Magic Formula Stocks for July

It’s hard to take something called a “Magic Formula” seriously.  But you should.  It’s beaten the market by a wide margin over the past two decades and with less volatility.

The Magic Formula—a stock screener designed by hedge fund guru Joel Greenblatt –ranks stocks by two factors:

  1. Profitability (based on Greenblatt’s chosen metric, Return on Capital)
  2. Earnings yield (the inverse of the P/E ratio, defined here by Greenblatt as EBIT / Enterprise Value)

Buying good, profitable companies at cheap prices is not exactly a revolutionary idea; this is what Warren Buffett has successfully done for decades.   But Greenblatt has created a systematic way to do it, and most of the heavily lifting of number crunching is done by the screener.

By Greenblatt’s analysis, the Magic Formula generates annual returns in excess of 30% per year.  Independent back tests have generally come up with smaller returns, though the general consensus is that the Magic Formula does indeed beat the market, even after taxes and transactions costs are taken into effect.

For the casual investor, Greenblatt recommends buying a portfolio of 20-30 Magic Formula stocks, holding for one year, and then re-running the process annually.  That’s one way to do it.  But I prefer to use Greenblatt’s screener as a starting point for ideas.  I like to see which sectors are overweighted on the screen.  And while I am not a big fan of technical analysis and charting, I do take a quick look at a chart to see what the stock price is doing.  It’s usually a bad idea to try to catch the proverbial falling knife; all else equal, I like to see a stock in the early stages of a new uptrend.

So with all of this said, let’s take a peek at which stocks make the Magic Formula cut as of July.  I ran a screen of for the top 30 Magic Formula stocks with market caps over $1 billion, and here are the results:



Abbott Laboratories


Activision Blizzard Inc


Apollo Group Inc


Apple Inc


Booz Allen Hamilton Holding Corp


CACI International Inc.


CF Industries Holdings Inc


Chemed Corp


Cirrus Logic Inc.


Cisco Systems Inc


Dell Inc


Deluxe Corp


Fluor Corp.


GameStop Corp.


Herbalife Ltd


InterDigital Inc


Lender Processing Services Inc


Lorillard Inc


Microsoft Corp


Northrop Grumman Corp


PDL BioPharma Inc


Pitney Bowes Inc.


Questcor Pharmaceuticals Inc.


Raytheon Co.




Seagate Technology Plc


Unisys Corp


United Therapeutics Corp


Valassis Communications Inc.


Weight Watchers International Inc.



A few names jump off the list, such as former market darling Apple (AAPL).  It’s a strange world  in which the second-largest company in the world by market cap appears in a value stock screen with a strong bias towards small caps.  But Apple is cheap enough—and profitable enough—to make the cut.

After spending most of the fourth quarter of last year in free fall, Apple has traded in a range of 400-450 for most of this year.  Could the stock have further to fall?  Absolutely. But it fits the Magic Formula criteria, and the price seems to have a fairly hard floor just below $400.

Apple’s old PC nemesis Microsoft (MSFT) also made the list, as did Cisco Systems (CSCO)—both of which I own in my dividend-focused portfolios.

Technology companies make up a full third of the screen.  In addition to the three I already noted, video game maker Activision Blizzard (ATVI), enterprise IT solutions companies CACI (CACI) and Unisys Corporation (UIS), semiconductor maker Cirrus Logic (CRUS), computer manufacturer  Dell (DELL), cyber security firm SAIC (SAI) and hard drive manufacturer Seagate Technologies (STX) made the screen.

Health and nutritionals company Abbott Labs (ABT)—a Sizemore Capital holding—also made the cut, as did Big Tobacco firm Lorillard (LO) and defense giant Northrop Grumman (NOC).

There are a couple points to note here.  First, cheap companies—even those with high returns on capital—can stay cheap for a long time.  Microsoft and Lorillard have both been regular fixtures on the Magic Formula screen for several years.  (Of course, both have also beaten the S&P by a healthy margin over the past five years, so duration of time on the list is not necesarily a bad thing.)

