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Business Sector Breakdown of the Magic Formula

Does the Magic Formula screen favor certain types of businesses?

This was the question that inspired the study we will be covering over the next couple of weeks. For the last 6 weeks, MagicDiligence has compiled all of the positions in the Magic Formula under our two screens: the top 100 over 50 million market cap, and the top 50 over 2 billion market cap. For each of these stocks, I've assigned a business sector and industry based on Morningstar's listings. From this data, we can see which sectors are most frequent in the Magic Formula screen, and possibly gain some insight into which business models the screen favors (or which sectors are currently cheap in the market). For each of the top 10 sectors, MagicDiligence will examine the basic business models used by companies in this sector, why the Magic Formula likes (or dislikes) it, and how particular companies stand out.

First, the results. The column on the left is, of course, the Morningstar business sector, and the middle column represents "stock days". This is the total number of days a stock in that sector appeared in either of our two screens. For example, if Cherokee, a Consumer Goods company, appeared in a screen for 5 different days over the research period, that would be 5 "stock days". The right column is the number of different stocks for each sector. The results since March 13:

Morningstar SectorStock DaysUnique Stocks
Business Services77833
Consumer Goods54224
Industrial Materials49125
Consumer Services43420
Financial Services263

There were a few surprises on the list. Media and Software are both very low capital businesses which should provide excellent return on capital figures. Industrial Materials companies, on the other hand, are generally very capital intensive and also very cyclical. What is not surprising is that Business Services tops the list. In general, companies in this category are very profitable due to low requirements of property and machinery, as well as "sticky" businesses where clients are reluctant to change service providers, lest it interrupt business.

The only Morningstar business sector not represented is Utilities. This is not a huge surprise. Utility companies are extremely capital intensive, and deregulation has really crimped the profits of these firms, leading to low return on capital. Also, Financial Services barely makes the list. This too is not a shock, as Greenblatt specifically throws out banks and insurance companies due to the oddities of their financial statements and how they make money. Earnings are not the best valuation metric for these companies (book value is), and the Magic Formula doesn't work well with them. The Financial Services firms that did make the screen were:

IGCIndia Globalization CapitalA venture capital firm in India.
UEPSNet 1 Ueps TechnologiesAlternative payment systems.
PPDPre-Paid Legal ServicesLegal insurance.

A few firms that appeared in the MFI screen had no data on Morningstar. Most of these stocks are not listed on one of the major exchanges, and are likely not very liquid investments. MD would not recommend buying any stocks not on the NYSE or Nasdaq. These stocks were:

CHCGChina 3C GroupElectronics retailer in China. Over-the-counter exchange.
CASTChinaCast EducationOnline education materials in China.
HBMFFHudbay MineralsMining. Trades on the pink sheets.
SNVNFSandvine CorpWireless technology. Pink sheets.

So, that's the list. Over the next few weeks, MagicDiligence will dedicate an article to each of the top 10 sectors, starting at number 10 with the Energy sector. In these articles, I'll examine the industry breakdown within each sector, pick apart why the Magic Formula is selecting these companies at this time, and decide if the sector/industry itself is attractive, or if there are standout companies within the sector that defy the poor business aspects. Stay tuned!

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