Saturday, 13 June 2015

Does the Magic Formula Really Work?

What You Will Learn
  • Understanding what the Magic Formula is and how to use it
  • Performance of the Magic Formula and whether it is achievable
  • Whether the Magic Formula is worth using going forward
That’s what you need to beat the market and that’s what the Magic Formula is supposed to do.
As a result of brilliant marketing, promotion and becoming a New York Times bestseller in 2005, Joel Greenblatt has turned the Magic Formula into a key strategy for many in the value investing and mechanical investing community.
Buy at least 20 stocks from the Magic Formula screening tooland then rebalance at the end of the year. Do this and you will beat the market, the book says.
little book that beats the marketGreenblatt wrote The Little Book that Beats the Market for his children who were aged between 6-15 at the time.
It’s written in plain English and 6th grade math to make it easy to follow along. This is the strong point of the Magic Formula theme.
Everything is very easy to understand. The concept is simple, the explanation is simple, but most important of all, the execution for investors is simple enough to do on their own.
In it’s most naked form, the Magic Formula is described by Greenblatt as
a long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices.

The Ingredients to the Magic Formula

Here is the formula courtesy of wikipedia. From beginning to end, it consists of 9 steps.
1. Establish a minimum market capitalization (usually greater than $50 million).
2. Exclude utility and financial stocks
3. Exclude foreign companies (American Depositary Receipts)
4. Determine company’s earnings yield = EBIT / enterprise value.
5. Determine company’s return on capital = ebit / (net fixed assets + working capital)
6. Rank all companies above chosen market capitalization by highest earnings yield and highest return on capital (ranked as percentages).
7. Invest in 20–30 highest ranked companies, accumulating 2–3 positions per month over a 12-month period.
8. Re-balance portfolio once per year, selling losers one week before the year-mark and winners one week after the year mark.
9. Continue over a long-term (3–5+ year) period.
Pay close attention to step 4 and 5 because they are the key driving formulas for it all to work.
  • Earnings Yield = EBIT / Enterprise Value
  • Return on Capital = EBIT / (Net Fixed Assets + Working Capital)
Earnings Yield is used because it targets companies with below-average prices. The idea behind of Return on Capital is to select good companies that are outperforming. This fits in line with what Greenblatt said
a long-term investment strategy designed to help investors buy a group of above-average companies but only when they are available at below-average prices.

The Magical Performance

So how magic is this Magic Formula in terms of performance? This table of values is from the revised 2010 version of the book.
and a better representation.
Starting with $10,000 the Magic Formula would have made you a millionaire by 2009.
The Magic Formula is famous for returning a 30% CAGR. From 1988 to 2004, it did achieve a 30.8% return, but the CAGR has declined significantly. No strategy can sustain a CAGR of 30%. Although the backtest in the book only provides data up to 2009, I wouldn’t count on 2010-2012 results showing vast out-performance.

The Magic Formula is a Fraud?

By popular demand, the Magic Formula will soon be added to the list of value stock screens, but the one thing that has held it back is the reliability of the backtest performed by Greenblatt.
I just don’t believe the results are as good as it seems.
What’s more, other blogs have tried to simulate the Magic Formula performance from the book, but none of them  have come close.

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