Second, some companies are not really investable at this point, or at least shouldn’t be.  I’ll use Dell as an example.  Given that Dell is currently in the midst of heated dispute over whether to take the company private, this is probably a company you should avoid.

I might also add that you don’t have to use my screen.  Greenblatt allows you to set a much lower market cap minimum (as low as $50 million), though you’ll want to be careful when trading in small, illiquid stocks.  And you can also expand the list from 30 to 50 stocks to give yourself a larger pool to research.

One final note: the math behind the Magic Formula is explained in Greenblatt’s book, The Little Book that Beats the Market

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Review: The Most Important Thing

If Warren Buffett, Christopher Davis, Joel Greenblatt and Seth Klarman recommend a book, it might—just might—be worth reading.   It certainly got my attention.

Warren Buffett calls Howard Marks’ The Most Important Thing “that rarity, a useful book.”  And as a researcher with a library of a couple hundred books myself, I couldn’t agree more.

For those unfamiliar with Howard Marks, he is the Chairman and cofounder of Oaktree Capital Management, an investment firm with $77 billion under management.  The Most Important Thing Illuminated, published in 2013, is an update to Marks’ original, published in 2011, though in Illuminated Marks has help.  Greenblatt, managing partner of Gotham Capital and author of The Little Book That Beats the Market, offers his own commentary throughout the pages, as do Christopher Davis, portfolio manager of the Davis Large Cap Value fund, and Seth Klarman, president of The Baupost Group and a well-respected value investor.  Marks keeps good company.

I had high expectations when I picked up The Most Important Thing Illuminated, and I wasn’t disappointed.  This isn’t yet another “how to invest” book or a tired rehashing of received investment “wisdom” that looks more like something found in a fortune cookie and which rarely seems to hold up in practice.

Instead, Marks gives us the insightful thoughts of a man who struggles with his own investing decisions on a daily basis.  There are no shortcuts, formulas, or easy tricks.  But there is a wealth of experience and thoughtful contemplation from a real “in the trenches” investor who has been doing this a long time.

Marks starts the book with a chapter on “second-level thinking,” and I consider this one of the most valuable lessons in the entire book.  Having a good understanding of this chapter alone will put you head and shoulders above most of your peers.

Mechanical trading rules work really well…right up until the point that they don’t.  And why don’t they work consistently over time?  As Marks explains,

The reasons are simple.  No rule always works.  The environment isn’t controllable, and circumstances rarely repeat exactly.  Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable. An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed.  And if others emulate an approach, that will blunt its effectiveness.

Investing, like economics, is more art than science.  And that means it can get a little messy.

“Messy” is not a technical term, but it is accurate and descriptive hear.  Markets are driven by people and by ever-changing real-world events.  Trying to cram this into a mechanical trading model or a black box is a recipe for disaster.  And frankly, it’s mentally lazy and reflects an unwillingness (or inability!) to grasp complexity.

This brings me to Marks’ points about second-level thinking.  What exactly is “second-level thinking.”  Perhaps it is best explained by example:

  • “First-level thinking says, ‘It’s a good company let’s buy the stock.’  Second-level thinking says, ‘It’s a good company, but everyone thinks it’s a great company, and it’s not.  So the stock’s overrated and overpriced; let’s sell.’”
  • “First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.’ Second level thinking says, ‘The outlook stinks, but everyone else is selling in panic.  Buy!’”
  • “First-level thinking says, ‘I think the company’s earnings will fall; sell.’ Second-level thinking says, ‘I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.’”

Call it contrarian thinking, applied game theory, or just being clever, but this is the mindset that is required to be a successful investor over time.  It’s also a skill that few investors have or have the mental discipline to use.

It’s not easy going against the grain and taking views that are contrary to the consensus.  But then, no one ever said that investing should be easy.

Market Technicals and Psychology

As a value investor, Marks is not a fan of technical analysis (i.e. charting) but he does stress the importance of understanding what he calls “market technicals,” or non-fundamental factors that affect the supply and demand for a security.  Failing to understand these can lure an investor who looks at value alone.

