econisvoodoo/piotroski/greenblatt.TRADEDUS.GL.AC.html

Cheers,
David

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Posted by Steve on 2010-04-17 20:36:53

Hi Aaron - Debt is actually a liability, so including it should increase the return on capital (net assets would decline).

The reason why you shouldn't include interest-bearing liabilities is because of this. Short-term liabilities actually are sometimes a good thing for a company. If a buyer like, say, Best Buy, can push back the time they can avoid paying their suppliers, they can earn a return on that money - and the longer they can defer it, the more they can earn as a return.

Debt does not provide these advantages. Debt is penalized on the asset side. When a company raises capital through bonds or lines of credit, that money initially goes into the cash account. Then, that cash is used for whatever purpose. If it is used to expand, for example, you have more assets in the property line item. So, debt is penalized in return on capital by adding to net assets.

Hope that was at least somewhat clear!

Best - Steve

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Posted by apmurray on 2010-04-25 13:25:35

Steve- thanks for your comments. I am not sure I totally understand using that metric with respect to screening purposes. Because I agree with your sentiment that sometimes debt can be ok, but needs to be evaluated on a stock by stock basis. In my mind, using debt in the calculation sort of normalizes the return across industries for a better screen.

As a side note, it seems to me that the purpose of using high ROC as a screen by Greenblat was to identify good companies. In my mind (and I know it isn't easy), but to identify truly great companies we need to see steady ROCs over some period of time. I am sure that Greenblat uses such a strategy, because even a blind squirrel can find a nut.

Thanks again,
Aaron

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Posted by salsero on 2010-05-06 10:59:43

Well, HTRN worked out well. Endo Pharma (ENDP) is buying them out at 30% above their market price. Since I own both stocks, I am a bit torn in my feelings.

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