Have Your own Magic Formula

A successful self trader – Rule # 1

The word magic formula may sound quite incongruous in the context of capital markets. But the fact is that not all strategies work for every investor. Can you imagine Warren Buffet as a short seller? Can you visualize Soros as a long term fundamental investor? Can you imagine Lynch as a trend trader? Each of them has identified their own magic formula and has religiously stuck to it. Touché!

FROM THE EDITOR’S DESK

There is nothing really magical about a magic formula in markets. It is simply a formula that has worked for you in the past, is based on sound business logic and delivered returns consistently in most market situations. When a formula works for you, there is nothing superstitious about it. It is just that it is probably a formula that is best suited to your market philosophy. Let me explain!

I recollect an investor in Delhi who had succeeded by consistently buying capital goods at every dip. A valuation of 10-12 P/E was an attractive level for him. The formula worked wonders for him through the 2003-2006 periods. By 2008 he was deep in losses as he had continued to buy these capital goods stocks at P/Es of above 30. He literally got burnt in the downturn. Now for the solution!

His success formula was not buying capital goods stocks but buying them at an attractive P/E. We asked him to unwind his entire position and wait for the carnage to settle down. Around late 2008, we again got him into capital goods stocks at a P/E of around 9-10. The magic formula worked once again. He had recovered his loss and made a pile by 2010. So what is the lesson?.

3 REASONS TO STICK TO YOUR MAGIC FORMULA

It is suited to your personality

 A defensive strategy for an aggressive trader does not work, and vice-versa. A magic formula is one that fits into your trading style and your personality. Hence it fits seamlessly and works for you in majority of the cases!

 Known devil versus unknown angel

 A magic formula is your known devil. It may have its shortcomings but it has

worked for you perfectly in the past. Be clear about the contours of your magic

formula and write it down on a piece of paper.

 About strategy and responses

 Your portfolio performance is not just a function of your strategy but also your response to changing dynamics. A magic formula is that which best captures your ability to respond to market stimulus. Probably, why it is successful for you!

“Your magic formula should be designed to beat the market and withstand market shocks along the way” – Joel Greenblatt

6 TYPES OF MARKET MAGIC FORMULA USED IN PRACTICE

  1. Dividend yield is a common magic formula. Normally, for stable companies with low growth, dividend yield of 4% and above is attractive. For high growth companies, a dividend yield of 2% may be attractive. Investing based on the dividend formula works consistently in case of quality companies!
  1. P/E based churn is another magic formula that has worked for many traders and investors. Getting into quality stocks closer to the lower P/E band and exiting closer to the higher P/E band works for many investors. It also makes economic sense as it is a liquidity neutral strategy!
  1. Quality managements on dips is also quite a common magic formula. Works beautifully in case of FMCG and pharma stocks. This works despite high P/Es. Typical cases are stocks like Asian Paints, Sun Pharma, Colgate etc.. Buying them after a 25% correction may invariably be accretive for you!
  1. Macro play on cyclicals is again a strategy that works. Going long on cyclicals in a macro uptrend and long on defensives in a macro downtrend is not only logical but works over longer periods of time. Better to avoid this as a short term strategy, as it works better over longer holding periods only.
  1. Quant based approach has again worked for a select few who know how exactly to apply the same. Automated stratgies based on technicals, charts, trends, derivatives data all capture short term trends and turnaround situations to perfection. This approach may not be meaningful to all investors.
  1. Lastly, there is the Next Big Story formula. Big money is made by betting on the next big story. Tech, pharma, MNC, Consumer discretionary were all big trends at some point. But the gestation may be too long and the success ratio can be quite low. This formula calls for deep understanding and patience!

 MAGIC FORMULA AND YOUR INVESTMENT PERSONALITY!

 The truth is that everbody has an investment personality. You may be patient, opportunistic, mercenary or it can be any other defining charactristic of your personality. First be clear that your magic formula fits into your investment personality. A mercenary trader trying out a Next Big Story formula is a recipe for disaster. You just will not have the personality to make a success of such a long term formula.

Once you are sure it fits your personality, back it with data. Create a hypothetical portfolio and try to run a dummy for a period of 3-4 months. While this may be a short period, it will give you a good idea whether your idea is good only on paper or in practice too. Your personality defines your strategy and your response to external stimuli. Your practical testing gives you a picture of whether your magic formula is workable in practice. Of course, rethinking and reworking will be a continuous process!

 TAKEAWAYS FROM THE “MAGIC FORMULA” DEBATE…

 Joel Greenblatt, founder of Gotham Capital Hedge Fund, was a pioneer of “Magic Formula” based investing. His magic formula of high ROCE combined with high earnings yield returned over 40% return for 21 years in succession. But these magic formulas have certain assumptions. High growth and cheap money are implicit assumptions of this kind of a formula. It may be difficult to replicate that kind of performance in Indian markets where the macros may be entirely different. Watch out!

The moral of the story is that these magic formulas (for want of a better word) help in creating scientific rules that are tailored to your personality. I always asked myself, “Would a Buffet style formula of perpetual investments work in India” Probably not. Remember that the leaders of the 80s, 90s and 2000s have been a different set of companies altogether. Trying to find long term value in that scenario will be as ambitious as it’ll be difficult. Rather, an Indianized magic formula. That should work!!

15 responses

  1. This is a very good article. It shows that the best strategy is to find your own wany to pick moeny from the market amongst those who operate their own practices, rather than copying them. Strategy is to build a portfolio using one or more of the above strategy and decide the manner in which to seperate upsides and safely park them.

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