What are some examples?  Marks lists two specifically: the forced selling that takes place when a market crash trips margin calls, which forces leveraged investors to sell at any price, and the cash inflows that go to mutual funds that are usually invested irrespective of price.  To these I would add short squeezes, secondary stock price offerings that dilute shareholders, and buyout offers.

These technical factors are often closely related to market psychology.  And as Marks writes, “The discipline that is most important Is not accounting or economics, but psychology…

Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity.  At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge.

Need an example?  Think of Apple’s performance over the past few years.  Apple was the “must own” stock of the 2010s.  Everyone owned it—individual investors, mutual fund managers, hedge fund managers…you name the investor, and chances are good that Apple made up a good-sized chunk of their portfolio.

There were cases of focused hedge funds having 20-30% of their portfolio in Apple.  Even now, after Apple’s massive slide, the stock accounts for nearly 15% of the Technology Select SPDR (NYSE:$XLK), one of the most popular ETFs for investing in the tech sector.  Apple’s position in the ETF is bigger than Google’s and IBM’s combined.

It’s not a figure of speech to say that there was no one left to buy Apple.  No matter how great a company is, there is a limit to how high a percentage of investors’ portfolios it could comprise.

And we all know what followed.  Apple’s share price fell by over 40%, and may or may not be finished falling.

A pure value investor wouldn’t have seen the risk in Apple.  Based on popular metrics such as price/earnings or price/sales, Apple wasn’t particularly expensive.  It actually looked pretty cheap compared to the broader market.

But if you had taken market technical and investor psychology into account, you would have known to be wary.  You almost certainly wouldn’t have timed the top perfectly, but you would have known that caution was warranted.

Unfortunately, as Marks acknowledges, “psychology is elusive…and the psychological factors that weigh on other investors’ minds and influence their actions will weigh on yours as well.”

There are no shortcuts here.  You have to remain as dispassionate as possible and, where possible, try to apply second-level thinking.

Thoughts on Risk

Risk is one of the most difficult concepts in investing because it is impossible to quantity.  Yes, we have measures such as standard deviation, variance, or beta, but these measure volatility.  Volatility and risk are not at all the same thing.

A better definition of risk is the possibility of loss.  But even this is hard to define or quantify in any meaningful way.  And at the time when a stock appears the most risky—such as after a recent volatile drop—it may actually be relatively less risky, as the selloff shook out the less committed investors.  And on the flip side, it is when a stock looks least risky—think Apple this time last year—when it is in fact most at risk.

And it gets more complicated than that.  You can’t gauge the riskiness—or the quality—of a trade based on what happened.  You have to base it on what could have happened.

In other words, you can take a phenomenally bad gamble with negative expected returns and still come out ahead.  But that doesn’t mean it was a good decision.  Let me state it bluntly: A good outcome does not mean that the decision that led to it was a good one.

If you don’t understand what I’m talking about, you should probably stop reading.  And you should definitely stop investing.

Winning the lottery is a fantastic outcome.  But the expected value on any given lottery ticket is negative because the possibility of a payoff is infinitesimally small. Most people would agree that winning the lottery is good luck.  But, being overconfident in their own abilities, they fail to see the role of luck in good investment returns based on bad trading.

Marks, in thinking very similar to that of Black Swan guru Nassim Taleb, does a good job of explaining this:

A few years ago, while considering the difficulty of measuring risk prospectively, I realized that because of its latent, nonquantitative and subjective nature, the risk of an investment—defined as the likelihood of loss—can’t be measured in retrospect any more than it can a priori.

Let’s say you make an investment that works out as expected. Does that mean it wasn’t risky?… Perhaps it exposed you to great potential uncertainties that didn’t materialize….

Need a model?  Think of the weatherman.  He says there is a 70 percent chance of rain tomorrow.  It rains; was he right or wrong?

It’s easy to get overly academic here and veer off into directions that are not particularly practical.  Perhaps it can be summed up with the old Wall Street adage to “Never confuse brains with a bull market.”

More broadly, we should always remember that risk is a complicated concept and that we can’t get complacent in our investment process.  When you have capital at risk, you need to be vigilant.

