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'Magic formula' aims for best of both worlds

What are we looking for?

Today we'll introduce a new batch of Canadian stocks selected using the "magic formula" strategy of Joel Greenblatt, a U.S. hedge fund manager and author of The Little Book that Beats the Market. Mr. Greenblatt's stock screen at magicformulainvesting.com covers only U.S. equities, so we'll use a Canadian screen developed by Validea Canada.

The methodology

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Mr. Greenblatt looks for companies that are both profitable and cheap by focusing on just 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 - defined 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.

By focusing on those two measures, the "magic formula" aims to get the best of both worlds. According to Mr. Greenblatt's book, this formula produced back-tested returns that handily beat the S&P 500 from 1988 through 2004.

"[Mr.[ Greenblatt's research shows that while beating the market is hard, it doesn't have to be complicated," says Validea, which has no affiliation with Mr. Greenblatt.

"The hard part comes not in developing a complex strategy, but instead in finding a proven approach and sticking with it through good times and bad. [Mr. Greenblatt]stresses discipline as much as any of the gurus we follow."

The results

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Today's screen shows the 10 Canadian stocks with the highest "strategy score" based on closing prices as of March 2. These are the stocks that Validea's Joel Greenblatt model portfolio would have included had it been rebalanced this week.

The model portfolio, which is rebalanced monthly, has gained 7.8 per cent since inception on Aug. 6, 2010. That trails the 19.9-per-cent gain of the S&P/TSX composite index over the same period.

Seven months isn't long enough to judge the merits of any strategy, particularly a value-driven one. We'll check back again in the future to see how the model portfolio is performing and to introduce a new batch of "magic formula" stocks.

Remember to do your own research before investing in any security. Use stock screens as the starting point for further investigation, not as the last word on whether you should invest in a particular stock.

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About the Author
Investment Reporter and Columnist

John Heinzl has been writing about business and investing since 1990. A native of Hamilton, he earned a master's degree from the University of Western Ontario's Graduate School of Journalism and completed the Canadian Securities Course with honours. More

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