CF - September Self-Indexing Strategies For A Possible Blue October

2023-09-11 02:21:19 ET

Summary

• The Magic Formula is still one of my favorite broad-based indexing strategies.
• I buy these lists in a price-weighted format and do not liquidate any of the positions.
• Whatever personal experiment you'd like to conduct with the Magic Formula, you can be confident that the strategy gets you a cheap high-quality cross-section of the US equity market.
• These are the top 30 dividend paying Magic Formula stocks scored for September 2023.

Magic Formula with a dividend kicker "self-indexing" strategy

Continuing with my theme this month for broadly diversified strategies in the face of an uncertain market direction, I present to you the latest list of large-cap Magic Formula picks. All of these picks are based on one of my favorite self-indexing strategies associated with Joel Greenblatt's The Little Book That Beats The Market . The book also has an associated free screener that can be used to screen for stocks that meet the "good" and "cheap" criteria of the Magic Formula.

To spare everyone an overly verbose description, previous articles where I covered it can be found here and here . In a very short summary, the formula is derived by adding the return on invested capital "ROIC", to the earnings yield and scoring the market. Since I am also an avid dividend investor, when I generate a list, I cross off all of the non-dividend payers. My readers know that I am a holder with the goal of ultra-low turnover. I am aware that not all of these picks will do well in the next 1-3 years. However, if I have a dividend, I can accumulate more shares on DRIP through accretion in set it and forget it fashion.

Greenblatt on the other hand advises to sell at the 1 year capital gains mark and buy a new list. I diverge here as I dislike selling and paying taxes. Compound interest models show clear differences between selling at the end of every year and letting your money compound indefinitely without selling. I am just an individual investor after all, not a hedge fund manager with endless access to margin and the goal of beating my contemporaries on an annual basis to attract more capital. Buying and holding is the best bet the individual has.

Human evolution and our 3,000 year old self

Carrying on with my broad-based buy theme from the previous article about the Vanguard S&P 500 ETF ( VOO ) in which I referred heavily to Nicholas Taleb's Fooled By Randomness, I would like to note a couple more observations. In one introspective part of the book, he recalls gazing upon statues in Greece and Rome. These statues are human figures that much resemble ourselves today, even though these may be 3,000 years old, our genetic makeup is much the same.

These individuals of the past stayed close to home, as travel could be physically harmful or even fatal. The information came in bunches by messenger with long intervals in between. Stress and emotion were more based on interactions that required us to survive. Life was simple. Taleb noted that he realizes that the same emotions a fellow trader expresses by smashing a computer screen after blowing up their account or the emotion that erupts from a bout of road rage are not as illogical as we think. Society has changed faster than we can evolve.

The point is, that our brains can still not differentiate accurately between the stresses of a bad trade, an offensive gesture, and a lion attack. Different people have different abilities to differentiate but some resonance of our 3,000-year-old self will remain with all of us. This falls along the three-brain theory where we have our survival/instinct reptilian brain, our emotional limbic system, and the higher-thinking neocortex. The evolution of your neocortex may determine your ability to hold a position.

Since psychologists have determined that a loss is twice as painful as the equivalent joy of a gain, the trick of convincing your brain to hold on through red days is difficult. It takes much meditation and historical reflection to train yourself in the right patterns. This is why day trading can be very injurious to the brain. It's a high-stress activity with fight or flight occurring daily.

If this is the case [regarding day trading], you would need to hit roughly 70% of your trades [if we are equal weighting the size of each return or loss], to remain chemically balanced and emotionally upright. Even though I am not a trader, I know this is not likely. The greatest compliment you can pay an investor or neurologist must be “what a big neocortex you must have”!

The list

There are multiple strategies you can use when generating a Magic Formula list. You can buy the whole market from small to mega caps, or set your market cap threshold. I use $12 billion and up as my market cap threshold as this is roughly where the S&P 500 starts. Technically it's $14.5 Billion, but $12 gives some leeway to companies that may have fallen below the market cap requirement for a period or for companies that are almost there.

