In the recent column "Adding Your Two Cents May Cost You A Lot Over The Long-Term" Joel Greenblatt found that individual investors who put their own spin on the Magic Formula-selected stocks dramatically underperformed a portfolio of the entire Magic Formula list. These investors did so by picking and choosing stocks from the Magic Formula list of cheap and good stocks instead of just selecting all of them or by changing position sizing over time. Pickers and choosers lagged the default portfolio by almost 25% in the two year period between May 2009 and April 2011. By adding their own filters to the Magic Formula rules, these investors turned a winning formula for outperformance into underperformance relative to the S&P 500:
Cumulative Returns May 1, 2009 to April 20, 2011 | |
Portfolio | Return |
Raw Magic Formula | 84.1% |
S&P 500 | 62.7% |
Magic Formula with Investor Selections | 59.4% |
Professor Greenblatt classifies the self-destructive tinkering of investors into four behaviors:
Investors avoided the scariest stocks. Many of the stocks with the highest returns were boycotted by tinkering investors because the future outlook for the firm was too dire.
Investors changed strategies when their portfolios underperformed the market. This is the investing equivalent of envy: Nothing is worse than seeing your strategy underperform the broader market.
Investors changed strategies when their portfolios lost money. Losing money hurts and investors switch strategies when they feel pain.
Investors added to winning positions. Retail investors invested more money after their holdings did well. Unfortunately, this is "chasing returns" masquerading as prudence.
These tinkering investors were overwhelmed by cognitive biases. They should not avoid the scariest stocks since they cannot know the future and their intuitions are not superior to the financial metrics the Magic Formula is based on. Tinkerers should also resist the temptation to time the market in reaction to past performance since this investment strategy is not a momentum strategy.
Mental Toughness and Today's Magic Formula Stock Picks
Consider the following stocks which rank highest according to Greenblatt's Magic Formula:
Ticker | Company | Performance (Last 12 Months) | Analyst Recommendation | Relative Strength Index (14 Day) |
Almost Family Inc. | -46.3% | 3 | 84.34 | |
Amedisys Inc. | -70.1% | 3.3 | 60.66 | |
Apollo Group Inc. | 13.2% | 2.2 | 42.38 | |
Astex Pharmaceuticals, Inc. | -37.0% | 1.5 | 39.03 | |
Amtech Systems Inc. | -62.8% | 2.7 | 44.52 | |
Activision Blizzard, Inc. | 10.3% | 1.8 | 46.59 | |
Columbia Laboratories Inc. | -71.7% | 2 | 34.59 | |
Career Education Corp. | -53.6% | 3.3 | 62.56 | |
Cherokee Inc. | -32.2% | 49.77 | ||
C&J Energy Services, Inc. | 1.7 | 75.52 | ||
Capella Education Co. | -26.8% | 2.6 | 49.3 | |
Cray Inc. | 4.8% | 1.7 | 65.58 | |
Dell Inc. | 18.0% | 2.2 | 47.62 | |
DEXO | Dex One Corporation | -75.8% | 1 | 41.62 |
Dolby Laboratories, Inc. | -23.9% | 2.4 | 67.51 | |
Deluxe Corp. | 1.3% | 2.3 | 54.78 | |
Vaalco Energy Inc. | 12.7% | 3 | 74.46 | |
ITT Educational Services Inc. | 2.8% | 2.5 | 61.09 | |
FriendFinder Networks Inc. | 2 | 70.95 | ||
Forest Laboratories Inc. | -6.8% | 2.6 | 56.67 | |
GameStop Corp. | 17.6% | 2.2 | 45.55 | |
GT Advanced Technologies Inc. | -17.8% | 2.3 | 58.93 | |
Gentiva Health Services Inc. | -70.7% | 3.2 | 62.05 | |
H&R Block, Inc. | 17.0% | 2.2 | 43.06 | |
InterDigital, Inc. | -31.7% | 2.8 | 50.41 | |
Korn/Ferry International | -29.7% | 2.4 | 42.03 | |
Kulicke & Soffa Industries Inc. | 13.7% | 2 | 62.68 | |
LML Payment Systems Inc. | -52.0% | 40.94 | ||
ManTech International Corp. | -14.4% | 3.1 | 57.77 | |
Multiband Corporation | 24.8% | 1.7 | 60.56 | |
MDF | Metropolitan Health Networks | 64.1% | 2 | 56.65 |
Motorcar Parts of America Inc. | -44.9% | 2 | 71.43 | |
MRX | Medicis Pharmaceutical Corp. | 21.5% | 2.5 | 46.51 |
Microsoft Corporation | 19.4% | 2.1 | 76.35 | |
Northrop Grumman Corp. | -1.3% | 2.9 | 57.1 | |
Nevsun Resources Ltd. | -35.7% | 3 | 36.06 | |
Nova Measuring Instruments | -21.3% | 1 | 41.3 | |
Osiris Therapeutics, Inc. | -33.3% | 4 | 34.74 | |
PDL BioPharma, Inc. | 44.2% | 2.8 | 53.15 | |
Raytheon Co. | -0.3% | 2.4 | 60.6 | |
SAIC, Inc. | -21.6% | 3.1 | 55.58 | |
SanDisk Corp. | -7.3% | 1.9 | 48.2 | |
TeleNav, Inc. | -36.2% | 2.8 | 42.89 | |
Unisys Corporation | -52.0% | 3 | 47.93 | |
United Online, Inc. | -13.9% | 2 | 54.37 | |
USA Mobility, Inc. | -8.1% | 56.71 | ||
USANA Health Sciences Inc. | 11.4% | 2.6 | 72.46 | |
Veeco Instruments Inc. | -41.2% | 3 | 68.11 | |
Exelis, Inc. | 2.5 | 69.36 |
Clearly, these stocks tempt investors to tinker with the portfolio! Notice that only six of these stocks have an analyst recommendation higher than three. Since three is a hold rating, most of these stocks are dogs according to analysts. Even scarier, 30 of these stock prices have dropped over the past year. Twenty of these stocks have underperformed the market based on their two week relative strength indices.
Conclusion
Investors should not try to casually time the market or pick stocks based on feelings. If these temptations are overwhelming, investors should not use the Magic Portfolio. However, if an investor is tough (or careless) enough to not tinker, the Magic Formula remains an attractive stock selection strategy.
Please read the article disclaimer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
