Magic Formula Investing Year in Review

NEW YORK ( TheStreet) -- Magic Formula Investing, or MFI, the strategy invented by hedge fund manager Joel Greenblatt and covered by MagicDiligence, had a good year in 2010. There were several big winners, a rather limited number of large losers, and as a whole, the strategy delivered its adherents gains solidly beyond that returned by the S&P 500.

The bible of Magic Formula Investing, The Little Book that Beats the Market, emphasizes including small-caps to maximize the strategy's returns. Below is a chart that shows the relative performance of MFI's "top 50 stocks over 50 million market cap" screen against the S&P 500 ETF ( SPY). The results below assume that all 50 MFI stocks were purchased on one date and held until Dec. 23, and compares the average performance of all stocks in the screen with buying SPY on the same day. 52 samples were taken, on Wednesday of each week in 2010.

The largest gains from MFI came early in the year, particularly in February, where the screen averaged almost 24% for each purchase, far outperforming the S&P's 14.8%. The worst performance came through April and the first part of May, when MFI trailed the S&P by 2.4% on average. In all, though, the strategy's success is evident. The formula outperformed the S&P in 41 of 52 samples, and for the entire year, the average MFI portfolio appreciated 13.1% vs. the S&P's 10.3%.

Also impressive was the "hit rate" of MFI. In just one of the 52 samples (the last one, on Dec. 22) did the screen have less than 50% of its stocks finish with positive gains. In 17 weeks, more than three-quarters of stocks delivered positive gains to the end of the year. Put simply, there were very few duds in MFI this year, a stark contrast to what I've seen in the past.

MFI dug up some big winners for the year:
  • Magic Software (MGIC): MGIC's performance in 2010 was truly magical. If you purchased the stock during its February run in the screen, you would have enjoyed nearly a four-bagger (300% appreciation). This Israeli cloud computing, "platform-as-a-service" provider was the single best performer of MFI in 2010.
  • Questcor Pharmaceuticals (QCOR): Questcor had similarly strong results, delivering more than a triple (200%) from January listings in MFI. A purchase as late as mid-March would have doubled. In the review, I mentioned that this was a risky, but potentially lucrative, stock, given its dominance of a niche market. Competitive failures and new indications for its single drug Acthar have pushed the stock ever higher.
  • Synta Pharmaceuticals (SNTA): Synta is a classic example of the unpredictable nature of development-stage drug companies. Frankly, I panned the stock in my review, as it lost its main candidate Elesclomol, had nothing out of phase II trials, and was burning a lot of cash. However, strong early results for STA-9090 have sent the stock sharply upwards. This is still a lottery ticket, but it is hard to argue with 130% gains from August.
  • CF Industries (CF): CF is up more than 100% from May/June MFI purchases. The completion of the Terra Industries acquisition has given the firm a dominant market share in nitrate fertilizer, which plays perfectly into a now 3-year long agricultural bull market. Back in the spring, the market was concerned that CF overpaid for Terra, but recent results have buried those concerns for the time being.

The losers:
  • SuperMedia (SPMD): This stock, both in current form and in its previous life as Idearc, has been kryptonite to MFI. It is down 80% from its appearance in the screen through February and March. This yellow pages publisher is the quintessential "bad" Magic Formula stock.
  • Jackson Hewitt (JTX): Tax prep firm, down about 50% since appearing last January. The loss of refund-anticipation loan funding, franchisee problems, a poor balance sheet and a move toward self-filing has decimated this once solid company.
  • Chinese reverse takeover stocks (China Sky One Medical (CSKI), China Jo-Jo Drugstores (CJJD), China North East Petroleum (NEP), China Education Alliance (CEU), etc.): Most of these have declined at least 20% since showing up. Successful short attacks, fraud allegations and an overall distrust of management and auditors has been the theme for 2010. I believe some may have been explicitly removed from the official screens due to fraud allegations.

The Magic Formula Investing strategy continued its history of market-beating returns in 2010, and investors should expect more of the same in 2011.

At the time of publication, Alexander had no positions in stocks discussed in this article.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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