In recap, the scores are derived of:

• ROIC %
• Plus Earnings Yield %
• Plus Dividend Yield %

Again, Greenblatt does not use the dividend as a kicker, this is simply a metric that I like to drill down on for the aforementioned reasons. The ROIC metric tends to hold the largest weight in the formula. Also please note, that earnings yield was calculated here by using the EV/EBIT multiple rather than the inverse P/E ratio:

The scores

Amongst the highest scores in the $12 Billion and above Magic Formula index for September include:

Top 3

Both Steel Dynamics and Nucor ( NUE ), have been consistently on this list for the past couple of years. Two impressive Steel giants, they have been operating at the top of their cycles for quite some time and are still priced cheaply according to their earnings yields:

CF Industries made noise during the Chinese Covid lockdowns and supply chain disruptions. One of the fertilizer producing giants, they are still operating near the top of their cycle with a near 20% earnings yield based on EBIT:

This above three year chart represents the Covid spike, which has been amazing to say the least. Investors are not so rosy on the future as we can see in the 1 year chart below :

APA Corporation , the holding company for the multi-national Apache, is a large cap play on the upstream part of the oil and energy market. As evidenced by stubbornly high oil prices, a depleted strategic reserve, and new ban on oil leases in Alaska, upstream is in a high momentum cycle and could have more left to run. It's top spot on this Magic Formula list shows they are clicking on all cylinders:

The dividend list

Now that we have the top overall performers out of the way, let's drill down on the top 10 dividend payers exclusively. These are sorted by yield.

YIELD

Drilling down on just a dividend-centric play for this month's large-cap Magic Formula would give us an average yield of 3.63% . As most will find it difficult to spread their money evenly across thirty bets with various share prices, even weighting these top 10 would be a good angle for the dividend centric long-term compounder. Even weighting is also the approach that Joel Greenblatt recommends when buying a Magic Formula portfolio.

Trends

This month is showing a common trend in the larger dividend payer deals. 5 of the 10 on the list are health care related stocks, a sector which normally trades inversely to tech. Two of the few larger outsized bets I've made this year have been in Johnson & Johnson ( JNJ ) and Amgen ( AMGN ). Health care looks like a good place for yield at the moment.

Know your limits, yourself and your sleeping point

Back to Taleb, he is very aware of himself and his limits. He is comfortable being an options trader because he can not sleep well at night holding a long position. We all must ask ourselves the same question. Here is a great analogy from Burton Malkiel on an encounter by J.P. Morgan :

J.P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, ‘What should I do about my stocks?’ Morgan replied, ‘Sell down to your sleeping point’ Every investor must decide the trade-off he or she is willing to make between eating well and sleeping well. High investment rewards can only be achieved at the cost of substantial risk-taking. So what is your sleeping point? Finding the answer to this question is one of the most important investment steps you must take.– Burton Malkiel

Since compounding models will show that buying right and holding on is the best long-term advice, we all need to find a psychological medium to achieve this. For me, this has been several indexing strategies mixed in with concentrated bets on big, broad market or sector pullbacks. I also mentally thrive in holding mostly institutional-sized companies that are S&P 500 size and larger. While I know small and medium-cap companies may provide larger, long-term returns, it simply does not fall within my sleeping point.

I do buy some smaller cap companies but in small quantities. I like to know that large institutions are my partners in these transactions. They typically only hold large caps. This is my strategy to prevent the psychological from becoming physiological and later psychosomatic.

Summary

The Magic Formula is still one of my favorite broad-based self-indexing strategies. I buy these lists in a price-weighted format for convenience and do not liquidate any of the positions unless I need capital for a bet I like better. I have even weighted with lump sums at certain intervals as well. Whatever personal experiment you'd like to conduct with the Magic Formula, you can be confident that the strategy gets you a cheap, high-quality cross-section of the US equity market.

For further details see: