What are we looking for?
Let's get an update on the Magic Formula portfolio we created in January. Our previous portfolio using this strategy smashed the benchmark, so we're curious to see if our success will be repeated.
U.S. hedge fund manager Joel Greenblatt outlined his stock-picking strategy in The Little Book that Beats the Market , published in 2005. He aims to find companies that are both profitable and cheap by focusing on two measures: return on capital and earnings yield.
The higher the return on capital - which he defines as pretax operating profit divided by the sum of net working capital and net fixed assets - the more effectively a company is using its capital to generate profit.
The higher the earnings yield - which he defines as pretax operating profit divided by enterprise value, or the sum of stock and debt - the more attractive the stock is from a valuation standpoint.
The goal is to find a company that's both profitable and cheap, so you're getting the best of both worlds.
We used the stock screener at magicformulainvesting.com to select U.S. companies with a minimum market capitalization of about $2-billion (U.S.). The screener lets you choose portfolios of 30 or 50 stocks; we only wanted 20, so we created a 30-stock portfolio and took the smallest 20 by market capitalization.
We invested a hypothetical $50,000 in each stock, for a total of $1-million.
From Dec. 31, 2009, through April 9, 2010, our Magic Formula portfolio rose 11.1 per cent in U.S. dollars (excluding dividends), led by large gains in clothing retailer Aeropostale Inc., which has benefited from a rebound U.S. consumer spending, and CF Industries Holdings Inc., which was acquired by CF Industries Holdings Inc.
Over the same period, the S&P 500 gained 7.1 per cent. Three months isn't long enough to measure the success of any strategy, but this portfolio is off to a good start. We'll check back every few months to see how it's doing.
It's worth noting, however, that a Canadian investor owning these stocks wouldn't have fared so well. Reflecting the loonie's 4.9-per-cent appreciation over the same period, the portfolio is up just 5.8 per cent in Canadian dollars.
Tomorrow we'll get an update on a portfolio of Canadian stocks we created using a similar methodology.