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MagicDiligence Six Month Checkpoint

Dear MagicDiligence Readers,

Six months ago this week I launched MagicDiligence with not much more than an idea. Joel Greenblatt's Magic Formula, as explained in The Little Book that Beats the Market, makes all the sense in the world - buy great companies at cheap prices. After all, isn't this how all of us want to shop for products? Buying great merchandise at cheap prices is our goal when acquiring our assets. Why should investing be any different?

One of the most difficult things to get over with the Magic Formula is how simple it is. Nothing this simple can be so successful, can it? We've been led to believe by asset managers, the media, college professors, and TV personalities how difficult it is to outperform the market. Nearly 90% of all mutual fund managers cannot do it, and these guys spend all of their time trying. Vanguard and index funds exist on the premise that it cannot be done. It just seems preposterous that a simple screening strategy can produce annual gains nearly 3x this "impossible to beat" benchmark. Emotion, as with many things, prevents us from seeing the simple logic of the situation. I was always struck by Greenblatt's "first day of class" example. Take a look at any stock's 52-week high and low differential. Most of the time, the high is 100% more than the low. Is it logical that a company's value can change that much in 12 months? Of course it is possible, but extremely unlikely. That this is the case for the large majority of stocks should indicate a basic inefficiency of equity markets. This inefficiency is human emotion, something that is removed when using mechanical investing techniques like the Magic Formula screen.

However, mechanical investing alone has it's faults, too. For example, if you followed a strict strategy of buying only low P/E (or high earnings yield) stocks, it is inevitable that you would blindly buy a company with a low P/E due to a huge one time gain, which clouds the "E" part. Likewise, the Magic Formula can produce mirages too. Fad and commodity stocks are notorious examples, where high return on capital is a temporary by-product of great short-term sales that are not sustainable. Or you can see dying businesses, where investors have rightly driven stock prices low due to a very poor long-term outlook for a once-great business.

The goal of this site is to do some legwork to find the mirages in the screen and avoid them while at the same time find the ones that have truly sustainable long-term returns on capital. After all, there are 2 ways a stock can fall out of the Magic Formula screen. Either the company's business deteriorates and return on capital drops to low levels, or the stock price rises so much that earnings yield becomes too low. Clearly, the second scenario is what we want, and the aim of the Top Buys selected for members.

I'm pleased to say that the first 6 months of MagicDiligence has been a solid success. Our Top Buy picks are up an average of 3.5% per pick, versus an average loss of 3.7% for the S&P 500. That's 7.2% outperformance on average. If we can even maintain that level for the future on an annual basis, the results will be outstanding. I'm happy with a positive gain in what has been a poor market in 2008. The portfolio has some impressive winners so far:

Resources Global Professionals up 43% in 5 months, outperforming the S&P by 46%

Hasbro up 42% in 4 months, outperforming the S&P by 45.2%

Accenture up 20% in 6 months, outperforming the S&P by 23%

This portfolio is not about a few big winners covering up a myriad of losers, however. Over 68% of the Top Buy picks have outperformed the market. Over 59% are in the green during this tough bear market. 7 of 22 picks are outperforming the market by double digits. Only 2 picks are down more than 10%.

I'm also pleased, frankly, about the "bad" Magic Formula stocks we've avoided. IAR was at $15.40 on Feb. 7, the day MagicDiligence marked it as a bad choice. Today, IAR is at $1.93 - a 87% loss. On Mar. 19, we said NVDA was not a great choice. The price then was $17.86, today it's $11.72, a 34% drop. GCI, MSTR, HLYS, and USMO have also all dropped significantly. Some not recommended MFI stocks will go up, but why take the risk with a company or business that is not truly great?

The strategy is showing it's soundness and potential for success. I believe strongly in it - enough to entrust my family's financial future to it. If you haven't yet, now is a good time to take a look with a free 30-day trial. If you don't believe that following this strategy can pay you back your $89 one-year investment, with a healthy interest, you can cancel and not pay a dime. An investment advisor will take 3 times that amount every month underperforming the market and making a mint selling annuities!

One more thing I wanted to mention. Magic Formula investors who don't already should really take a look at Marsh Gerda's MFI Diary, which for my money is the best blog on the Magic Formula out there. He does a great job commenting on a wide range of MFI stocks, as well as running contests and relating a personal MFI investing experience.

Thanks again for reading MagicDiligence! Best, and Happy Investing,

Steve Alexander

Editor, MagicDiligence

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Disclosure: Steve owns no stocks referenced here.

Joel Greenblatt and MagicFormulaInvesting.com are not associated in any way with this website. Neither Mr. Greenblatt or MagicFormulaInvesting.com endorse this website's investment opinions, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr. Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website. The information on this website is for informational purposes only and solely represents the views and opinions of the author. No warranty is provided or implied as to the accuracy, completeness, or timeliness of this information. This information may not be construed as investment advice of any kind, nor can it be relied upon as the basis for stock trades. Alexander Online Properties LLC, the proprietor of this website, is not responsible in any way for losses or damages resulting from the use of this information. Alexander Online Properties LLC is not a registered investment advisor. All logos are trademarked properties of their respective companies.

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