MagicDiligence
Magic Recipe -0.05%
Deep Value -0.19%
Star List -0.15%
S&P 0.17%
Today's Performance (see long-term performance)

Some Thoughts on the Spell Tracking Portfolios

As some of you may have noticed, I had to take down the Tracking Portfolios for a time. The data provider I was using to update them unexpectedly shut down, so there was a scramble to come up with a replacement strategy! Today they are back up and using a more sustainable updating system. Check them out!

There had to be some simplifications to the tracking portfolios. Since the updating is a more manual process now, I had to cut back from 20 examples per spell to just 5. Unscientifically, the ones chosen were portfolios 1, 5, 10, 15, and 20 from the previous setup. Using 5 gives us a decent compromise between capturing the variety of outcomes from each Spell and being maintainable.

Also, I've removed tracking for the Star List Spell. This one never really worked well with a mechanical strategy anyway - there are just two few stock examples to get the diversity needed.

All that said, the results through June give us 16 months of "real money" portfolio tracking, and the outcomes have been pretty interesting so far.

Overall Thoughts on Performance

Historically, MagicDiligence has been a value-focused screening site, particularly interested in Joel Greenblatt's Magic Formula Investing (MFI) screening strategy. With the Spells, we've tried to branch out a little bit and explore other strategies as well.

Good thing! Both the Magic Recipe Spell (which is similar to MFI), and the value-oriented Deep Value Spell have underperformed the market to date, by an average of 1.47% and 9.91%, respectively. The Magic Recipe portfolios have exhibited fairly consistent performance, with the best portfolio up 28.4% (beating the market), and the worst one still in positive territory at +10.53%. Deep Value, on the other hand, has had an extremely wide range of outcomes, ranging from +27.3% to -3.65%! Despite its worse average performance, 2 of the Deep Value portfolios have nevertheless outperformed the market, while only 1 of the Magic Recipe portfolios has accomplished that feat.

The real surprise here has been the Quality Growth Spell. Those portfolios have performed outstandingly, outpacing the market by an impressive average of +11.7%. All 5 tracking portfolios have beaten the market substantially, and the range of performance has been tight as well, with a minimum return of 28% and a maximum of 34.5%. Simply put, anyone that would have used Quality Growth to run a mechanical portfolio has likely smoked the market over the past year and a half.

That may come as a bit of a surprise to value-based investors, but actually I'm not astonished by these results. While 16 months is a pretty short example period, in fact I expect the Quality Growth spell may continue to show outperformance over the value-based screens over the long term. Let's go into some detail to figure out why this is the case and what we might be able to learn from it.

The Root Difference Between Value + Growth Screens

There is a very stark difference in how the 2 value-based spells and the Quality Growth spell are constructed.

The two parameters for Magic Recipe are earnings yield and return on capital. For Deep Value it is earnings yield and free cash flow yield. For Quality Growth, it is 3-year revenue growth and cash return on capital.

Notice a pattern? Earnings yield and free cash flow yield are based on the stock, while (cash) return on capital and 3-year revenue growth are based on the business.

Both have merits, but it is important to realize the different mindset between the two styles of investing.

When focusing on just the stock, the mindset needs to be of a shorter-term, trader's nature, where you are looking for something trading below a reasonable intrinsic value for a valuation correction. You are not necessarily looking for a company that can grow for decades. The focus is on short-term market inefficiencies where you may be able to grab a 30-50% return in a year or two and then get out.

When focusing on the business, the mindset needs to be of a long-term owner's, where the investment is made based on the quality of the business and its future prospects. The stock price isn't necessarily as important, as the holding period is intended to be many years (at least 3, and usually longer). The focus is on finding companies that can double, triple... even increase by 10 times (or better!) over a many year period.

While investors can make a lot of money doing valuation-based investing, most of the true greats use the second strategy. Peter Lynch focused on these companies. So did Shelby Davis, and in the earlier days of Berkshire (when it was smaller), so did Warren Buffett and Charlie Munger. If you've ever looked at the Motley Fool, their flagship newsletter pits two brothers, Tom (who initially was a valuation guy) vs. David (a business-focused guy). Guess who has performed better over a 15 year period? You guessed it... David has outperformed Tom by over 4x!

It is this business focus that Quality Growth was designed for. As the screen uses slow moving business statistics, its turnover is quite low. Because of this, many of the tracking portfolio holdings have been "renewed" for additional years, allowing us to reap the benefits of holding great companies for the long-term. Additionally, while valuation might net you a 50% return, a great business can do much better. Look at some of these one-year returns from Quality Growth:

LifeLock (LOCK) +129%
Veeva Systems (VEEV) +121%
Inogen (INGN) +111%
Supernus Pharma (SUPN) +94%
Paycom (PAYC) +90%
Splunk (SPLK) +86%

And that's just the best. Many others have generated 50, 60, 70% returns. The two value screens have their share of winners, but we see very few names from them generate these kinds of returns. The upside is more limited.

It's also clear when scanning the Business Model Ratings that the business models populating Quality Growth are of a higher caliber than those in the value spells. They tend to have greater growth prospects (duh), more predictable and recurring revenue streams, and better competitive advantages.

It's Still Early

While I'm encouraged by how the Quality Growth experiment has gone so far, it is important to note that 16 months is hardly a very long time horizon for an investment experiment. The entire period has been basically a bull market... it is quite possible that the value screens will outperform in a down market, when investors "run to safety". I think it is also likely that the volatility of the Quality Growth spell will be greater than that of the value spells over time.

I would also note that valuation still matters! Finding a great business with a cheap valuation is really the best recipe for nailing those 10+ baggers over the long term. By combining the valuation statistics, with the business statistics, with our Business Model Rating, MagicDiligence is trying to highlight the best of the best opportunities in the market for our money.

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