Last month, two European quants, one working for Robeco and the other for Allianz, published a paper asking (and answering) whether formulaic investing is possible. Marcel Schwartz of Allianz and Matthias X. Hanauer of Robeco are also associated with the Technical University of Munich.
The pair studied four formulas, including a conservative low-volatility strategy, The Acquirers Multiple, The Piotroski F-Score, and Joel Greenblatt’s Magic Formula.
Interestingly, people associated with developing these formulas, such as Tobias Carlisle of Acquirers Funds and Wes Gray and Jack Vogel of Alpha Architect, also consulted on the paper.
To make a long story short, all four formulas delivered excess returns.
I am a huge fan of formula investing and have used the Acquirers Multiple and the F-Score strategies successfully over the years.
To me, they are both extensions of Ben Graham’s original value-investing and margin-of-safety theories.
I am quite familiar with the Magic Formula, although I have not used it as much as I probably should have.
If the Acquirers Multiple and F-Score models are descendants of Ben Graham, the Magic Formula is the reincarnation of a young Charlie Munger. Greenblatt’s formula helps identify companies that are earning high returns on the capital used to build and run the business and trading at bargain prices.
I decided to run a survey to find stocks that fit the Magic Formula definition in today’s overheated market.
I also added some features that increase my comfort level with owning these bargain issues.
The broader market may face tough sledding going forward as large-cap stocks are priced for perfection in an imperfect world.
Because of that, I want to collect a dividend.
Dividends, once paid, cannot be taken away.
Finally, I am always aware that it is unlikely that one will beat the market by doing what everyone else does.
I want my stocks to be under-owned by institutions.
If the company keeps earning high returns on capital, the big money funds will eventually pile into the stock, and their buying pressure will send the prices soaring.
United-Guardian UG makes the list of undervalued high-return companies.
Although the name sounds like an insurance company, United-Guardian makes personal and medical lubricants and pharmaceuticals.
The company is earning very high returns on the capital employed in the business, with an earnings yield of over 10%.
The cash dividend yield is 5.6% at the current price.
Although it is not part of the formula, United-Guardian also has a bulletproof balance sheet with plenty of cash and no long-term debt.
The President of United-Guardian owns almost 30% of the company, which has discouraged institutions from buying the stock. Funds currently own just 22% of the company.
We often find high-return companies trading at bargain prices because they are in a business everyone hates.
This is doubly true for Alliance Resource Partners LP ARLP.
This natural resource company mines coal and sells it to utilities and industrial users in the United States.
I would be hard-pressed to think of a business more hated than coal in today’s world.
Moreover, Alliance Resource Partners is just that: a partnership.
It is a Master Limited Partnership, which means you get a K-1 instead of a 1099 each year for tax purposes.
K-1s are a pain in the backside region.
It is probably worth putting up with the hassle. Alliance Resources earns high returns on capital and generates a ton of cash, most of which ends up in shareholders’ pockets.
The earnings yield is 13%, and the cash dividend yield is 10.25%.
While coal is the dominant business, Alliance also has a growing royalties business. It owns 68,578 net royalty acres in premier oil and gas producing regions that produce over 3 million barrels equivalent of crude and natural gas.
Plenty of skin is in the game as insiders own about 17% of this company.
Most institutional managers would cut off a limb before getting caught with a coal company on their sheets, so ownership by the big funds is just 17%.
On the renewable fuel side of the equation, we find Future Fuel FF, a company that makes fuels from a mix of diesel, vegetable oils, and grease feedstock.
They also have a chemical division that makes products used in everything from farming to dish detergent.
The dividend yield is over 4%, and the earnings yield is over 15%.
Institutions own very little stock apart from index funds.
Insiders, on the other hand, own 41% of Future Fuel.
You may notice that I did not do a “deep dive” on any of these companies.
That is the whole idea of formulaic investing.
In the last interview he gave, Ben Graham suggested that most investors would be better served by a value-based formula approach to investing.
He told the Financial Analysts Journal, “In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”
He suggested instead that a formula approach, rigidly followed, would likely deliver market-beating results with a minimum of effort. Who are we to argue with Ben?
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