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So-called 'systematic value' strategies that use fixed rules to hunt down companies with strong quality characteristics at attractive prices are not only naturally appealing to many investors, but also the basis of some of the world's most admired Guru inspired models. But while the concept of investing in 'cheap' and 'good' companies may seem intuitive, one of the most famous examples of this approach has endured a protracted period of underperformance in the UK... until recently.

The strategy in question is the 'Magic Formula' - an approach devised by Joel Greenblatt, who cemented his reputation as a star fund manager after producing 50% annualised returns at Gotham Capital over a 10 year period. In his now famous book that followed - The Little Book That Beats The Market - Greenblatt spelled out to individual investors how they could free themselves from the shackles of underperforming funds by using a Magic Formula for finding cheap, good quality shares that would improve their returns.

Inspired by the value investing principles of Benjamin Graham, Greenblatt's Magic Formula was hardly as mystical as it sounded. He introduced two simple measures to rank every company in the market, adding them together to produce an overall Magic Formula score. The first of the two metrics is Earnings Yield, which is a measure of how much profit a company 'yields' in proportion to its value - the higher the earnings yield, the cheaper the company and the more bang for you get for your buck. Greenblatt's second metric is Return on Capital, which is an indicator of how efficient a company is at generating a profit from the investment it makes in itself - the more profitable the company is, the higher the perceived 'quality' of the stock. You can read more about the precise workings of the Magic Formula here.

Has the magic gone?

Greenblatt claimed that his backtests over 17 years to 2006 showed that a portfolio of around 30 companies with the best combination of both metrics would have produced a very impressive annual return of around 30.8% per year - a return that would turn £10,000 into almost £150,000 over 10 years! But he also cautioned that the Magic Formula wouldn't always work and there would be periods - perhaps running into a few years - when his methodology was likely to underperform. Until recently, our tracking of a Greenblatt-inspired Magic Formula model has indeed underperformed the FTSE 100. We have written extensively about why this might be the case and whether the now eight-year-old formula is still (or ever has been) an effective route to systematic value. Recent work by by Dr Wesley Gray and Tobias Carlisle (which Ed has written about) claims that Greenblatt's methodology actually overpays for quality and that a greater focus on value produces better results. However, more recent academic research counters Gray and Carlisle's assertions by suggesting that it is better to weight one's portfolio more heavily towards quality - so perhaps the Magic Formula actually sits pretty in the centre of the argument.

But while all this has been going on, our version of the Magic Formula has tentatively broken out over the past month - producing a 5.0% return against 1.0% for the FTSE and taking the screen's 1-year performance up to a respectable 19.7% (see chart below). So is Greenblatt's assertion that patience is critical and that his strategy will always eventually outperform actually coming true? Well, we're not the only ones to have recorded some positive momentum in the screen recently. According to Societe Generale, which tracks a handful of popular investment screens on a monthly basis, Greenblatt's Magic Formula enjoyed a strong month in August, with their long-only UK portfolio up by 3.3%.

(click to enlarge)

Among the best performing stocks in the current Stockopedia-tracked Magic Formula portfolio, is Renew Holdings (LON:RNWH) , the infrastructure engineering services business, which has seen its shares rise by 37% to 140.5p since the start of August. Over the same period, oil services group Kentz (LON:KENZ) has seen its shares rise by 28% to 550p on news of two separate (but rejected) takeover approaches. Meanwhile, UTV Media (LON:UTV) , the broadcaster that runs talkSPORT radio, has risen by 20% to 190p despite an underwhelming set of half-year results (as discussed by Paul Scott here). Engineering consultancy WS Atkins (LON:ATK) has also been a major contributor to the portfolio, rising in price by 40% to 1236p since early June following news that many of its divisions had made a strong start to the year.

Casting a new spell

With all but three stocks in the 25-strong Magic Formula portfolio recording positive gains since it was rebalanced at the start of June, Joel Greenblatt's approach to systematic value appears to be finding form. With the quarterly rebalancing due later this week, it will be fascinating to see whether new entrants to the portfolio can help keep up that outperformance. After a prolonged period when the strategy struggled to match the momentum of the wider market, it could be that Greenblatt's insistence on being patient will now be rewarded.

Source: Why Joel Greenblatt's Famous Formula May Not Have Lost Its Magic