Does this mean we should avoid risk?  Not at all.  As Marks puts it, “risk avoidance is likely to lead to return avoidance.”  Assuming risk is part of the investment game.  It is just a matter of keeping risk under control and making sure that the returns we realistically expect are worth the risk we are taking.

On Cycles

While Marks eschews charting and most forms of technical analysis, he does have respect for market cycles.  In fact, he offers two rules for investing with a mind to cycles:

  • Rule number one: Most things will prove to be cyclical
  • Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.

Marks’ interest in cycles ties back to his belief in the importance of market psychology:

Objective factors do play a large part in cycles, of course—factors such as quantitative relationships, world events, environmental changes, technological developments and corporate decisions. But it’s the application of psychology to such things that causes investors to overreact or underreact and thus determines the amplitude of the cyclical fluctuations…

Cycles are self-correcting, and their reversal is not necessarily dependent on exogenous events.  They reverse (rather than going on forever) because trends create the reasons for their own reversal.  Thus, I like to say success carries within itself the seeds of failure, and failure the seeds of success.

Well said.  Marks’ views are consistent with those of Hyman Minsky, who believed that stability inevitably leads to instability (and vice versa) because stability encourages risky behavior and instability prompts more sober behavior.

Within the markets, a long period of stability and growth leads investors to assign higher and higher earnings multiples to stocks—think of the 1980s and 1990s.  But during long periods of economic malaise and market turmoil, investors assign lower and lower earnings multiples.  This cycle is probably the one permanent fixture throughout the history of the capital markets.

Marks offers so specific trading strategy to trade cycle fluctuations; his intent is simply to offer a word of advice to not ignore them.

In this book review, I have barely scratched the surface of The Most Important Thing.  This book is chocked full of very accessible, very down-to-earth investment advice, and the praise heaped on it by Buffett, Klarman and the rest is well deserved.  This is a book that I recommend you keep on your desk and thumb through on those days where the market isn’t making sense and you need a little grounding.

Compliments on a book well written.

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.



Five Smart Money Dividend Stocks

Now and then it is nice to take a peek over the shoulder of a successful investor to see what their high-conviction buys are.  When you read a headline that “Warren Buffett is buying Company X,” you’re naturally inclined to do a little digging into Company X’s financials.  After all, if it’s good enough for Buffett, it might be good enough for you.

You have to be careful with this line of thinking, of course.   The SEC filings that disclose the holdings of large investors are generally pretty dated by the time we have access to them.  For all we know, the conditions that made a guru buy a given stock may no longer be valid by the time we read about it, and there are no guarantees that they haven’t already sold it.  For these reasons, I tend to focus on larger holdings, the conviction buys that they are likely to hold onto for a while.

Today, I’m going to look at one high-conviction dividend stocks each from five well-known superinvestors.  My criteria is simple enough: the stock must be a significant holding in the guru’s portfolio and it must pay a respectable dividend.





Warren Buffett Wal-Mart



David Einhorn Apple



Joel Greenblatt Northrop Grumman



Bill Ackman General Growth Properties


Mohnish Pabrai Goldman Sachs




We’ll start with Mr. Buffett.  Warren Buffett’s Berkshire Hathaway ($BRK-A) has been accumulating shares of retail behemoth Wal-Mart ($WMT), and it’s not hard to understand why.  Wal-Mart is exactly the kind of company that Buffett is famous for buying.     It has a dominant position as the leading discount retailer in the world.  It has competitive “moats” in its size and logistical efficiency that competitors have a hard time scaling.  And naturally, it’s attractively priced. Wal-Mart trades for 14 times 2013 expected earnings and at 0.55 times sales.  Its 2.10% dividend, while not exceptionally high, is growing at a nice clip.  Wal-Mart raised its dividend 9% last year and 20% the year before.

Our next guru is David Einhorn.  Einhorn is better known for some of his high-profile short positions—he even wrote a book about his short of business development company Allied Capital, Fooling Some of the People All of the Time—but he is certainly not afraid to make large, concentrated long bets as well.

As of his most recent filings, former high-flyer Apple ($AAPL) was his largest holding by a wide margin at fully 15% of Greenlight Capital’s publicly-traded long portfolio.

