MFI and Volatility

I'd be interested to know the experiences of others, but as far as my first year of Magic Formula Investing goes, I've been a little surprised by the day-to-day and week-to-week volatility of the MFI stocks in my portfolio. You really have to be a believer in the formula, because -- again, based on my own experience -- these stocks tend to jump around a lot. This bothered me at first, but now it is something that no longer phases me. Time and time again, my overall portfolio will drop 1-3% in a day, only to rebound a few days or weeks later. Also, my portfolio crashed this summer (falling well into negative territory), when the Federal Reserve announced that they would continue raising interest rates. I believe this is why it's important to be a true believer in the formula. It gives you confidence to hold on those days when your stocks are falling rapidly. Without that confidence, you are at the mercy of Mr. Market and his crazy daily moods.

More on LEAPS . . .

In an earlier post, I discussed the possibility of leveraging the Magic Formula using LEAPS -- which are long term options to purchase a particular stock at a given price. There are three benefits that I see to using LEAPS to leverage the formula (as opposed to using a margin loan). The first involves the margin call. If you take out a margin loan, you could be forced to sell at the worst possible time if your overall holdings drop to the point where there is no longer enough equity in your account to cover your margin loan. With LEAPS, there is no such risk that you would be forced to sell during a sudden and rapid drop in equity prices.

I believe that there may also be a tax benefit to using LEAPS. With a LEAP, the amount that you pay for "interest" is built into the option itself -- eliminating the possibility that you will be paying capital gains on amounts that you actually had to pay in financing charges. You also may be able to deduct your margin interest, but the rules are complicated, and you are not allowed to add the interest charges to the basis you have in your stock. (Admittedly, I am not that fresh on the IRS regulations re: deducting margin interest from your capital gains).

The third benefit of LEAPS is that you can decide for yourself how much leverage you want to use. You can be conservative and buy LEAPS that are solidly "in the money," or you can put down very little and buy LEAPS that are highly leveraged and must rise several percentage points. I tend to favor a more conservative approach, but the flexibility is there if you want to go with more leverage than your margin account will allow.

The main downside to using LEAPS -- which a reader pointed out in an earlier post -- is that you can only buy LEAPS on large cap stocks. I've run the MFI using stocks with market caps above 1000, and most of these have 1 and 2 year LEAPS. The MFI approach works for large cap stocks, but, as Joel points out in his book, returns have not been as high as those for small cap stocks.

Your thoughts?

Disappearing MFI Stocks: What's Going On?

If you subscribe to either of the MFI discussion boards (one is on the Motley Fool site, the other is on Yahoo), then you probably have noticed the discussion about disappearing MFI stocks. Every now and then, a stock will show up as a top 25 stock for a few days or weeks, and then disappear entirely from the list for apparently no reason. This happened to me with TOPT (the stock that is the subject of the post below). It also has happened with GSTL and FTAR, as well as some others on the list.

MFI investors have given several possible explanations for this. Some have argued that small changes in the stock's price can cause it to jump off the list. I don't buy this explanation. I've gone back and checked the departed stocks, and in several instances it will be trading at the very same price that it was trading at before it left the list. Also, the natural progression for most of the MFI stocks that do well is for them to slowly move down the list: they may drop off the top 25 list, but still remain on the top 50. Stocks that do poorly tend to stay on the list -- the only thing that changes is their Pre-Tax Earnings Yield, which goes up. In light of this, I don't think that the disappearing stock phenomenon can be explained by changes in stock price.

Others have argued that the disappearing stocks are caused by the time delay between the point when earnings are reported, and the point when they are entered into the Compustat Database. The Compustat Database is where Joel gets his information, which he then uses to calculate Pre-tax Earnings Yield and Pre-tax Return on Capital. I think this is a better explanation, and it explains why some companies are dropped from the list weeks after they report their quarterly financial results. However, this explanation does not explain those stocks that are on the MFI list for only a few days, and then disappear (this happened with TOPT and GSTL). I still don't think anyone has explained what is going on with those stocks that are on the list for only a few days.

Any thoughts?

Continue to Hold When Company Restates?

This morning we got a nice little surprise from Top Tankers, Inc. (TOPT). There are probably very few MFIers who hold TOPT (it was only on the MFI list for a few days, and then it disappeared). I am, however, one of the lucky few. Anyway, this morning, management announced that they were firing their auditor and will be restating Q1 and Q2 earnings. Oh, what fun! TOPT was down 14% today, and this is on top of the 20% it was already down since I purchased the stock.

This begs the obvious question: should I continue to hold TOPT for the full 1 year holding period. The fact that TOPT is restating its Q1 and Q2 financial results suggests that TOPT was never really a MFI stock in the first place, but simply made its way onto the list by virtue of faulty accounting. On the other hand, selling before the 1 year holding period would be a break from the formula. I'm sure Joel would say that his back-testing took these types of companies into account.

I'm going to hold. Still, in this particular instance, selling is tempting and has crossed my mind.

MFI and LEAPS?

After reading Joel's earlier book "You Could Be A Stock Market Genius," I came up with another possible way to leverage the MFI (see my post on using margin to turbo-charge your returns below). One could leverage the Magic Formula with LEAPS. As Joel explained in his earlier book, LEAPS are option contracts that typically have very long expiration dates (as long as 2 years). The benefit of LEAPS -- like all options -- is that they are highly leveraged. Leverage, of course, works both ways. Still, I've thought about using the MFI to identify top companies, and then investing in LEAPS.

Any thoughts?

How Long To Hold? Why It Matters

I am a true believer in the Magic Formula. Still, there are a few things that I wish Joel Greenblatt and his compatriots would have looked into a little bit further. One such area is the holding period. In the "Little Book," Joel argues for a 1 year holding period (a few days less than 1 year for losers in your portfolio, and 1 year and a day for gainers). The 1 year holding period means that I'm going to be paying capital gains every year. I have no problem with that if I'm going to be getting the type of returns Joel outlines in his book.

However, Joel recently suggested in an interview that a 2 and/or 3 year holding period works equally well. I'm surprised Joel did not look at this in his book. All things being equal, I'm definitely going to want to hold the stock in my taxable accounts for 2 or, even better, 3 years. Then I can delay paying capital gains and put that extra money to work for me. I wish Joel would have compared the 1, 2 and 3 year holding periods. Investors could be better off going with the 3 year holding period if returns are comparable.

Any thoughts?

Leverage Anyone?

I've been wondering a lot lately whether it is smart to use leverage with the MFI? If you can get 30% returns with the MFI, then why not turbo-charge your portfolio with leverage -- i.e., a margin loan. I have to admit that I've done a little of this the past year. However, I've also taken Joel's advice -- which he lays out in his earlier book "You Can Be A Stock Market Genius" -- and only taken a very moderate amount of margin out in my brokerage account. This can be dangerous if done at high levels.

Any thoughts on this?