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I read The Little Book over the weekend. It came near the end of a flurry of reading I've done recently on value investing. Since I've found this board and enjoyed the posts here, I thought I would share my initial thoughts.

First, the screens make a lot of sense to me. I was already coming to the conclusion that high ROIC was perhaps the single most important factor for a successful value stock investment approach. I hadn't focused on EBIT as a measure of earnings, but it makes sense. EBIT levels the playing field for companies with different tax rates and is the appropriate earnings measure to compare against total capital (which includes interest bearing debt). The next best alternative would be EBITDA - capital expendtures. But if you're only looking at firms with high ROIC, you shouldn't be too worried if capex currently exceeds depreciation and amortization. All in all, the two screens are an elegant way to call one's attention to companies that are likely to be good value plays.

On the other hand, this is at heart a mechanical investment approach and the track record of other mechanical investment strategies is pretty dubious. And with only 17 years of back testing, the research comes up a little short, in my estimation. I would have preferred to see the results with data including the doldrums of the 1970s and at least two full secular bull and bear market cycles (say, 40 years or so of data). But I know the Little Book is not intended to be an academic research paper, so I'll leave it at that.

As for actually trying this investment strategy, I'm not sure yet. Aside from the limited data tested and the dubious record of mechanical strategies in general, I have several other concerns:

1. The test data were based on buying the 30 top ranked stocks at one time. (The formula was also tested using the top decile, i.e., the top 250 of the 2500 largest companies.) But the book and the website encourage you to buy 5 to 7 stocks at a time over a period of 9-10 months. The strategy has been tested with groups of 30 - 250 stocks, but it does not follow that just because the strategy works for the top 30 stocks that it will work if you select only the top 5 or 7 stocks. In my experience, many times the very top stocks selected by any screen tend to be "flawed" in some way. That is, they popped up on the screen because of some abnormality or temporary situation that resulted in financial statistics that don't accurately reflect the true conditon of the company. What if that's the case here? I don't recall this issue being addressed in The Little Book. Until it is, I would not recommend that anyone try to find the top 5 or 7 stocks using this formula. You would be better served (or at least more likely to achieve results in line with the historical results described in the book) if you buy a totally random assortment of stocks from the top 25 or 50 or 100 that come up. This in fact may be the reason why the website gives the results in alphabetical order, rather than ranking the stocks in order.

2. The website lets you screen for stocks as small as $1 million in market cap. I would not do so. The back testing described in The Little Book was based on companies with a minimum market cap of $50 million. This may well work for smaller companies, too, but there is no data to support that assumption. Because this is a mechanical approach, going outside the bounds of the data that have been tested is very risky no matter how much sense or intuitive appeal there is for applying this to smaller market cap companies.

3. There is a temptation to tweak the formula to achieve even better results. The Little Book even seems to encourage this. After all, the 30 (or 25 or 50 or 100) top stocks are bound to include many losers (that underperform the market) as well as winners. In fact, the losers might even outnumber the winners. So it is tempting to try to add some criteria to use to select which stocks to invest in out of the 25, 50 or 100 top stocks. The problem is, if you choose the wrong criteria, even though it seems to make sense, you might end up inadvertently systematically eliminating the best companies and investing in the wrong stocks. For example, you might want to eliminate all companies that haven't had sales growth of at least 5% per year over the past 5 years. Or you might prefer to invest only in companies that pay a dividend and where the dividend does not exceed 80% of earnings. Those are good qualities to look for in general, but will they help you pick better stocks among the top stocks in this screen? I really don't know.

The screen seems to me to focus on value stocks, so I suggest that tools used to evaluate growth stocks or income stocks are not appropriate. I'd like to hear from others as to what kind of value investing tools might be used effectively on the Magic Formula stocks. Some things I am considering include:

A. Th screen relies heavily on ROIC. All things equal, I would prefer to invest in companies with have maintained a strong ROIC over a number of years (even if the ROIC is gradually declining -- with pre-tax ROICs of over 70% it seems inevitable that many of the ROICs of these companies will fall over time).

B. I might eliminate any companies that have a large amount of non-operating or "other" income (e.g., investment income or income from sales of assets).

C. I might eliminate any companies that have negative equity or any other unusual captial structure that I'm not comfortable with.

D. The screen ranks companies using a relative valuation technique (firms with the highest EBIT/EV yield). Perhaps one could try to apply some other valuation methods that do not rely on relative valuation techniques. Because the companies all have high ROIC, I suspect that most of them will seem fairly attractive using a discounted cash flow valuation, so that may not be much help. A different approach would be to try to come up with a balance sheet-based valuation. For example, I might try to estimate the value of the firm's tangible and intangible assets (including off-balance sheet "assets" like R&D, brand awareness, existing business relationships, etc.). Bruce Greenwald (who is quoted on the back cover of The Little Book) describes such a method is his book Value Investing: From Graham to Buffett and Beyond. The problem here is that this seems like it would be a lot of work (and one of the virtues of the Magic Formula is that it shouldn't require much work) and there are many areas of uncertainty in any valuation method.

Anyway, those are my initial thoughts. I'm looking forward to continuing to discuss this approach and ways to implement it.

Slee
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