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Kiplinger recently did a piece on Magic Formula Investing. Click here to read the entire article

The premise of the article is that, 2 1/2 years later, those who are following the Magic Formula are having trouble sticking to the principals outlined in the book. This is largely due to the poor performance of the highest ranked MFI stocks at the end of 2007 and now into 2008. The article mentions that nearly 90% of posts on the Yahoo! MFI Boards are dedicated to modifications to the strategy. Examples of this are changing the buy/sell points, using stop loss orders, and looking for external recommendations.

MagicDiligence's response to this is simple: as long as you are still following the rules in the book, you are adhering to the Magic Formula strategy. If you are using stop loss orders, you're not following the rules. If you are changing the buy/sell points beyond the one (or two) year recommendations, you're not following the rules. If you aren't picking enough stocks (20-30), or too many, you aren't following the rules. However, if you are doing additional research on stocks that are still part of the Magic Formula screen, it is not changing the strategy! An investor following the strategy blindly may pick the same stocks as, say, someone who reads MagicDiligence. This is a possibility. Using MagicDiligence picks for your MFI portfolio doesn't alter the strategy one bit.

Also, no where in The Little Book That Beats The Market does Joel Greenblatt say his strategy is successful because of luck. Yes it's true, some of the stocks discarded at MagicDiligence will probably go on to post big gains. The unforeseen happens in the stock market pretty regularly. But the premise of the strategy is to buy great companies for cheap. The Magic Formula screen produces these. But it also produces mirages. Fundamental stock analysis can easily weed these out. Good performance from poor fundamental stocks is a result of luck, and happens less than good results from good fundamental stocks.

Quote from the article:

"Greenblatt can prove that his simple formula works; the tinkerers cannot prove that their enhancements add value."

This is true for those advocating stop loss or new holding periods. But not for doing some fundamental checking. Would Buffett buy one of these companies sight unseen? Would Graham? Would..... Greenblatt?

We stick with the program at MagicDiligence. But we want to afford our portfolios every possible advantage, and that includes minimizing risk and downside. The Kiplinger article makes some good points and reiterates the superior performance following the Magic Formula produces. But it's criticisms do not apply to the mission here.

Happy investing!

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

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