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MagicDiligence and Magic Formula 2012 Review

The MagicDiligence Top Buys portfolio had a solid year in 2012. The average for all positions held during the year was a 10.2% gain, vs. a 8.2% return for a matching position of the SPY (S&P 500 tracking fund), giving us a decent 2% outperformance. 60% of our positions outperformed their respective SPY comparison. Remember that we utilize a newsletter-style portfolio instead of real money (i.e., all positions are weighted equally and averaged to calculate performance).

Our results are even better when placed head-to-head against the respective Magic Formula Investing® (MFI) screen (top 50 over 50 million) for the same period. The picks recommended or renewed in 2012 outperformed their respective MFI screen benchmark by an average of 6.9% through 12/27, with 21 of the 29 positions outperforming. This marks the second year in a row that we have outperformed the underlying strategy.

We sold 4 picks early this year. 2 of them, Easylink Services and Mediware, were acquired at significant premiums of 43% and 56%, respectively, each just about a month after recommendation! The other 2, Accenture (ACN) and Time Warner (TWX), reached the "sell early" target price before their 1 year holding period expired.

We did pretty well at picking stocks that went up, as well. 19 of the 29 2012 picks (66%) posted positive gains from recommendation through the end of the year. Mediware and 2011 holdover USANA Health Sciences (USNA) were the year's best picks, each appreciating 56%.

Like any portfolio, we had our losers too. The worst was GT Advanced Technologies (GTAT), down 59% on the year.

Magic Formula® Investing at Large

No beating around the bush here - this was the worst year for the MFI strategy since I started following it in 2008. To measure the performance, I took one MFI screen for each week of the year (using the top 50 over 50 million screen), averaged the performance of each stock, and compared it against the performance of the SPY fund through 12/27. Here are the results:

Only *one* week (week 47) of the MFI screen outperformed the SPY on the year. Early 2012 samples underperformed the market by as much as 12%.

This is the second year in a row the overall screen has appeared to underperform the market. In 2011, MFI outperformed in 13 of 52 weeks, and had individual samples underperform by as much as 20% early in the year. MFI was much more impressive in 2010 (41 of 52 samples outperformed with a max underperformance of just 2.4%) and 2009 (10 of 12 months outperformed with max underperform of 2.5%).

We pointed to Chinese reverse take-over frauds and home healthcare as the big drags in 2011. So what were the causes for 2012? 2 primary ones:

  • For-Profit Education: This sector has been a thorn in MFI's side for the past 2 years, but really was a problem in 2012. Stocks like Apollo Group (APOL), Career Education (CECO), and ITT Education (ESI) are down 60-80% from early in the year.
  • Solar Collapse: A massive oversupply of wafers, credit problems for panel makers, and a U.S.-China trade war have crushed this sector. Two MFI stocks in particular felt this blow: the aforementioned GTAT and Amtech Systems (ASYS), both down over 70% on the year.

In the early year screens, stocks in these two sectors made up as much as 20% on some days. I believe one of the principal "simple diligence" steps a mechanical MFI investor can make is to ensure his or her picks are diversified by industry to prevent situations like this.

MagicDiligence will have some additional articles over the next week recapping the 5 best performing, 5 worst performing, and some thoughts on 2013 as it relates to the strategy.

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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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Comments

Posted by fatso68 on 2012-12-31 06:31:22

Steve...not sure I understand how you're calculating the S&P returns. I'm showing an 11.6% return for the year (excl dividends) for the SPY (ETF), and 11.5% for the index itself. Both of those numbers are simple price appreciation and, as such, excl dividends, which I assume your model portfolio ignores as well. So, for instance, SPY closed 2011 @ 125.50 (12/30/2011, final trading day of the yar), and closed Friday (12/28/2012) @ 140.03, for a gain of 11.58%.

Posted by Steve on 2012-12-31 09:17:07

With a newsletter-style portfolio, it's not just year start to year end performance (that would be a "real money" portfolio). With a newsletter style, you compare positions against a matching SPY for the period, then average all the positions together to get a composite performance. Since positions are recommended throughout the year, the average SPY pick will be different than just end-to-start. I tried to allude to this in the first paragraph but I understand it is a point of confusion with these annual performance articles. Hope this helps.

Posted by fatso68 on 2012-12-31 11:28:54

Got it, thanks.

Posted by stonewallv2 on 2012-12-31 15:52:18

Steve,

Thanks for your thoughts on 2012. The performance of the MFI portfolio is concerning. Greenblatt warned us that we could expect some down years to account for bac variance

Posted by stonewallv2 on 2012-12-31 16:16:14

Steve,

Thanks for your thoughts on 2012. The performance of the MFI portfolio over the past two tears is concerning, especially given that there have been no years with significant over-performance in memory. Greenblatt warned us that we could expect some down years due to variance, but It is worth asking some questions about the results.

You point out the effect solar and education have had on the results. One common theme in the two industries is government interference, which may be a possible explanation for what is hopefully an anomaly of bad years. If we remove these industries from the average, what are the results?

It is worth exploring the results of the MFI screen because of its larger sample size relative to the Top Buys portfolio. The MFI screen is the foundation of our strategy, and if we deviate too much from it, we just become other stock pickers. Your Top Buys success is commendable, but the sample is small and as you note in your writeup, timing was a major factor in the results. It could easily have gone the other way.

Cheers to your success. Your advise about diversification is also very sound. Happy New Year!

Posted by jwad75 on 2013-01-01 16:46:29

All,

If the Magic Formula worked every year--always generating 25-plus returns--everyone would do it! It takes a patient investor who understands the core principles of the underlying strategy to reap the benefits. Do not get worked up over the fact that we've had some below average returns the past several years. In time, you will make lots of money, especially using some of the advice on this website. Great info!

Happy New Year!

All the best,
Ryan

Posted by Steve on 2013-01-01 17:00:38

Thanks for the comments guys. I would certainly agree that government interference in certain sectors has dinged the strategy badly in the past 2 years. In fact, I'd go as far as to say that it has been the single biggest factor in the strategy's underperformance. For-profit education, solar, home health agencies, and government/defense contractors were all big components of MFI in 2011-12 and all 4 have had poor stock price trends. Another poor performing MFI sector is tech, but gov't had less to do there and in fact I still see the tech sector at large as grossly undervalued.

It's not really fair to say that MFI has not over-performed in memory. The strategy did quite well in 2008 and 2009, and just crushed the market in 2010. If it were not for the numerous Chinese RTO frauds that showed up in 2011, the strategy probably would have been very close to market performance then.

I still believe the strategy is very sound, and that 2012 was one of the "down years" Greenblatt talks about. In 2013, I wouldn't be surprised to see for-profit education, solar, and tech to do pretty well.

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