Today I am going to introduce you to my own creation and contribution in the world of finance. It’s called the Magic Number. I don’t think I’ll win a Nobel Prize for inventing an all-encompassing investing metric, but I do think it’s a contribution to investing that can help you more profitably pick stocks.
You may have heard about the Price / Earnings (PE) ratio or the Price / Sales (PSR) ratio as you have analyzed stocks in the past. The P/E ratio is probably the most common valuation method known to mankind.
It’s also incredibly flawed.
You see, more and more companies are resorting to gimmicks to pull the wool over our eyes as investors. It’s unfortunate we live in a world of short-termism where companies must beat Wall Street expectations on a quarterly basis or be severely punished with a lower stock price.
Management is highly incentivized to keep the stock price up because they have a lot of wealth tied to their company through stock, stock options, and bonuses paid based on financial performance.
So, when the business hits a bump in the road, instead of being open and honest about it, they pull a few shenanigans to make the numbers look better than they really are. It’s just a mirage to paste over short-term, or long-term problems.
Like a mouse on a treadmill though, eventually this leads them nowhere and management will have to deliver the bad news that the company has fallen short of expectations. Down goes the stock price with that news.
Managing a business minute by minute is no way to live life. But, this is the world we live in today. So, if we are going to buy a stock, we might as well be assured that the numbers being reported are true and sustainable.
How do they get away with this?! Well, Generally Accepted Accounting Principles are called GAAP. And, the gap between GAAP and what management makes up with the stroke of a pen can be so wide as to drive a bus through it. So, we need to tread carefully when buying a stock.
This isn’t illegal. There’s a lot of gray area and interpretation of the rules. Consider an income statement. Revenue is at the top and earnings at the bottom. By the time you get to earnings, there’s a lot of levers management can pull to derive whatever net income they want to report. This is how big multi-national corporations hit the number on the head quarter after quarter to please Wall Street and investors. It would be virtually impossible for a company to project how it’s going to perform even over the short-term without resorting to financial engineering. But, this happens all the time.
The higher up the income statement that management is distorting, the bigger the problem. As you may have heard before, S**t flows downhill. For example, if management is aggressive with reporting of revenues, that’s a serious problem because everything flows from that line item on down.
By the time you get to earnings there could be a whole host of adjustments made. So, the P/E is meaningless in a world of companies just making stuff up.
A lot of people know this so they resort to using the Price / Sales ratio instead. Conventional wisdom assumes that it’s harder to manipulate revenue than earnings. Well, I am here to tell you that it is never safe to assume that it is safe to assume. In fact, I have made a whole career from betting against companies that mess around with their revenues. It’s my number one strategy for betting on the decline of a stock.
In my book, What’s Behind the Numbers? (McGraw-Hill, 2012) I wrote a chapter on the many ways that management can manipulate revenues. When they do so, it’s particularly dangerous for a stock because there’s no reason for management to play games with revenues unless demand for their product is softening. It doesn’t matter whether they sell shoes, software, pizza, hearing aids or whatever.
So, I take the Price / Sales ratio with a huge grain of salt too. When companies resort to revenue chicanery Wall Street often defends them by saying “well, they have top notch customers so they will collect on that revenue”. Of course, Wall Street has this totally wrong. It’s not whether the company will collect the revenue, but when they record the revenue on their books.
If they booked revenue today that otherwise would have been recorded at a later date then they have stolen from the future to benefit the present. Now they have to find a new customer down the line to replace the revenue they pulled into the present. If demand was strong for their products in the first place, they’d never play hanky panky.
Enter the Magic Number.
The Magic Number?! What’s so Magical about it?
Nothing really. The word “magic” grabs your attention. It has some intrigue and is mysterious. After all, if I called it by what it is, it might seem boooorrring and not grab your attention.
It’s sort of like beef tenderloin versus filet mignon. Filet mignon sounds fancy. Plus, a restaurant can charge about $35 or more for filet mignon versus $28 for beef tenderloin even though it’s basically the same thing.
But, I’m not charging you anything. The first 25 scores each quarter are free of charge. You just have to supply a valid email address to receive the list and receive communication from me. Other than that, there’s no obligation.
