The site is run by Joel Greenbalt - a hedgie who returns an impressive 40+% p.a. return since 1985. The Magic Formula site is actually the extension of his book-The Little Book that Beats the Market. If you are interested, try pick it up and read. It is quite short, can probably read it within an hour without buying it from book shop.

What the magic formula says is that, Joel back tested the returns data of US stocks and found that by just buying stock that are ranked with high ROIC+Low PE, the portfolio of stock will outperform the market and most fund managers by a significant margin. Joel method is subsequently tested on international stocks and it is found to have similar characteristics, that is, if you buy stocks with low PE + high ROIC, you will beat the market.

The reason for the 20+ stock holdings is that, the Magic Formula do not require any due diligence and research, you just buy what the magic formula list tell you to do. So, a concentrated portfolio is not suitable in this case as stocks may be cheap for a valid reason. It may have problems that fundamentally affects its operations. Without research, you won't know these reasons. So, by buying 20 stocks, it hopefully will diversify away the risks of some stocks that will go to zero.

I think Buffett look at all of those. The differences between ROI, ROIC verus ROE stems from the type of return there are measuring. For ROI and ROIC, it incorporates both debt financing (e.g. banks and bond holders) and equity financing (e.g. stock holders like us), so it measures the total return of company in utilizing both type of financing. For ROE, it measures the return on equity financing only. The problem with ROE may be that, since it disregard debt financing, companies may generate extraordinary ROE by taking a lot of leverage. So, ROIC may be a better measure if companies employs a lot of leverage. Take the private equity firm Blackstone as an example, their ROE is impressive but if you look at the leverage, then it is a bit scary. Even Olam, the Singapore-based commodities trader, my school professor like them a lot and use it as a case study of good companies, I tell my prof that this company is doing crazy stuff and if things goes bad, can easily collapse. If you look at their leverage and what they are trying to do, you will understand why I say so. Or back to Malaysia, we look at Parkson, their ROE is pretty decent, above 20+% if I am not mistaken, but, if you look carefully, a lot of their assets is not stated on the balance sheet through the use of operating leases, so their ROE is actually overstated. If you bring those things back to balance sheet, their ROE is still very high, but it is achieve through the use of leverage rather than via operations.

So, at times, ROE may not give a good measure of a business if there is a lot of leverage. Using ROIC and ROI will allow users to easily compare across industry as it is not affected by their financing decision (e.g. how much debt a company holds). A Chinaman company with a lot of cash may looks bad when compared to a modern firm using some advanced but questionable theory like optimal capital structure. But, when compare based on ROIC and ROI, this Chinaman company may be better than all these so-called modern firms. This Chinaman company survive better during a crisis too. If Genting Malaysia were to leverage its balance sheet crazily like what Las Vegas Sands did, GENM would have one of the most impressive ROE in the world. At the peak before the crisis, it took LVS $7 dollars of debt to generate $1 dollars of revenue. LVS runs into trouble during crisis, but, they manage to take care of their debt. They could easily went bankrupt if not for their wealthy majority owner pump money into the company. But, that's was history, people already forgotten about that. Those who bought at the depth of the crisis would have made 20x their money buying LVS, but, hindsight is always 20/20.

The problem with red chips is that, there is a perception problem. I can't fault the investors for thinking so, in fact, now I am a bit worried about Red Chips myself after I talk to some people who have been to China and audited the accounts and stuff. Now trying to look really carefully at their accounts of proven fraud in Singapore and HK to see whether there are any similarities among them.

It is sometimes a bit hard for auditors to catch them because their method is a bit sophisticated at times. Plus, for Red Chips in Msia and Singapore case, it is generally audited by Singapore auditor or HK auditor. Now, for Singapore auditor, I am a bit worried, cause most of these guys are inexperience plus the command of mandarin among Singaporean is not that good. You stick them to China in a completely unknown environment, it is hard to pick up any funny stuff. Some of the fraud happen because the company manage to fake the cash balance by using short term loans into their account because they know the bank managers.

For those who are interested, there is this famous letter rumoured to be written by a fraudulent s-chip CEO on how they fooled the investors: Confessions of a S-Chip CEO

Yup. In fact, I will probably end up as one of them lol. Auditors are generally not that smart, the whole profession is overated. Malaysia and Singapore sama-sama saja. Singaporean are not that superior to Malaysian, it is just that they have a good government that are not corrupt.

US is very transparent. There is a reason why US stocks can sell for 15x PE and it is still considered cheap, it is because of their transparency. Even smaller companies have conference call and you can hear them. Management cannot disclose insider info to analyst. If want disclose, need to disclose to everyone, so insider trading is less. People see US like got a lot of problems with their company, a lot of fraudulent company. But, there are probably less than ten a year and most of them happen in the micro cap space i.e market cap less than USD100mil. But, if we take into account that US has 40000 listed companies, 10 companies blow up every year do not seems to be that much compared to Bursa who have a few hundreds company and probably we have one blow up every year. It is just that in US, things tend to get exagerated by the media. In Malaysia, the media tend to treat fraud less seriously. Probably also due to lack of good journalist that understand these frauds and can write a good story.