It is debatable whether Apple should be considered a “dividend stock” given that the company only recently started paying a dividend and yields less than the broader S&P 500.  Still, given Apple’s gargantuan $100 billion cash hoard and continued shareholder agitation, it is safe to assume the dividend will be rising in the years ahead.

Joel Greenblatt of Gotham Capital is one of my favorite gurus. His “Magic Formula” is one of the best stock screeners I have ever come across, and he gives away access to it for free.  I’ve stumbled across more great investment ideas than I can count from browsing his site, and I recommend that you give it a look.

Greenblatt is heavily invested in defense firms these days, and one that caught my eye was Northrop Grumman Corporation ($NOC).

Northrop Grumman is not a “high conviction” pick of Greenblatt, per se, as its weighting is not materially higher than any of his other holdings.  It is, however, a highly-profitable company selling at a very attractive price.  Northrop Grumman trades for just 9 times expected 2013 earnings and yields an impressive 3.3% in dividends.

Next on the list is Bill Ackman, Greenblatt’s former partner at Gotham Capital and the principal of Pershing Square Capital Management.  Ackman is an activist investor with a history of taking large positions in companies and then agitating for radical change.

One such company in need of radical change is the iconic American retailer JC Penney Company ($JCP).  Penney is Ackman’s largest position, comprising fully 17% of his portfolio.

The company recently cut its dividend and is in the midst of an existential crisis, so we’ll move down the list to his first dividend stock of any size, diversified REIT General Growth Properties ($GGP).

A retail REIT may raise eyebrows when consumer spending appears to be slowing, but investors don’t appear to be worried. General Growth is up 20% year to date, roughly double the return of the S&P 500.

With a yield of 2.20%, General Growth is certainly not a big income generator, particularly by REIT standards. Still, a reliable 2.2% is attractive in a low-yield world.

As a side note, Ackman has a large position in Sizemore Investment Letter recommendation Beam Inc ($BEAM), the maker of Jim Beam bourbon whiskey.  Though not much of a dividend stock, it is attractive as a recent spin-off and as a money-minting sin stock.

Finally, we come to Mohnish Pabrai, author of the Dhandho Investor and one of my favorite investors. Pabrai is known for running a highly-concentrated portfolio and for good reason.  As of his most recent filings, two thirds of his portfolio was invested in the financial sector.

Pabrai’s largest holding that pays a dividend of any size is Wall Street superbank Goldman Sachs (GS), which yields a modest 1.8%.

Pabrai is betting big on the financial sector, and Goldman alone accounts for over 19% of his portfolio.  To say that this was a “high-conviction” investment for Mr. Pabrai would be an understatement.

Of all the guru stocks profiled in this article, the one I find most compelling is Mr. Buffett’s Wal-Mart, which I own both personally and in client accounts.  Though considering the track records of each of the gurus, a case could be made for considering any of these dividend-paying stocks.

Disclosures: Sizemore Capital is long BEAM and WMT.


When in Doubt, Follow the Greats

The art of investing is an exercise in making decisions under conditions of uncertainty. But today, it seems that the cloud of uncertainty is a little thicker than usual. During times like these, I like to do what your college professor might have called “cheating.” I like to look over the shoulders of other investors and see what they are doing.

Stocks fell sharply as we started trading this week on fears that Europe’s sovereign debt crisis was again spiraling out of control.  Of course, I could have used that same opening sentence at almost any point in the last 10 months and it would have been equally true.  The remarkable thing about 2011 is that it has been largely devoid of any real news.  The macro concerns driving the market haven’t changed much in two years—and yet we continue to see some of the most volatile daily price swings since the Great Depression.

The art of investing is an exercise in making decisions under conditions of uncertainty.  But today, it seems that the cloud of uncertainty is a little thicker than usual.  Despite having two years to discount the likelihood and consequences of default by one or multiple “PIIGS,” the market’s persistent volatility shows that investors are as uncertain as ever.

I’ve been consistently bullish for most of the past year, arguing that the low prices on offer more than compensated investors for the risk of meltdown.  But I’m also the first to admit that the volatility of recent months has thoroughly frayed my nerves.