So, let’s dig in. The Magic Number distills into one metric the quality of the earnings a company reports. It’s essentially the Price / Earnings Quality ratio. This is important because we know earnings can be manipulated. The Magic Number was developed to overcome the flaws in common valuation metrics like Price / Earnings and Price / Sales. Rather than take the numbers a company reports at face value, I make adjustments to come up with a metric more useful to valuing a company based on how true and sustainable to reported financial results actually are, and not what management is telling you.
This isn’t a court of law. This is your money. It’s your hard-earned cash. Therefore, it’s better to assume every company is guilty until proven innocent. And, just like the great hitter Ted Williams in baseball or renowned investor Warren Buffet, you do not need to swing at every pitch.
Wait until there’s a mistake by the market. A hanging curveball of sorts and then unleash your capital just like Williams catching the ball with the fat part of his bat.
I’ve been using the Magic Number for years as a quick and easy way for me to focus my attention on companies to bet against. I’m a short seller by trade. That means I bet on stocks to go down. Think of me a bit like a financial detective. I’m looking for the worst of the worst. The bottom of the barrel.
What I have found in both testing and in real-time is that the Magic Number is actually quite good at determining which stocks are good to own. It’s performed very well in both testing and in the real world. In fact, the performance is better when it comes to owning stocks than trying to find good shorting opportunities.
The Magic Number is a component of a much more comprehensive model called The Forensic Accounting Stock Tracker (FAST). I developed the FAST model to help quickly narrow down the universe of stocks that I wanted to focus on. The model uses dozens of factors to score companies A-F, like a report card grade, on revenue recognition, cash flow quality, earnings quality, shareholder yield, valuation, and expectations.
My initial try at this not only worked great, but it was statistically significant. That meant that it was likely to work well in the future. After nearly a decade of real-time use, I am exceedingly pleased with the results.
Initially, FAST was a bit ugly. It was just me using it. Then a few years ago I was approached by a major Wall Street firm make it commercially viable. They had been using my book to help market their own stock selection software program.
Their clients were paying big money for this data.
While it was a great opportunity for me, a formal deal never came to fruition. So, now I have software that I can use on my own or provide to others as I see fit. It’s not much different than what some of the biggest institutional investors use. Except, I have developed some homegrown, proprietary metrics. And, in the past I have had clients pay me $25,000 or more per year for this type of analysis.
Why am I giving the Magic Number away? Well, I am only giving away the top 25 small and mid-capitalization stocks based on the Magic Number each quarter. As a portfolio, over time, this has done well. It’s important to realize that anything can happen with any individual stock. Use it as a starting point to do more research and don’t just blindly follow any metric.
Many of the stocks at the top of the list look pretty ugly on the surface. But, as I always say “ugly stocks make beautiful investments”. If it were all champagne and caviar there is no way you could out-perform the broader market because it will be reflected in the price of a stock. What the Magic Number gives you is often a stock with reasonable value, low expectations, and good earnings quality. It’s a great starting point to do more work on a stock. Or, build an entire portfolio.
The FAST model has may more inputs that I find help enhance the analysis and flag more risks.
How’s FAST performed?
The top ranked stocks have out-performed the market by over 13% annualized since 2000.
Over time, that adds up.
In 17 ½ years that’s over 1,100% total returns adjusted for commissions and trading.
I’m not giving away the formula because sadly people steal stuff these days and don’t give credit where credit is due. Or, they create investment products and don’t properly compensate folks for their ideas.
If you’re interested in a more comprehensive model that uses accounting forensics, then my Forensic Accounting Stock Tracker (FAST) is available. Think of FAST as CSI for your stock portfolio. It’s an institutional quality product available to the everyday investor at a reasonable price. It covers 1,500 + stocks across many factors that help determine where there are clear skies and where there are landmines. It can help you up your game and have some of the same types of metrics as the very biggest global asset managers. Subscriptions are strictly limited too.
You can learn more at forensicstocks.com.
So, what are you waiting for? To get the Magic Number’s top 25 small and mid-cap stocks just subscribe here below.