Perfect World's Magic Formula

By Charly Travers | More Articles
August 11, 2010 | Comments (1)

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Do you want to invest in stocks but find that you have too many demands on your time to research companies? You have a demanding job, want to spend time with your family, and have a hobby or two.

If you want low-fuss investing options that aren't mutual funds or exchange-traded funds, you should consider a mechanical investing strategy. One of my favorites is Joel Greenblatt's Magic Formula. You can read all about it in his book The Little Book That Beats the Market. This is a great book because it is short, easy to read, and it will help you make money.

Is it cheap?
Value investing is a proven strategy and the first part of the Magic Formula is to screen for stocks that are cheap. The valuation metric that Greenblatt uses in his book is the earnings yield, which he defines as EBIT / enterprise value. EBIT is the profitability (i.e., earnings) of the business before interest payments and taxes. Enterprise value reflects the market value of the company's stock – its market capitalization -- plus the company's net debt. A company that is generating $1 of EBIT for every $10 of enterprise value has an earnings yield of 10%. For a stable business, the higher the earnings yield the cheaper the stock. The Magic Formula requires an earnings yield greater than 10%.

Is it a good business?
Sometimes stocks are cheap for a good reason. The business may be falling apart, for example. You wouldn't want to buy shares of a company that is statistically cheap if it is on its way to going out of business. This is why the second part of the Magic Formula is to screen for healthy businesses. Greenblatt recommends using return on assets greater than 25%. What that means is that for every $4 in assets -- things like inventory and manufacturing plants for example -- the company is able to generate $1 in after-tax profit. As a general rule, low ROA is a sign of a poor business and high ROA is a sign of a strong business.

Putting the formula into practice

Company	Enterprise Value	EBIT	Earnings Yield	ROA
Perfect World (Nasdaq: PWRD )	$1,043	$172	16.5%	26.1%
Shanda Interactive Entertainment (Nasdaq: SNDA )	$1,297	$284	21.9%	10.7%
NetEase.com (Nasdaq: NTES )	$4,018	$306	7.6%	16.3%
Changyou.com (Nasdaq: CYOU )	$1,190	$179	15%	32.7%

Sources: Capital IQ, a division of Standard & Poor's, and author calculations. Dollar amounts in millions.

Here's an example of the Magic Formula applied to Chinese video-game companies. With an earnings yield of 16.5% and a ROA greater than 25%, Perfect World meets the criteria of the screen as does Changyou.com with its 15% yield and sky high ROA. Both of those companies would be suitable for purchase by an investor following this mechanical strategy. Shanda has an earnings yield much higher than the 10% threshold; however, it falls short on the ROA criteria and as a result would not be selected by an investor using this strategy.

The Foolish bottom line
The advantage of the Magic Formula for the time-pressed investor is that all you need to do is run the screen and buy the stocks. You don't need to do all the time-intensive fundamental analysis most stock pickers do. Instead of figuring out if you trust management, analyzing the competitive landscape, or poring over financial statements, you get to spend your free time enjoying the activities you like.

Since there is no guarantee that any individual stock that meets these screening criteria will make you money, you need to buy a basket of stocks ranging from five to 30 companies. Once purchased, you hold them for a year to get long-term capital gains tax treatment. After one year has passed, you sell them all and run a new screen. Rinse and repeat.

Like many strategies, this mechanical approach doesn't work every year. Assembling your basket of stocks is the easy part. The hard part is psychologically sticking with the strategy when it's underperforming. That's an important part of making this approach work and you have to be honest with yourself before you get started about whether you have the patience to stick to this strategy year in and year out. It does work, but you have to give it time. If you've used the Magic Formula before or are thinking of giving it a try, share your thoughts with the Fool community in the comments box below.

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Charly Travers does not own shares of any company mentioned in this article. NetEase.com, Perfect World, and Shanda Interactive Entertainment are Motley Fool Rule Breakers picks. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment icon found on every comment.

Report this Comment On August 11, 2010, at 3:08 PM, ParkerAllen wrote:

Hi. I play the game and I made an account here just so I could post about this stock.
This game (PW has many games, but one main game, and that is Perfect World International, which will be referred to as PWI for the remainder) has been on a downhill slope ever since last year.
In September of 2009, the game introduced what was to be called an Anniversary Pack, in honor of the game reaching the 1 year mark. The packs cost $1 from the cash shop. The packs had a 3% chance to contain "endgear items" and the rest with tokens of luck. The tokens could be exchanged for some relatively useful items, but the endgame items were just amazing. Things that used to take months to acheive were now randomly awarded from a $1 pack.
Players started charging money to the game by the thousands. You can see how stocks went up because of this. Everyone wanted to get those endgame items.
It quickly became apparant to some that these endgame items took some of the fun out of the game. You now didn't need to work for your items. But that didn't matter, since packs were supposed to only last a month.
PWI is unique in that it offers players the chance to purchase "gold" (cash shop currency acquired by charging money to the game) with coins earned in-game. Before these packs were introduced, gold prices were about 100K. When the packs came out, gold shot up to 300-500K. This was another source of discontent.
At the end of the month, packs were taken out as promised. A week or two later, now hungry for the money they just saw flow in from the sales, they were released again. Players were outraged, thousands of posts flew up on the forums about how this wasn't right, this was unfair, and many people quit the game right then and there.
But to a large majority of the cash shopping population, this did not affect them. They embraced the idea of attaining more items, ones they might have missed out on during the first sale.
Over the past year, there has rarely been a span of 2 weeks where some form of these packs have not been out. It has kept gold prices up and player satisfaction down. All player complaints are ignored, there are so many bugs with the game, and every maintenance seems to bring some new form of horrible game-ruining features.
They've lowered the amount of coins you are able to get in game from lowering prices of monster drops, equipment decomposition rates, and just recently they've taken out TW pay, which was large amounts of coins paid to players who participated in controlling the map. They said they did this to control inflation, when in reality, the packs that are still here give a special kind of token, where when you receive two, you instantly get 10 million coins. TW pay gives about half a billion coins weekly to players all over the server. These special tokens inject about the same amount of coin every day.
They have been pushing us and pushing us to the point where we cannot function in game unless we keep charging real money to this game. People that used to play this game for free now cannot keep up with the costs and are either being driven away or forced to charge money.
The company does not listen to player concerns, and with the latest patch, a mass exodus has occurred. Stocks will continue to plummet as this company and its horrible reputation drive this game straight into the ground.
If you own any of these stocks; sell out now.

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