During times like these, I like to do what your college professor might have called “cheating.”  I like to look over the shoulders of other investors and see what they are doing.

As I wrote last week in an article on Warren Buffett’s recent acquisitions, you should never mindlessly ape the trading moves of another investor.  But studying the moves of successful investors can be an effective way to step back and get a little perspective on your own trades.

With all of this said, today I’m going to take a look at the portfolios of three of my favorite institutional investors: Mohnish Pabrai, Joel Greenblatt, and Prem Watsa.

Mohnish Pabrai

We’ll start with Pabrai, the author of the must-read The Dhandho Investor and a well-respected value investing guru.  Based on his SEC filing for the 3rd quarter, Pabrai went on a buying spree in the financial sector.  After initiating a massive position in Bank of America ($BAC) and adding to his already-large positions in Wells Fargo ($WFC) and Goldman Sachs ($GS), Pabrai’s weighting to the financial sector jumped from 39 percent of his portfolio to a whopping 58 percent with a fair bit of the reduction coming from basic materials. Materials dropped from 46 percent to 33 percent of the portfolio (see Pabrai’s portfolio here).

Though his returns are not reported, we can assume that Pabrai’s high allocation to financials has hurt his returns this year.  He wouldn’t be the first.  John Paulson’s flagship fund was at one point down by nearly half this year due to his high allocation to financials and his use of leverage (see Don’t Mess Up Like Paulson).  Still, Pabrai has proven to have a sharp eye for value over the years, even if he—like many other high-profile value investors—tends to be a little early.

Joel Greenblatt

Moving on, let’s now take a look at what Joel Greenblatt is buying these days.  Greenblatt runs Gotham Capital and is the author of the eminently readable The Little Book that Beats the Market.  Unlike Pabrai, Greenblatt tends to have a relatively high portfolio turnover.  He made few major moves in the third quarter, though he was a net buyer and added to his already large holdings in technology and industrials (see Greenblatt’s portfolio here).

Greenblatt is conspicuously under-allocated to the financial sector because much of the money he runs today follows his “magic formula,” which stresses high returns on capital.  Suffice it to say, the big banks are a little light on profits these days, so financials are not showing up on Greenblatt’s screen.  But with more than 40 percent of his portfolio invested in the cyclical technology and industrials sectors, Greenblatt is every bit as aggressively invested as Pabrai.

Prem Watsa

Finally, let’s take a look at Prem Watsa.  Watsa is the CEO of Fairfax Financial Holdings and is considered by many to be the “Warren Buffett of Canada.”  He has certainly earned the nickname.  He and his team have grown Fairfax’s book value per share by 25 percent per year for the past 25 years.  He was also one of the few managers that made money during the crisis year of 2008.  Not a bad run indeed.

Watsa’s portfolio moves will certainly raise a few eyebrows. In the 3rd quarter his added to his already large position in battered BlackBerry maker Research in Motion ($RIMM). He also increased his position in Citigroup ($C) by 50 percent.  Overall, his exposure to the financial sector rose from 9 percent to 24 percent in the third quarter (see Watsa’s holdings here).

Watsa was a slight net seller in the 3rd quarter, though the composition of his portfolio hardly suggests excessive bearishness at the moment.  More than 80 percent of his equity holdings are in technology, financials, and telecom.

As a caveat, there is a limit to what you can glean from reading SEC 13-F filings.  For example, only long positions are reported; short position and derivatives hedges are not.  And Prem Watsa, for example, does indeed hedge his equity positions.  Still, his willingness to be so heavily invested in some of the most volatile sectors would imply that he’s not quite as bearish as some of his public comments would suggest.

So there you have it.  Given the recent volatility, it’s entirely possible that the Dow has moved 100 points in the time it has taken you to read this article.  That’s nerve-racking, of course, even for an experienced investor.  Still, I see compelling bargains at current prices, and I consider the pervasive fear and bearishness among rank-and-file investors to be a contrarian bullish sign.  And when I start to get that feeling in the pit of my stomach, I take comfort in knowing that I’m on the same side of the trade as some of the brightest value investors in the business.

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