Magic Formula Version 2.0?
In Joel Greenblatt's book "The Little Book That Beats the Market" he developed a quantitative investing strategy known as the "Magic Formula." The Magic Formula seeks high quality stocks at low prices by looking primarily at two metrics: the earnings yield ("EY"), defined as Operating Income/Enterprise Value, and Return on Capital ("ROC"). These two metrics are simple, logical, and presumably effective. Greenblatt is more than happy to tout the formula's back tested results. In fact, he offers readers the opportunity to freely try the strategy on their own by visiting MagicFormulaInvesting.com, buying the top 30 - 50 stocks that the screener provides (you can change market cap minimums if you like), and rebalancing once per year.
Now, Robert Novy-Marx, assistant professor of finance at the Simon Graduate School of Business at the University of Rochester, New York, and a faculty research fellow of the National Bureau of Economic Research, has created his own dual-metric "magic" formula that claims superior, back tested results. How does it work? Mr. Novy-Marx explains:
I employ gross profits-to-assets and book-to-market as the quality and price signals here because these yield trading strategies that are far more profitable than strategies based on ROC and EY.
And unlike Mr. Greenblatt's strategy, whose higher returns are frequently attributed to buying small-cap stocks, Novy-Marx's back tested results came using only large-caps.
The signal in gross profitability is extremely persistent, and works well in the large cap universe. Profitability strategies thus have low turnover, and can be implemented using liquid stocks with large capacities.
Novy-Marx says that value investors who base their decisions strictly on price signals could benefit from the diversification added by incorporating quality stocks, and those who base their decisions on quality with little regard to price would benefit from incorporating stocks based on price signals. The back tested results look to confirm this. The joint price-value strategies performed better and with less risk than either alone in most periods.
In order to replicate this investment process, an investor would have to:
- Take the top 500 largest non-financial and non-utility stocks,
- Rank them according to price using Price-to-Book (Book-to-Market),
- Rank them according to quality using Gross Profits-to-Assets,
- Sum the two rankings to determine each stock's combined ranking,
- And purchase the top 150 stocks with lowest combined ranking with the option of shorting the bottom 150 with the highest combined ranking if using a long/short strategy.
I followed this ranking process and, for the sake of brevity, present the top and bottom 300 as compiled on March 6, 2013.
Top 30 Stocks
Apollo Group Inc.
Best Buy Co. Inc.
J. C. Penney Company, Inc.
Abercrombie & Fitch Co.
Murphy Oil Corporation
Quest Diagnostics Inc.
The Interpublic Group of Companies, Inc.
The Washington Post Company
Western Digital Corp.
Harman International Industries Inc.
Forest Laboratories Inc.
Big Lots Inc.
CVS Caremark Corporation
Waste Management, Inc.
Marathon Oil Corporation
Bottom 30 Stocks
Kinder Morgan, Inc.
Delphi Automotive PLC
H&R Block, Inc.
United Parcel Service, Inc.
Kraft Foods Group, Inc.
Ford Motor Co.
Western Union Co.
Altria Group Inc.
Rockwell Collins Inc.
Range Resources Corporation
Deere & Company
Goodyear Tire & Rubber Co.
Cabot Oil & Gas Corporation
FMC Technologies, Inc.
Wynn Resorts Ltd.
Automatic Data Processing, Inc.
American Tower Corporation
Williams Companies, Inc.
Lockheed Martin Corporation
Crown Castle International Corp.
Plum Creek Timber Co. Inc.
Note: I began with the S&P 500 and eliminated financial and utility stocks without replacing them. Therefore, my investment universe was approximately 400 companies, less than the 500 used in the back test.
It will be interesting to see how these stocks perform over the next year.
Keep in mind that this methodology of ranking stocks against one another is all relative value. If the entire universe of stocks is overpriced, as is the case in a bubble, then you will only be choosing the best of the worst. That should still allow you to perform better than the overall market, but it will not help those seeking absolute return.
Likewise, if everyone began investing using this formula then efficient pricing would eliminate this strategy's excess returns. Regarding the Magic Formula, Greenblatt confidently stated that scenario is unlikely to happen because most investors would abandon the strategy during the years of the formula's underperformance, and he is probably right. Still, I would advise interested investors to use the formula as a way to find interesting stocks for further research. In other words, don't put blind faith into it.
To read Mr. Novy-Marx's full study with more details on the various investment strategies that can be utilized with his formula, click here. I also want to thank the excellent investing blog Greenbackd for bringing this study to my attention.Disclosure:
I am long WAG, PSX, INTC, ABT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.