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MagicDiligence	-14.31%
S&P 500 ETF	-18.72%
OUTPERFORM	4.41%

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Updated daily. All values annualized from Jan. 2008.

Last Thursday I participated in a live interview with George of Value Investing News (VIN) and Fat Pitch Financials. Here is part one (of two) of that interview. Please note that all figures and facts were accurate as of last Thursday 10/30 (the Top Buys portfolio actually has widened it's lead over the S&P since then).

George: Welcome Steve. Thank you for joining us here at Value Investing News. Tell us a bit more about MagicDiligence. What do subscribers get?

Steve: 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.

George: What inspired you to start MagicDiligence?

Steve: 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.

George: Speaking of bad MFI picks, what do you consider as a bad MFI picks? Have you studied the poorly performing MFI picks? Do they exhibit any patterns or commonalities?

Steve: 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 (HLYS), NutriSystem (NTRI), or Crox (CROX).

The second thing is similar - stocks in once good businesses that are in terminal decline. For example USA Mobility (USMO) is a pager company. Pagers are clearly going the way of the dodo, and USA Mobility really has no backup plan. Or Gannett (GCI), 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 (CALM), 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.

George: In addition to pointing out the obvious bad picks, what other value does MagicDiligence add to the Magic Formula?

Steve: 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.

George: How has MagicDiligence performed since you started?

Steve: 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.

George: If I'm not mistaken, the MagicDiligence picks are outperforming the Fat Pitch Financials Port over the same period. It's been a very unforgiving market.

How has MagicDiligence performed versus the standard Magic Formula Picks?

Steve: 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%.

Stay tuned for part 2 of the interview where we discuss what to do if the official Magic Formula website went offline, observations about the strategy, and more.

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

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