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Interview with George of Value Investing News, Part II

This is part two of the interview MagicDiligence did with George of Value Investing News (VIN) and Fat Pitch Financials. Part one can be found at this link.

George: What if something happened to the official Magic Formula Investing site? What would MagicDiligence do?

Steve: That's a good question and one I've thought about a lot. I think the first thing to realize is that the official site should be able to keep trucking for some time. Right now there is no monetization of it and there are plenty of opportunities if the need arose. The site has good traffic numbers and could easily make money through selling ad space. They could also make it a pay screen as it already requires a login. Plenty of buyers for the site may emerge also... So, I think the official site will be up for some time.

If it did close up shop, it wouldn't be the end of the world, either. There are a couple people that have created "unofficial" MFI ranking screens, some of which are very good and correlate well with the official one. The Little Book itself provides a formula for using widely available stock screens to approximate the Magic Formula using P/E ratio and return on assets or equity. MagicDiligence would use one of these methods, or potentially create a screen of it's own.

George: After tracking the Magic Formula for a while, what observations have you made?

Steve: The Magic Formula screen certainly prefers certain kinds of industries and hates others. Consulting firms are very popular, especially on the small cap screens. Healthcare firms, especially pharamaceutical companies, are frequent entries. You find very few heavy manufacturing companies on the Magic Formula screen... it's just too hard for these companies to maintain high return on capital when there are so many capital expenditures and hard assets required.

Also, commodity and fad stocks are pretty common. Commodities are volatile, and you'll often see them appear in the screen coming off a cyclical high, which is usually a pretty bad time to buy. Fad stocks like Heely's, Crox, NutriSystem are common but always show up when their time in the sun is in decline. Acquisitive companies are pretty popular as much of their book value is in goodwill, which the Magic Formula subtracts out.

One other thing I've noticed is that the truly great MFI picks tend to stay on the screen for long periods of time, often years, while the poor ones fall out relatively quickly. This is great as it allows you to buy excellent companies at low prices and then hold them for longer periods of time.

I have pretty convincing data that confirms that the small cap screen does drastically outperform the large cap one (in aggregate) as Greenblatt illustrates in the book. I also have convincing data that the small cap screen is significantly more volatile and more prone to turn up huge losers.

The last thing I'll mention is that the best MFI picks are not necessarily the highest ranked ones. In fact, I would say that the stocks listed as ranked #25-100 are generally better investment opportunities than the ones ranked #1-24, regardless of market cap limitation. Value traps have a tendency to get cheaper than true quality companies!

alexg (VIN member): Like you I have been following the magic formula. Unfortunately, like many magic formula investors I am down big. Now, is this a time period in which value/magic investing is simply not working?

Steve: Alex - as I mentioned in a previous answer, the Magic Formula has been underperforming the S&P since about May, at about a 5-7% clip. That underperformance has accelerated since Lehman went down on September 15. For September 16, the 100 over 50m screen has underperformed by 8.6%, and the 50 over 2 billion screen has underperformed by 7.3%. MagicDiligence was up on the market by over 10% heading into September, now we're only up 2%.

It's hard to explain why a strategy that throws out financial and insurance stocks is underperforming so drastically. But I think you need to keep a 3-5 year perspective. Over that period, I'm confident the strategy will continue to outperform.

George: Steve, what would you consider changing about the Magic Formula? I've toyed with the thought of making my own Magic Formula. I know Joel Greenblatt has warned that folks would likely not stick with his formula, but he has also mentioned that he personally normalizes operating profits and that you can refine MFI picks using intrinsic value estimates. Have you considered estimating the intrinsic value of MFI picks?

Steve: The more I follow it, the more I think Greenblatt's modifications make a ton of sense and add a lot of value to traditional screening methods. I think MFI is the best stock screen out there for value focused investors. Using enterprise value instead of market cap makes it more difficult for debt-laden companies to show up. Subtracting out intangibles makes a fair comparison possible between a company that books intangible value, like Coca-Cola (KO), to be compared against one that doesn't, like Harley-Davidson (HOG). I've found that MFI also does a very good job at removing one-time events from operating earnings, which can skew both earnings yield and return on capital figures.

There are two things that I might suggest for a "Magic Formula 2.0", if you will. First, subtracting out goodwill makes companies that overpay for acquisitions look better than they should. Goodwill is, of course, the amount an acquirer pays above book value for a purchase. By removing this from invested capital, it makes it look like the acquirer never overpays, when actually they may not be efficiently investing shareholder capital in high priced acquisitions.

Second, and less important, it might be useful to use a 5-year average return on capital figure. This would help to weed out some of the short-term fad and commodity stocks. However, you would also lose some of the high quality spin-offs that occassionaly find their way into the screen.

As far as calculating intrinsic value, I do a discounted free cash flow valuation before recommending Top Buys. As you know though, DFCF involves a lot of assumptions about the future. I tend to keep it simpler - if I think a stock is quite undervalued based on what it has produced in the past, and it is likely to again reach that level of performance, then you are looking at a solid investment opportunity.

George: Thank you Steve for sharing your time with us tonight. I think you are really on to something with MagicDiligence.

Steve: Thanks for the time George, and for running two outstanding websites for value investors.

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