One of the compelling things about the Magic formula is how well-defined the buying and selling is. Unlike other investment strategies, Magic Formula investing not only gives you a list of stocks to buy, it also details a clear time frame for buying and selling your stocks. “Selling” is in italics because other services make stock picks, but knowing when to sell is often the hard part. I was a subscriber to the Motley Fool Stock Advisor service for several years and one of the many criticisms I have with their service is they are reluctant to tell subscribers to sell anything, even when their recommended stocks are clearly overvalued. When you buy a Magic Formula stock, on the other hand, you know you’re going to sell it in about a year, replacing it with another Magic Formula stock. What could be simpler? Well, there is a hitch…
You must keep an eye on your Magic Formula Portfolio
Take a look at this graph, from Google Finance, of Brocade Communications (BRCD) which appeared in the Magic Formula Investing Screener for part of 2016:
I bought this stock when I started playing around with Magic Formula stocks in a different account (this one is not currently in my portfolio). What should be jumping out at you is that, over a few days between the end of October and the beginning of November the stock shot up in price and then flat-lined at about $12.47 per share. This is because, on about November 2nd, 2016, shortly after I bought Brocade communications, it was announced that the company was being bought by Broadcom and the stock shot up in value to just below the sale price. This is normal when a company is acquired. Lucky me, but I was completely unaware of the purchase for weeks! Well, when you have all these stocks in your portfolio they become hard to keep track up – I guess it’s time to set some alerts or something.
What happens if you do nothing? Unless the sale falls through, which sometimes happens, the stock will be purchased as scheduled, which in this case is some time over the summer. That’s fine, but the price is going to be pegged at about $12.50 until the sale happens, so you would most likely be better off to take the money and run – investing it in another Magic Formula stock using the screener.
Tax Considerations
If your portfolio is not in a tax-protected retirement account then you must consider long-term capital gains vs. short term capital gains, the latter of which is taxed at a higher rate. If the sale is scheduled to take place after your one-year holding period is up you may wish to wait it out and pay less in taxes. If, on the other hand, the sale is scheduled to take place before you’ve held the stock for a year – and this was my case – there is no tax advantage in leaving your money parked in an investment that will never pay off more than it already has. Assuming The Formula works, you should re-invest. I did, but a couple months after I should have simply because I didn’t notice that anything was going on with the company at all!
This situation will happen to you – probably many times – if you continue using The Formula. And this is just one of the many little details, or nooks and crannies, in following this strategy. Despite its simplicity, you can’t just fire and forget. You have to check up on your stocks to see what’s going on. Maybe not every day, but once in a while. Most online brokerage accounts have a feature where you can set alerts that are triggered when an investment changes value over a certain percentage threshold in one day. Or maybe you could check one stock per day. Is this too much for you? Then forget Magic Formula Investing and go buy an index fund!
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