https://www.youtube.com/watch?v=I7GBHGg3pds

In my article “Stop being a patsy in the stock market in the link below,

http://klse.i3investor.com/blogs/kcchongnz/127246.jsp

I suggested that one should not speculate in the stock market following rumours, hot tips, hypes and fads as most people doing so have lost money. In the above article, I have shown you some example of speculative stocks which I talked about them from 4 years ago. The portfolio of 9 speculative stocks lost an average of 54%, with 70% of them lost more than 43%, one up to a loss of 92% over the 4-year period.

Instead I advocated investing following the “right path” to build long-term wealth. That involves looking at the stock as owning part of the business of the company which issued the stocks. The “right path” of investing will involve the plausible logic of buying good companies at reasonable or cheap price. Your investment grows with the business of the company.

In the following article “Invest in good and cheap” in the link below,

http://klse.i3investor.com/blogs/kcchongnz/127444.jsp

I have shown a portfolio of ten stocks named “GE13 Stock Watch”, followed the principle of investing in good and cheap, as published on 21^st January 2013 some four and a half years ago in i3investor returned an average of 151% as on today, widely out-performed the gain of the broad market KLCI of just 19.1% and the FTSE Bursa Small-Cap Index of 58.2% during the same period.

But how to identify good companies? How do we know if a company is good and selling cheap?

Just 2 days ago, I introduced a value investing strategy of buying good companies cheap in Bursa, the “ColdEye 5 yardsticks” investing strategy as shown in the link below.

http://klse.i3investor.com/blogs/kcchongnz/127559.jsp

The strategy identifies a good company with high return on equity, or ROE, and cheapness from some metrics such as P/E, P/B, P/Cash flows, and dividend yield. P/E is a very common metric to determine if a company is selling at reasonable price.

A portfolio of 9 stocks meeting the criteria above and were chosen as good investing candidates at about the time on 17^th March 2013 basing on the 5 metrics. After four years and four months and as on 10^th July 2017, the portfolio returned an average of 325%, with the median return of 222%. This return way out-performed the total return of 18.3% of KLCI over the same period.

As you can see, investing in good companies cheap did provide high extra-ordinary return over a medium period of four to five years.

However, there are some problems of using ROE and P/E ratio blindly.

Pitfall of ROE and P/E ratio

For the metric of ROE,

ROE = Net profit / Common equity

The first problem of the ROE formula is the net earning is the bottom line of the Income Statement which may include some one-time-off items and non-operating items such as foreign exchange gain/loss, revaluation gain, gain in disposal of assets, etc. These items are non-recurring and can distort the true performance of the company.

There are other problems about this metric of ROE as discussed in the thread below,

https://klse.i3investor.com/blogs/kcchongnz/63417.jsp

Similarly, the P/E ratio, with “E” the net profit can also distort the true value of the company.

Remedies

One way to minimize this problem is to look at the earnings before interest and tax (Ebit), a number before all the extra-ordinary items such as gain in revaluation of assets, gain in foreign exchange, gain from sales of land and other assets etc which are one time off and non-recurring.

As Ebit is the income for both the equity and debt holders, to be consistent, enterprise value (EV), which includes all capital providers, is used instead of the market capitalization. This ratio of EV/Ebit replaces the simplistic P/E ratio to determine if a company is worth buying.

In place of ROE, which measures the performance for the equity shareholders only, we use the metric of return on invested capital, or ROIC. This return of Ebit is the return for all shareholders as well as debt holders, and Invested capital includes all capitals provided by the equity holders as well as the debt holders. That is the essence of the Joel Greenblatt Magic Formula Investing.

The Magic Formula Investing

The concept of the Magic Formula is simple, the explanation is simple, but most important of all, and the execution for investors is not that difficult to do on their own. For more detail explanation of the Magic Formula of Greenblatt, how has it performed, and why it performed and continues to perform, please refer to the link below:

https://klse.i3investor.com/blogs/kcchongnz/51631.jsp

The key driving formulas used by Greenblatt for his Magic Formula are:

• Earnings Yield = EBIT / Enterprise Value
• Return on Capital = EBIT / (Fixed Assets + Net Working Capital)

Note those metrics above, unlike ROE and P/E, are generally not that readily extracted from the financial statements. One needs to know some accounting and do a little more homework in addition, subtraction, multiplication and division to obtain those numbers. It is not very difficult though.

According to established records, the Magic formula outperformed S&P 17 out of the 22 years from 1988 to 2009, and achieved a compounded annual growth of 23.8% as compared to the 9.6% of S&P. $10000 invested 22 years ago in 1988 has grown to 1.09m by the end of 2009, even after the US sublime crisis in 2008-2009. This is by no means a small feat.

My investing experience in Bursa

I have been using the principles of The Magic Formula for most of my stock picks. Note that the sharing is just a discussion that the Magic Formula works in Bursa, rather than boasting the return of my investment.

Here is a portfolio of 11 stocks, named “2013 2H Stock Pick Challenge” as established and published in i3investor from 1^st August 2013, about 4 years ago.

http://klse.i3investor.com/servlets/pfs/19386.jsp

The investment thesis of all those stock picks can be found in the link below which you can assess to,

http://klse.i3investor.com/blogs/stock_pick_challenge_2013_2h/blidx.jsp

How has the portfolio performed if holding for 4 years until today on 13^th July 2017?

Performance of Stock Pick Challenge 2H 2013

Table 1 in the Appendix shows 11 stocks chosen mostly using the Magic Formula investing strategy from 1^st August 2013 to the end of the month. Slightly less than four years have passed and as on 13^th July 2017, the average total return of the 11 stocks chosen is 175%, with the median return of 136%. This return is equivalent to a CAGR of 30%. It way out-performed the total return of 10% of KLCI, and 67% of the Small Cap Index over the same period.

Many stocks over-performed the market by wide margins, with 6 out of 11 more than 100%. There is no loser, and only with two underperforming the overall market, by just.

Heads I win; Tails I don’t lose much.

I must acknowledge the role of luck could play an important part in the good return. However, it is hard for us to dismiss the probability that the extra-ordinary outperformance could also be due to the viability of the strategy of the Magic Formula.

Conclusions

The Joel Greenblatt Magic Formula investing appears to be another attractive investing strategy of buying good companies when they are selling cheap. It has also provided high return with limited downside in my stocks selection. The two metrics may require a little work to compute but it is not as daunting as most people think.

Aren’t you also interested to make use of this proven investing strategy to buy good companies when they are selling cheap to building long-term wealth, surely, slowly and safely?

I just can’t stop talking about the benefits of fundamental value investing.

Again, if you are interested in learning about fundamental value investing and at the same time, getting some investing ideas for investing in Bursa, you may contact me at

ckc14invest@gmail.com

K C Chong

Appendix

Table 1: Return from Magic formula Investing