BOGOF

“Jewel-Osco is running BOGOF today… got to hit the supermarket”, my wife proclaims from time to time. Other times I will be sent off on a grocery shopping run with the following list:

• Crest Toothpaste (BOGOF)
• Oranges (BOGOF)
• Oreo Cookies $2.99 / pack.

So what exactly is “BOGOF”? It basically stands for buy one get one free. That is my lovely wife’s definition, as she goes out on a mission to save money for the household. What I define BOGOF as, is basically opening up of my fridge to a Florida orange farm, or opening up my freezer to about 100 lbs of chicken breast packs sliding away and landing on my feet at 6am.

What does this have to do with the stock market? Well, let’s take my wife’s true definition of BOGOF. With the Dow Industrials taking a massive plunge of more than 5% since the start of the year, a lot of stocks have been taken down like a typical UFC fight. Some stocks are now entering the BOGOF territory from their highs of just a few months ago. With ten grand sitting around, I have to take advantage of this opportunity and wade in. The recent sell off has also brought to mind a recent book I read from Joel Greenblatt titled, “The Little Book that Beats the Stock Market”. It is quite an easy and interesting read, and I highly recommend it. Mr.Greenblatt’s system is very simple and I decided to try this out. His system is to buy stocks with high earnings yield (a company’s earnings relative to the share price) and a high return on capital (how much a company earns based on its investments in capital, stuff like machines, delivery trucks, robots, and such). I am somewhat simplifying his formula, as he uses a slightly different formula for earnings yield and return on capital to level out differences in taxation between companies. You can read more about the details of his approach in the appendix section of the book. The system requires an investor to buy sets of 5 to 7 stocks every quarter until you have about 20 to 30 stocks after one year. As each stock matures to the one year mark, you need to dump that set, and buy a new set of stocks based on the same set of criteria. He has made it easier for the average investor by creating a site which returns a set of stocks which pass these criteria daily (http://www.magicformulainvesting.com/).

He back tested this formula over the last 17 years with great success, earning returns of over 30%. That is quite impressive. So impressive I decided to give it a shot with my portfolio. The problem with the magic formula web site list is that it is not ranked in the order in which the book describes, and his return on capital data values are aggregated into quartile buckets. His list is ranked in alphabetical order so I can’t really tell which stock ranks at the top. So I decided to run similar criteria by doing the leg work myself and see how many companies overlapped the list from the magic formula site. Using a stock screener, I set it up using the following set of criteria:

• 5 to 15X P/E (trailing twelve months). Picking the stocks with the lowest P/E ratio is pretty much the high earnings yield definition Mr.Greenblatt speaks about in his book.
• Return on Assets (ROA) > 20%. This is similar to the high return on capital criteria the book describes.
• Removed all international companies (ADR’s) and ETF’s

You can download to see the complete list. To get the ranking as the book described, I sorted by P/E ratio from smallest to largest and assigned the rank to each stock starting with 1. I then sorted the same list but this time by return on assets from largest to smallest and assigned the rank to each stock starting with 1. I summed up both columns to get the final score for each stock and sorted the list again by this new summed up column.

As I cruised down my list there were a few names I recognized (Coach, Moody’s, Herman Miller, etc.). I then cruised over to Mr.Greenblatt’s list to find some overlap, but not all. The differences exist because of the slight variations in the formulas we used for earnings yield and return on capital. That’s ok though because the concept is relatively the same and I needed to see that ranking. It was time to make my first set of picks for my portfolio. I walked down the list looking into each company’s story, what their business was, and how strong it was especially in light of the worsening economic picture in the US. Following the system, I had $2500 to spend ($10,000 divided by 4 quarters) in the first quarter of 2008. I decided to pick 5 companies so I would end up with 20 stocks by year end. The following is my first set of buys that I made on Jan.16.2008:

Symbol	Company	Quantity Purchased	Purchase Price
NTRI	NutriSystem Inc.	21	23.65
DST	DST Systems Inc.	7	73.60
TRMS	Trimeris Inc.	70	7.01
IVAC	Intevac Inc.	43	11.37
PCU	Southern Copper Corporation	6	88.98

We’ll see how this set performs a year from now. The proposed benefit of Mr.Greenblatt’s system is that you don’t really have to think, because the “magic formula” he describes does the work for you. The two screens he uses, makes good business sense. I’m a bit weary of anything termed “magic”, so I’ll be walking through each of these 5 stocks in the next set of posts to explain their story and do a good discounted cash flow valuation on each. One of my goals when I started this site was to keep things as simple as possible and try to make common every day sense out of all the financial jargon. I can’t explain discounted cash flow in a few sentences, so I’ll try to explain the process using some simple examples and apply them to my stock picks. I’ll also refer some books that I think explain such financial topics very well.

Not everyone is a fan of Mr.Greenblatt’s system. A review from the guys at Motley Fool labeled him in 2006 article as one of “Wall Street’s worst stock pickers”. Ouch. In any case, I’m going to test Mr.Greenblatt’s approach anyways. NPR covered an interview of Mr.Greenblatt a few years ago which is pretty good.

Each bit of analysis takes some time, so I’m already behind. As my wife proclaims, it’s BOGOF time! I need to start making my shopping list for the 2nd quarter. Happy trails… you’ll need it in this punishing environment.