How do I use the magic formula sheet…

I received a query on how to use the data in the sheet here for investment and/or trading.

Well, firstly to understand the concept of magic formula and how that works you need to read the book “The Little Book That Beats The Market” by Joel Greenblat.

To summarize, he developed the magic formula to find companies that are selling below their intrinsic value or are the best bet in the market on prevailing conditions.

One way to find that is to analyse the company in detail, which calls in for high expertise, understanding of the business model and a good amount of financial literacy. The whole process is time consuming and one needs to be as diligent as Rohit Chauhan ( I am a big fan of his) to be able to value a company correctly. Where most analysts make a mistake is in the future earnings of a company while trying to arrive at the intrinsic value of a company.

Joel Greenblat in his book considers the following factors for assessing a company:

P/E Ratio: Price to Earnings ratio to a reflects the current price with respect to the last declared earnings per share of the company. Low P/E could mean that the company is undervalued (this is not the only criteria though) and a high P/E is a reflection on higher valued company. (There is a Caveat to this though, higher P/E also reflects optimistic outlook towards future earnings of a company). I will post more on P/E Ratios later.

ROCE: Return on Capital Employed is the measure of how good the company is in managing its assets and capital to gain maximum leverage and returns. Higher the ROCE better the prospects and returns of a company. Banks normally have a very high ROCE since they are less capital intensive, hence he suggests removing them from the magic formula list.

If you are able to find a company with a low P/E and high ROCE you are likely to gain with the investment.

 We are all aware of the uncertainties of the market. During a bull market everyone makes money. Harshad Mehta Scam got the sensex to a PE of 22 odd before it crashed in the 90’s. Ketan Mehta Scam got the sensex to a PE of 41 before it crashed. Then sensex hit a PE of 21 before crashing again in 2008 but this time there was no scam. One of the major reasons was FIIs pulling out money from the markets.

 The point I am driving here is that no one knows where the market is headed next. During a bull run you make money in all stocks no matter what unless you happen to pick on a company that has been posting losses across multiple years. It is during the Bear phase that one finds real value picks and that is where magic formula investing really helps.

 Here is how you could use the Magic Formula

 During normal market conditions where there is no greed or fear you list all the profitable companies (which you find in the excel sheet in my google groups here.) in order of their magic formula ranking.

 I personally do not invest more than 5% of my capital in a single stock. Which means the minimum stocks you should have in your portfolio over a period of time is 20. This is purely my considered opinion and I respect the sentiments of those who wish to disagree.

 Pick the top 20 in the list and make sure that you have checked their EPS over the last 5 years. If you find any wild fluctuations in earnings or see that the company has posted losses skip the company.

 For Eg: Simplex Infrastructure is listed on top in the Magic Formula. You can find the progression of earnings below

Annual results in brief

	Mar ‘ 09	Mar ‘ 08	Mar ‘ 07	Mar ‘ 06	Mar ‘ 05
Sales	4,694.78	2,835.82	1,710.96	1,344.58	999.01
Operating profit	433.68	291.21	161.86	118.11	70.18
Interest	141.79	103.72	63.23	40.36	28.09
Gross profit	304.48	191.32	109.26	81.03	43.30
EPS (Rs)	24.33	18.14	12.48	9.67	6.76

 The growth has been consistent and hence the P/E is likely to be correct. If the P/E for Mar,09 was listed very high as compared to the previous years I would skip the company as it would take a lot of time to figure out the reason for this jump like in case of the company listed below (JM Financials):

 Annual results in brief

	Mar ‘ 09	Mar ‘ 08	Mar ‘ 07	Mar ‘ 06	Mar ‘ 05
Sales	2.11	–	39.18	–	-0.04
Operating profit	-8.97	–	35.56	-0.30	-4.28
Interest	0.04	0.05	–	–	–
Gross profit	13.42	28.88	35.76	14.60	9.48
EPS (Rs)	0.11	45.37	1.18	0.91	0.84

 Look at the EPS in Mar’08. That does not look realistic and there has to be a reason. It could be a one off deal or “Chefs at work in Finance” as I would call it.

I wish there was a holy grail for investments but there isn’t. You need to dedicate at least some amount of time to check these.

 Now read the below carefully

 Once we have ranked the companies pick the best 5 in different sectors among the top 20 with consistent realistic financial performance.

 Repeat the same thing every quarter.

 What you achieve by repeating the steps in 4 quarters is:

•  Diversify adequately
• By the end of the year you would have 20 stocks bought over a period of one year.
• This will help you cost average. Because you buy stocks through the year, impact of wild fluctuations of the market on your portfolio and mental health will be minimal. It can be very stressful to see your portfolio drop by 40% and remain calm. It is normal and human to have emotions attached to your hard earned money.

 Here are a few tips to maximize your gains:

•  Buy on a day when the market is predicting doomsday. Doomsday theory has a short term impact on the market and use the volatility to your benefit. Conversely do not buy on a day market is up north. (There have been days when markets have moved 1000 points on sensex in either direction.)
• When it’s a bear market the Magic Formula Works Magically on large caps and mid caps. What I normally do is pick the best ones in Magic formula for companies that have a market capital in Excess of 500 Crores or create the magic formula list after sorting the companies in terms of market capital. This ensures liquidity and at least 50% of these will turn multibaggers. Have a look at the difference in current price and 52WK low of these stocks from the list. Most of them have appreciated by about 400%. Even if you have a 50% success rate your portfolio would have beaten the market by a whopping margin.
• During normal sentiments it is better to indulge in small caps. Some would eventually go on to become multibaggers over a period of time. Identifying multibaggers is not my area of expertise at the moment, but I will surely post something on it when I have my crystal ball.
• During a Bull run buy anything any stock broker recommends. Honestly I have back tested it over the last 12 months and every broker claims a 70% success rate. The same ones will ask you to buy a Sesa Goa at 250 and not recommend that at 80 when there has been no change to the financials of the company during the period. Strange BUT True !!!! That is what Mr. Market is all about. Sentiments !!!!!

 PHEW !!!!! that was one hell of a long post.  I hope I have clarified the question!! Did you like the post? If so comment and ask more questions !!!!