Wall Street has its share of axioms. Two fairly well known ones are "the trend is your friend", and "winners keep winning". Both of these are applicable to momentum based investing, a field of technical analysis. However, the Magic Formula Investing screen is strictly a quality at low prices strategy, a decidedly value based approach.
However, we've applied alternate statistics to the MagicDiligence universe of stocks before. For the record, that's two Magic Formula Investing screens: the top 100 stocks over 50 million market cap, and the top 50 over 2 billion market cap. But we want to make sure that these alternate statistics have been proven to add value in choosing stocks. After all, there is little reason to list all Magic Formula stocks with a 4-letter ticker if that filter has not been shown to add value in the form of better returns!
To answer this question, I turned to a valuable resource, James O'Shaughnessy's 1998 book What Works on Wall Street (read the MagicDiligence review). This book is very useful for Magic Formula investors, as O'Shaughnessy focused his strategies over a one year period, just like Greenblatt's strategy. He also compiled these strategies over 45 years of data from 1951-1996, a sufficiently long period that included both tremendous booms and deep recessions. Greenblatt, on the other hand, used a much shorter 17-year period.
O'Shaughnessy's findings related to relative strength were fairly striking. In the book, "relative strength" simply refers to a stock's price performance vs. a benchmark, such as the S&P 500, over a 12 month period. O'Shaughnessy found that choosing stocks based solely on relative strength was a strategy that outperformed the market. However, when adding relative strength to value based filtering like price-to-earnings (P/E), price-to-book (P/B), or price-to-sales (P/S), significant increases in performance resulted. These are the annualized returns using these strategies over the 45 year period:
|Stocks with Lowest||Without Relative Strength||With Relative Strength|
Clearly, adding a relative strength component added significant value to value-based screening strategies. Therefore, it makes sense to further filter our Magic Formula universe to the stocks with the best relative strength to find what may be interesting investment opportunities. So, here are the top 10 Magic Formula stocks ranked by 12-month trailing relative strength against the S&P 500:
|ViroPharma Inc (VPHM)||77.07%|
|Innophos Holdings (IPHS)||68.70%|
|Cal Maine Foods (CALM)||35.16%|
|Vaalco Energy (EGY)||32.80%|
|King Pharmaceuticals (KG)||32.46%|
|Exxon Mobil (XOM)||26.71%|
|Dynacq Healthcare (DYII)||20.18%|
|Acuity Brands (AYI)||18.99%|
|Versant Corp (VSNT)||17.21%|
Conversely, here are the bottom 10 Magic Formula stocks (in the MagicDiligence universe), those stocks that have most underperformed the market over the past 12 months:
|Foster Wheeler (FWLT)||-44.96%|
|Healthways Inc (HWAY)||-44.72%|
|McDermott International (MDR)||-44.08%|
|Graham Corp (GHM)||-44.02%|
|Manitowoc Company (MTW)||-41.72%|
|CTC Media (CTCM)||-40.76%|
|Seagate Technology (STX)||-40.13%|
|AgFeed Industries (FEED)||-39.36%|
|Gannett Company (GCI)||-38.46%|
That's not to say that these stocks will continue to underperform. The biggest gains are often made when buying at or near the bottom. However, historical research has shown that buying on the way up has been a better mechanical strategy. Some of these may prove to be attractive investments after applying due diligence.
You may have noticed that price-to-sales was by far the most successful single value statistic in O'Shaughnessy's studies. We will take a look at Magic Formula stocks by price-to-sales in the next article.
Disclosure: Steve owns no position in any stocks discussed in this article.